Efficient Markets vs. Mortgage Leverage
By Arnold Kling
Patri and Mike want to argue that taking out a big mortgage to invest in the stock market is really clever. Here is the counter-argument.
Think of this transaction as two transactions:
1. First, you take out a 6 percent mortgage to buy taxable bonds yielding 5 percent.
2. Second, you trade the taxable bonds for stocks.
Step 1 is a loser. True, you can deduct the mortgage interest from your taxes. But you have to pay taxes on the interest on the bonds. So, whether we’re talking pre-tax or post-tax dollars, you lose money.
Step 2 is a risk-return trade-off. In an efficient market, the “equity premium” is not an arbitrage opportunity. It is compensation for taking more nondiversifiable risk.
You can do step 2 without doing step 1. For example, you can buy exchange-traded index mutual funds on margin. Or you can buy futures contracts on the S&P 500. Or you can buy call options on S&P futures. You pick the mechanism that offers the lowest interest rate, and that would not be the mortgage rate.
This is one topic where I think that untrained people are really, really out of their league making comments. For example, anyone who says that efficient markets theory only holds when all investors are identical clearly has never worked through the proof of the portfolio separation theorem. And unless you understand that theorem, I am not going to be convinced by what you have to say.
One final point: in an efficient market, tax effects are clientele effects. If you are in a moderate income bracket, chances are you do not benefit from a tax-advantaged investment, such as municipal bonds. That is because investors who are in higher brackets than you will bid up the price of these bonds to the point where your after-tax returns on them are low.