Are Margin Loans a Major Cause for Concern?

"Housing is not the only asset against which banks have been making sub-prime loans – there are shares as well," warns Alan Kohler at BusinessSpectator.com, in a blog written earlier today. "After a long period of cheap money and an unusually long and very strong bull market in shares there is now a large but unknown amount of leverage in the share market and the derivatives connected to it. And shares are now doing what the housing market did – that is, falling," he says. He goes on: "What might be called the share market's sub-prime problem has not surfaced and it is earnestly to be hoped it does not."

Unlike shares, Kohler argues, residential real estate is an illiquid market, so any price contagion is slow moving. "In the very liquid stock market, this process is much faster and much more dangerous. The stock market is falling around the world as banks confess to the bad loans they made against housing." Kohler asks: "How many bad loans were made against shares? Margin calls force highly leveraged investors to sell shares, driving prices lower quickly and sparking more margin calls. An avalanche can develop, as happened in October 1987."

Some commentators argue that margin lending played a big part in the 1929 crash, since margin lending often accounted for more than 20% of the New York Stock Exchange's market value during the 1920s by some estimates. But margin lending accounts for a much smaller percentage of present day market capitalization. Margin debt rose from $32 billion in 1990 to $278 billion (2.9% of market cap) at the height of the dot-com boom in 2000, then fell to $134 billion by 2002. But it's been climbing steadily since, eclipsing $300 billion in April last year.

To gain some perspective, note that the $300 billion margin lending problem is roughly half the size of the $600 billion U.S. subprime problem, accounting for about one-fifth of the U.S. home loan market. The big question: Now that we've had a taste of a $600 billion U.S. subprime problem, can we extrapolate the consequences of a $300 billion margin lending problem? How much of the de-leveraging have we already witnessed, and how far do we have to go to get to the bottom for the stock market?

I agree that margin lending could be massively destabilizing, but I argue here that margin lending, on a macroeconomic scale, is not as important as the subprime problem. The relationship between margin lending and stock market weakness/volatility is not as clear cut as Kohler suggests.

There will always be individual investors that use leverage inappropriately, and it is only natural (and necessary) that they suffer the consequences. Of much greater importance to the broader market is broker protection. "Broker protection is, arguably, a more appropriate objective if a broker's failure can create spillovers and add to the financial system's instability," says Peter Fortune at the Federal Reserve Bank of Boston. Fortune argues that margin lending does not pose a significant risk to the broader financial system, since brokers can protect themselves by setting high maintenance margins, and by liquidating securities, without customer approval, well before the customer's equity has disappeared.

In other words, as long as brokers remain protected from margin loans, spillover is limited, and there is little damage to the broader financial system. "Even in the less adaptable financial world of 1929 there was little evidence of significant broker failures adding to systemic risk," adds Fortune. Going by this argument, we shouldn't be too worried about any macro-economic damage that may come from the $300 billion margin lending problem.

Another common belief is that high levels of margin loans increase market volatility. Surprisingly, if you draw a chart of margin loans vs. market volatility, as measured by the VIX index, there is a NEGATIVE correlation. This means that higher margin loan levels lead to lower market volatility! Click here to see the chart. But don't get too excited, this might be a statistical illusion. Peter Fortune suggests two reasons for this curious relationship:

1. Margin loans might be a tool for knowledgeable investors to take positions that stabilize the market, lowering volatility (i.e. the smart money uses margin loans to take bets on positions that deviate from intrinsic value, reducing volatility that may come from unbalanced markets)

2. The negative correlation might arise not from a causal relationship but from the influence of other factors on both margin loans and volatility. "For example," says Fortune, "stock price volatility is known to be lower in bull markets than in bear markets, and margin loans typically increase in bull periods when expected returns are high and fall in bear periods when expected returns are low. Thus, the association we see in the chart might reflect changes in the market's expectation of future returns rather than any causal relationship between margin debt and volatility."

Even if the negative correlation is a statistical illusion, it is important to note that an increase in stock volatility does not automatically translate into broader economic weakness. "Even if margin lending contributed to short-run stock market volatility, there is little indication that this would translate into changes in overall demand," concludes Fortune.

Don't get me wrong. I believe there is still much de-leveraging to come, and stock markets will suffer some more. The subprime problem had dire macroeconomic consequences, but de-leveraging of margin loans will have a much smaller impact on the broader economy. Commentators should not automatically assume that a $300 billion margin loan problem will create half the havoc of a $600 billion U.S. subprime problem.

Disclosure: None.

Comments

[RichShinnick]

Margin goes both ways these days-long and short. If you went out on margin and bought SKF or SRS or SDS or really any ultra-short etf, you have no worries at this point.