Investors who utilize maximum margin to leverage their equity purchases in rising stock markets often greatly increase their gains. The problem is that they also increase their risk of loss. Investors who keep utilizing their buying power resulting from price increases to maximize their margin debt are like casino gamblers who never take any chips off the table. No-one should expect a favorable run to continue forever. Rising stock market averages and prices of the common stock of even the most successful entities tend to overshoot their fair value and eventually incur corrections.
Present margin rules as set by the Fed require initial margin of 50% and maintenance margin requirements of 25%. The maintenance requirement only comes into play if the value of a portfolio declines. For example, assume you have $10,000 to invest. You could buy $20,000 of stock on margin. “The broker lends you the other $10,000. If the stock triples and goes up in value to $60,000 giving you an equity of $50,000 you can borrow an additional $40,000 and purchase additional securities of the same or a different entity. You have maximized your use of margin. Had you not bought on margin your investment would be worth $30,000. Now suppose the portfolio doubles again. Your initial investment is now worth $150,000 ($200,000 of equity minus $50,000 of debt) versus $60,000 of equity had you not utilized margin. Suppose you borrow an additional $100,000 to purchase additional securities leaving you with $300,000 of securities with maximum margin debt of $150,000.
Now, let’s assume the stock market goes into correction and your securities decline by 20%. They are now worth $240,000, leaving you with $90,000 in equity and $150,000 in debt. To meet the 25% maintenance requirement you must have a total equity of $187,500 (25% above the debt of $150,000). Suppose the decline from the top reaches 40% leaving you with an aggregate value of $180,000 or a net equity of $30,000. This is below the 25% maintenance requirement and you will be required to either add cash or sell securities to reduce the debt to meet the maintenance requirement. After a meteoric rise from $10,000 to $150,000 the value of your account is back to $30,000. Had you not bought on margin your hypothetical investment would be worth $36,000 ($60,000 less $24,000). Had you not borrowed the last $100,000, Your investment would be worth $$70,000 ($120,000 minus $50,000). You would not have received a margin call.
Every investment situation is different. The above example is an attempt to examine the risks and potential advantages and disadvantages of use of margin leverage. In periods of “irrational exuberance” the risk of loss increases. The Fed can reduce margin risk by increasing the initial margin requirement thereby limiting the ability to increase margin debt if it perceives a significant risk of a market decline.
The Fed should be cautious of margin risk. Sales to meet margin requirements whether by choice or by requirement can exaggerate a decline in a falling stock market. Such sales, coupled with the inept uptick rule adopted by the SEC that permits short sellers to initiate a market decline and the potential waterfall effect of stop loss orders that might in a declining stock market be executed electronically at declining prices, can be leading contributors to a stock market crash.
The Fed is raising the wrong rate. As described in my previous post it should not be raising interest rates which both cause inflation and slow the economy leading to stagflation or a recession. It should have been concerned about controlling individual investor and market risk caused by excessive margin debt as market averages and p/e ratios rose to new highs. Hopefully, it will have that opportunity again in the future.