Rational Advisor

Margin Debt — and Risk — Is Growing

Every market crash has been preceded by an increase in margin debt. So, it’s important that we understand and keep an eye on it.

Margin debt remains within spitting distance of the all-time high it hit in July, and 43% higher than it was a year ago. It’s become a source of concern to as it makes the stock market more vulnerable to a nasty tumble, particularly if equities’ continue to go up.

Margin debt is essentially the loans that banks and brokerages make to investors, using their stock and bond holdings as collateral. Brokers will lend up to 50% of the market value of a security. By borrowing, an investor is able to ramp up his bet on a favorite stock or bond; however, it also raises his risks. If the value of the stock drops, the broker can ask the investor to put up more collateral or cash to back the loan or call the loan.

Brokers sometimes give investors little or no time to cough up more cash before they liquidate a portfolio at bargain-basement prices. A brokerage firm may force a margin call on the one hand, while helping set the price on the securities sold to meet it on the other. This gives the brokers knowledge and power that a Las Vegas croupier would envy, particularly in the over-the-counter market, where operating as agent and principal, they can assure themselves of fat spreads and commission dollars.

Based on historical levels, margin debt makes the market look risky and subject to a sharp downtick right now. For the US it comes to 2.4% of total adjusted-market capitalization — 3.4 times its 62-year norm of 0.74%. These are certainly not the kind of numbers you see at the beginning of a bull market

Margin debt in the US 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.

The frothiness became very evident in the summer. In July, margin debt hit an all-time high of $381 billion. But as worries about subprime-mortgage loans set off a credit crunch in August and we saw a market downturn, more than $50 billion of the debt got erased. Almost half of the margin drawdown came from brokerages such as Merrill Lynch, which called loans backing two Bear Stearns hedge funds.

What’s particularly worrying to some is that margin debt is just one tool available to investors seeking leverage these days. Now we are seeing, options and futures make it easier than ever to obtain leverage. So the near-record margin numbers may actually understate the situation.

The Bottom Line:

Margin lending, as a percentage of stock-market capitalization, is nearing levels last seen in the midst of the Internet bubble.

Heavy margin debt can be a sign of an overleveraged market, vulnerable to sharp declines. And it tends to show up closer to the end than the start of a big bull-market rally.

BE CAREFUL - YOU HAVE BEEN NOTIFIED

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