Margin loans: investors take on cheap debt to buy stocks

Count me among those who are skeptical about how quickly central banks will raise interest rates. Yes, they’re making noise about it – and with inflation high, many analysts are suggesting they should act faster. But our heavily indebted world cannot stand high interest rates and policymakers know it. So, while rates should start lowering the floor next year, the pace of increases will likely be slow, and they will take advantage of any reason – a new variation here, a swing in the markets there – to hold back.

Unlike the negligence that central bankers displayed in the 2000s, when their dragging feet created the housing bubble and the global financial crisis, perhaps it is even for the best. The economy is so troubled that a wage-price spiral that inflates liabilities may be the less perilous path. But if monetary policy tightens, it’s hard to see the markets ignore this.

Soaring debt

When we talk about stricter policy we tend to think of higher rates making other investments less attractive: if you can get 1% on a bank deposit again, a ten year bond with the same yield becomes a worse one. case. But another way the tightening could affect the markets is to reduce the supply of nearly free money that has supported them.

One obvious example is the growth of margin loans (see below) among brokers in the United States. This has skyrocketed since the start of 2020, reaching $ 936 billion in October from $ 545 billion in February 2020. The same expansion in margin debt occurred as the tech bubble of 2000 approached and of the 2008 financial crisis, but the rise this time was much sharper.

Indicators like this are not a reliable signal of market timing – there is no level that signals danger. When you look at margin debt as a percentage of the total S&P 500 market cap, it’s around 2.5%, according to data compiled by economist Ed Yardeni. In the 1990s, the S&P 500’s margin debt as a percentage of market capitalization was consistently below 2%, except at the peak of the dot-com bubble. Conversely, in the ultra-low interest rate environment after the financial crisis, it increased around 3% for many years. It only started to fall back to 2% after the Fed started to tighten faster in 2018.

In other words, the market has grown even faster than the growth in margin debt – trends like this are only part of a bigger picture. Nonetheless, this is an example of how traders grabbed cheap debt during this rally and it can make markets vulnerable to any real tightening. When stocks go down traders tend to deleverage and this makes the sell worse. The S&P 500 faltered a lot in 2018. The point at which stricter policy is causing pain may well be lower this time around.

I’d like to know what the margin was, but I’m too embarrassed to ask

When traders buy stocks or other assets, they sometimes borrow money to finance the purchase. The aim is to increase their potential returns. Suppose a trader buys £ 100,000 of shares and borrows £ 40,000 to do so. The shares go up by £ 6,000, they sell the lot and pay off the loan. They have £ 66,000 left, a 10% gain on the total capital they have personally invested (£ 60,000), even though the share price has only risen by 6%. Of course, it also works the other way around: a 15% drop in the value of the shares would mean that the trader lost 25% of his capital.

The concept of using debt to fund part of an investment is known as gearing or leverage, but the specific practice of using money provided by a broker is known as buying on margin. The collateral that a trader has to provide to protect the broker from credit risk (i.e. the risk that he will not pay off his debt) is known as the margin, and the amount borrowed is the margin loan. In our example, the trader has set up £ 60,000 of margin and has a margin loan of £ 40,000. In reality, the collateral is not always new cash poured into the account: the trader may be able to borrow against other actions.

The amount of margin needed depends on industry regulations, the broker’s own policies, and the asset being traded (trading small volatile stocks requires more margin than trading large stable stocks). Derivative trading exchanges such as futures set their own margin requirements and may increase them when volatility increases.

The amount of collateral that a trader must have before starting a trade is known as the initial margin. The minimum collateral value that must then be held while the position remains open is the maintenance margin. If the collateral value falls below the maintenance margin requirement, the trader has to pay more collateral or their position will be closed. The demand for more collateral is known as a margin call.

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