Borrowing Money to Invest – Is The Strategy Back In Black?

by Mike Holman

This post has been written by Mike from Green Panda Treehouse. He is a financial planner and run several finance blogs within his online company. If you like this post, make sure to stop by Green Panda Treehouse and subscribe to his RSS feed.

When I contacted Mike to write a guest post at Money Smarts Blog, he asked me if I could share my vision on leveraged investing. I thought it would be a great idea to share my experience, as I bought my first house through leveraging and I also implemented the Smith Manoeuvre Strategy with my HELOC.

A few years ago, I was working as a banker in a very special sector; we were granting investment loans. I started in this new department back in 2003 and left at the beginning of 2008 (sounds like I may have known something back then ;-)). During those four years, I had helped structure financing for at least 200M$ in investment loans across Canada. During the last 2 years of work, I was working exclusively on investment loans over  500K.

Making money with the stock market was as easy as picking berries during summer time, the interest rate charged on investment loans was extremely low (prime +0% in most cases) and the only fools were the ones who were getting 5% on their GICs!

Only a few months after I started, I opened a 20K line of credit for myself and started my leveraging strategy. Between 2003 and 2006, I made enough money to put a nice cash down payment on my first house. Fortunately for me, I had stopped while the markets were still high.

2008 – The Year When People Cried when They Learned What a Margin Call was

I left the lending side in 2008 switching to a financial planner career opportunity. I remember the discussions I had with the guy I had trained to be my replacement as senior advisor on the leverage team. All he was doing, day in & day out, was margin calls. What is a margin call anyways? This is the worst call you can get apart from the police calling to tell you that your wife is dead:

“Hello, may I speak to Mr. Leveragedboy?”

“Yeah, it’s me”

“My name is Mr. Bad Ass Banker and I am calling to request the amount of $75,000 to be deposited in our account by the end of the week. If you don’t we will have to sell all your (losing) positions to pay off your investment loan”.

Silence on the phone…

A margin call is basically when the value of your investment goes lower than the level required by the bank. For example, if you have a margin clause at 0.90 and you invested $100,000, you will be required to maintain (at any moment) a minimum of $90,000 in your investment account. What happens when the market loses 10% within a week?…. well this is when you get a margin call!

In fact, this is what had caused a part of the high volatility levels of the market investors suffered during the last months of 2008 as Hedge Funds received margin calls for several millions of dollars.

After the Storm, the Sun Rises Again

Capitalism almost died of a heart attack in 2008, but survived the ride and was reborn sooner than expected in 2009. Now that we are slowly emerging from the fear of seeing the old continent going bankrupt, we can hear the evil words “borrowing to invest” coming back to our ears like an old Beatles song.

Markets are low as investor hesitation is still present and interest rates are still low too. This sounds like the perfect match for another investment loan rally! In any case, I seriously think it is a good time to borrow money to invest.

Why I think it is the Right Time To Leverage?

While people who had borrowed money in 2006 are still paying interest without really understanding why they had done such a “stupid” thing since their investments are still in red, I think it could be the perfect time to start a new investment loan. I agree that this technique is not for beginner investors, but if you know what you are doing, leveraging should be considered.

Here’s why:

  1. US companies are showing strong results but investors fear the market so they still undervalued.
  2. We have a strong dollar which allows us to invest in both Canadian and US currencies.
  3. Interest rates are still low.
  4. There are several high paying dividend Canadian stocks on the market. Enough to build a strong investment portfolio where dividends will pay more than interest costs.
  5. The level of liquidity (i.e. money sitting in cash accounts or money markets) is still very high. Once the fear is gone, we might see another peak in the markets.
  6. You now know what losing money means (if you were in the market in 2008) and have seen what happens if you stay in while people are selling (during 2009). You are now fully prepared to live with the leveraging risks.
  7. The most important reason of all: because everybody thinks it’s stupid to leverage! Buy when there is blood on Wall Street… and that’s all I e to say folks ;-)

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{ 5 comments… read them below or add one }

1 Mich@BeatingTheIndex

The key is to have a component of dividend payers that cover more than your interest. This is possible in this low interest rate environment. If your portfolio was to take a plunge again due to market conditions, at least chances are you won’t be paying that interest while you wait.

I started a HELOC portfolio recently, so far so good. I am in the “recovery slowing down camp” not the “double dip on the way” camp and have all the time in the world for the markets to recover!

2 Pete

I realize timing the market is a fools game, but getting into leveraged investing after the markets have gained 60%+ in the last year and a half seems like asking for trouble. Sure, if you go for stable dividend yield, price appreciation may not be a great concern.

And how are US companies showing strong results? They lower their ‘estimates’ many times leading up to earnings and everybody cheers when they ‘beat’. The big US banks have so much ‘off balance’ stuff it is impossible to fairly evaluate their balance sheet. The continued, allowed suspension of mark to market on their real estate holdings tells me this off balance sheet ‘value’ is pure fantasy. (ie: they are likely insolvent). Companies have “record cash levels”, but they also have near record debt levels. They are not investing in cap-ex or human-ex.

Unemployment in the US stayed steady at just under 10%. That’s only because they keep dropping millions of people from the “in the labour force” number. When you magically (and drastically) remove the number of people suposedly looking for work/working, of course the unemployment number will not get worse. Here in Canada for July we only lost what 9000 jobs? But look into the numbers and you’ll see something like 129,000 FULL time jobs were lost and 120,000 PART time jobs were created. In the long run, that does not lead to an economic rebound.

Canadian debt to income levels keep rising (we’re still sustaining our lifestyles on more and more credit). How’d that work out for the US? We’re just a couple of years behind them. It’s different in Canada is pure fantasy, too. Europe’s soverign debt problems were solved by broke European countries guranteeing to loan money to the broke-er European countries. US debt will hit 14 trillion soon, and China, well, they just make up numbers and build cities that nobody lives in.

The world is solving it’s debt crises by creating more debt, and you’re recommending borrowing money to invest in all of this?

Yes, I’m obviously a bear, but if anybody can show me (with math and real numbers) how the world can service its current debt level AND create economic growth without adding more debt then I’m willing to listen. Your 7 points sound great, but I always have trouble reconciling theories like that with real math.

Call me crazy.

3 Tracy

Some very interesting views and opinions. I don’t agree that capitalism almost died in 2008. It called a recession. We go through them every 10 to 20 years. It’s always been like that.

4 Multiple Egg Baskets

I concur with the last comment that you are essentially gambling with your money. However, I did the same strategy in 2009 to buy some POTASH stock and it definitely worked in my favour.

5 Mich@BeatingTheIndex

@Ryan,

While I agree with you regarding leverage for buying a house. I will have to disagree when it comes to investing being equaled to playing poker.
Borrowed funds or not, are you playing poker on behalf of your clients?
Investing has its inherent risks just like being alive and walking the street everyday. One will never be able to eliminate risk completely but between playing poker and investing, ill take my *chances* with investing for the long term!

Cheers!

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