As small investors drive equities to uncharted highs, might they be a risk to the system as well as themselves?   © REUTERS

Back in 2008, the world’s biggest banks were, infamously, leveraged to the hilt. Barely 3 per cent of their assets were funded with equity, down markedly on the level of prior years, as managers gorged on cheap debt finance to maximise profits and bonuses. Spoiler alert: it ended in tears.

Excessive leverage has often ended that way — from the panic of 1772, when an international credit squeeze helped trigger the American war of independence, to the global financial crisis, when losses rooted in the US subprime mortgage bubble caused economic turmoil.

So what about now? The debts of governments and companies have spiralled, exacerbated by the economic pressures of the pandemic. Average consumer debt may be down a little in some countries, thanks to injections of government support, but the trend is likely to be shortlived.

There is one subset of personal debt that is particularly worrying: that taken on by have-a-go investors to magnify their bets on the soaring stock market.

Much attention has been paid to the recent “populist” investment craze focused on a few unloved stocks. GameStop shares jumped from about $20 to $480 in a fortnight, before collapsing rapidly. Swapping ideas via adrenaline-fuelled chat rooms, and using slick mobile phone apps such as Robinhood, an army of young private investors have talked of retribution against the financial establishment.

And no wonder: young people have found the odds increasingly stacked against them; years of ultra-loose monetary policy have boosted the value of the property, equities and bonds hoarded by older generations. There have been spates of popular equity investment before. But this one is larger — and far more powerful — for all of the above reasons, plus another: more leverage. 

Regulators have worried for years about whether big institutional investors pose a systemic risk in markets, driving herd-like swings in volatile times. As small investors, with leverage, drive equities to uncharted highs, might they, too, be a risk to the system as well as themselves?

Alex Kearns’ parents reckoned that when he started trading shares on Robinhood, he may have had a few thousand dollars to his name. By the time the 20-year-old died by suicide last summer, within months of starting to trade, he had been told he was $730,000 in the red. In a suicide note, he claims to have had “no clue what I was doing”, adding: “I only thought that I was risking the money that I actually owned.”

Last week Kearns’ parents filed a lawsuit against Robinhood alleging “reckless conduct” in luring inexperienced investors into big risks. Robinhood has expressed regret and pointed to improvements in its processes. It has said it always seeks to comply with the relevant regulations.

Kearns, a student with no income, had been able to self-certify himself as having a little investment experience. That was enough for him to be granted access to options trading as well as the standard margin share trading account — leverage tools that together gave him close to $1m of investment capacity. 

Margin trading will typically double the amount at your disposal to invest — for every $2,000 of cash you deposit, you can borrow $2,000 at an attractively low rate of interest. According to Finra, the US investment watchdog, the volume of borrowed money in margin accounts swelled 38 per cent last year to $778bn. That compares with $242bn at the end of 1999.

In options trading — which include “calls” that magnify the effect of a bullish bet, and “puts” to hedge a position or bet on something falling — the 20-year charts read like a sea of gentle waves suddenly hitting a vast cliff of ice.

Small investors took out 87m call contracts for the most recent four-week period, according to the Options Clearing Corporation. Until last year, the comparable tally had consistently run at under 10m. Options products look deceptively simple but they put vast sums at stake.

So far, with most investors buying call, not put, options and the market still booming, few will have lost money (top-of-the-spike GameStop investors aside). As valuations lose touch with underlying performance and outlook, that cannot continue.

Warning of the risks is not about trying to stop younger investors from grabbing their share of wealth, as some angry young traders allege. It is about trying to avert the kind of personal disaster that befell the Kearns family. If the current rate of small investor leverage growth continues, it may also be about heading off the next incarnation of systemic crash.

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