The Wall Street Journal recently reported that margin loans have increased to more than $800 billion. To offer perspective, that is a 50% increase from last year. 2007 was the last time for such an increase. Before that, it was the dot-com bubble in 1999. None of this is to say we are on the cusp of a market meltdown due to increased margin lending, but it pays to understand margin loans and how they can exacerbate a declining market for the rest of us.
How does margin lending work?
Say you wish to buy a stock but want to borrow a portion of the purchase price from your broker-dealer, using your account as collateral. The sole benefit of margin lending allows an investor to increase their exposure to specific assets.
Regulation T of the Securities and Exchange Act of 1934 limits margin lending to 50% of the portfolio value. If you buy $10,000 worth of marginable securities, the most you can borrow to make that purchase is $5,000, with you providing the remainder, or the margin. Some stocks require more margin because of their volatility. For example, if you wish to buy Tesla on margin at Charles Schwab, 25% is the maximum Schwab will lend.
What are the risks?
The risks of margin lending are many, but those listed here are the most concerning. You can lose more than your original cash outlay if your stocks drop fast enough and far enough.
- If markets fall, your broker may force you to deposit additional cash or securities in your account on short notice.
- Your broker can increase margin requirements at any time without advance notice.
- When you offer your portfolio as collateral for a margin loan, banks will do anything necessary to protect their investment. They can take whatever collateral they need, including other securities in your account, without consulting you first.
When you use margin loans, things can go wrong really fast, and your lender is not your friend.
A double-edged sword
As with any leverage, the downsides of margin loans can be devastating. One of the contributing factors to the financial crisis in 2008 was the massive leverage employed by financial institutions exposed to the housing market. Regulators belatedly recognized the problem and since then have imposed stringent limitations on how much leverage banks can utilize.
Margin lending can destroy big players too. Last month a hedge fund named Archegos Capital Management received a series of margin calls. Archegos borrowed heavily to obtain exposure to a small set of stocks whose prices had climbed rapidly in the first quarter. When the value of those stocks reversed course and declined, the banks to whom Archegos had pledged the shares began to sell those shares to protect their collateral. Losses for Archegos are estimated at $30 billion on a base portfolio value of $10 billion, to say nothing of the losses experienced by the lenders. The irony is that this all happened in the middle of a rising market. Imagine how much more significant the losses could be for margin borrowers in a declining market.
15% of investors today report having first entered the markets over the last year. Many of these started with the help of investing tools like Robinhood and other on-line trading apps, seeking alternatives to the boredom of a quarantine. Long on enthusiasm and short on experience, it is no surprise these investors think markets always go up. In due time these investors will experience down markets too. Choosing to employ margin loans will make those tough lessons even more painful.