Margin debt owed on stocks listed on the New York Stock Exchange has surpassed $350 billion. This is up to $35 billion, or over 10%, in just one month. The jump in margin debt brings new warnings to investors concerning the risks of leveraged investments.
Traditional theories concerning the stock market include that small investors are always wrong. They jump into the market when it is near its highs and get out near the lows. There is both a guesstimate and empirical data to support this theory. One measure of investing by small investors is margin account debt. With the exception of hedge funds, most large investors do not use margin.
Considering this theory, the warnings are thus two-fold. Not only is high margin account debt an indicator of a market top, but margin investing can also be very dangerous. Margin debt amplifies losses and even a moderate drop in stock prices can cause forced liquidations. As well, the cost of margin interest exacerbates losses in leveraged accounts. Non-margined investors can wait for recovery without liquidation or enduring interest costs.
While dangerous for investors, margin loans are remarkably safe for brokerage firms. Margin loans begin as 200% collateralized, comparable to making home loans which require a 50% down payment. As well, the loan collateral is required to be liquidated if an investor’s equity falls below 25% of the portfolio value. These standards, coupled with high liquidity of the securities collateral, mean losses to brokerage firms on margin loans are relatively small.
Brokerage firms earn huge bucks on margin debt. Interest rates charged investors are usually several percentage points higher than brokerage firms’ cost of capital. Because the losses are quite small, as discussed above, firms can easily earn as much as a third of the interest it charges its clients. If, for example, the net return to brokerage firms is 2% of the current margin debt on NYSE stocks, margin loans would earn them an extra $7 billion! Add perhaps another $7 billion made from loans on NASDAQ stocks and (as a U.S. senator once said) pretty soon we are talking about real money!
NYSE officials wish to attribute the rise in margin debt to relaxed standards granted on margin requirements when option hedging techniques are used. In any event, margin accounts are very profitable to Wall Street. Meanwhile, using the stock market as a casino is simply not appropriate for many investors. How about you?
Shepherd Smith and Edwards represent clients that are the victims of securities fraud. If you have lost money in a margin account or because of misconduct by someone in the securities industry, hiring an experienced law firm can greatly increase the chances of recovering your losses. Contact us to arrange a free consultation with one of our attorneys.