Sunday, January 09, 2005

Leverage, cheap credit and the punch bowl

Now that the Fed has made it clear that it is taking away the punch bowl, it is time for me to write on a topic I have been planning on writing for a while now - leverage.

Following the market bust of 2000 and the 9/11 tragedy, the Fed reduced interest rates to historic lows. Soon after that, various credit cards started offering some unbelievable balance transfers / cash advance offers. I spent a couple of months making sure that there were no fine-prints designed to fleece me later on - and then I jumped in.

Over the last 2 - 2.5 years, I have borrowed over 150K from various credit cards and invested in companies that are potential takeover targets and have recently been hit by bad news or warnings. Most of the borrowing was at 0%, with a very low one-time transaction fee and in some cases, no fees at all. If the rate was fixed and was a sufficiently long term offering, I borrowed at 1.9%, 2.9% and most recently at 3.7%. With each borrowing I made sure that the effective rate was less than the fed rate + inflation.

There may not be such a thing as a free lunch, but this one came very close to the real deal, especially if you had a near-certain forward income stream to borrow against. With each borrowing, I made an estimate of the monthly payment and the total time needed to pay off the entire amount.

Now that the punch bowl is going away, these offers have almost completely disappeared. I have paid off 80% of my borrowing and will be done with the rest soon. I used this to fund only my takeover speculation, and did not route it to fund short-term or day trades. That would have been very risky and would not have given the peace of mind I needed.

The most generous offers were from MBNA, Fleet (now Bank Of America) and Household Bank - a big Thank You to you guys. MBNA (KRB) itself is among my takeover bets! Discover was among the stingiest cards.

With some of these the offers were so simple, you could have reaped a profit by just borrowing and putting all that money in a 1-year CD! Or, if you were ok with a slightly higher risk, you could have gone after dividend yielding stocks that were battered by the downturn.

For the first year or so, I hesitated to recommend this technique to others. I did try later on to get a few friends to do the same, but couldn't convince anyone.

It could be a few decades before such a free lunch becomes available again. But as the minutes of the December Fed meeting indicated, the rates are going up for the foreseeable future. In fact, among the clues cited in the minutes as evidence that credit has become too cheap, is the recent increase in M & A activity. Now, we have really come one full circle!


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