A Deutsche bank special on margin debt and its implications for the market

Deutsche Bank Special Topic: Red flag! – The curious case of (NYSE) Margin Debt

A recent survey by the Create consultancy of >700 asset managers globally, managing USD 27.4 trillion between them, found that 78% of defined-benefit plans would need annual returns of at least 5% per year to meet their commitments, while 19% required more than 8% – far higher than reasonable projections. Institutions are also taking on more risk. According to a fund manager, “a target of 5% per year can be reached but only by using […] LEVERAGE, SHORTING AND DERIVATIVES.”

This special topic focuses on the critical development of margin debt, a term commonly understood as a tool used by stock speculators to increase their winnings. Investors borrow money from brokerages to buy more stock than they could otherwise afford on their own. If the stock rises, they end up making far more money than they would without borrowing. If the stock crashes, the opposite materializes. This kind of speculation is highly alarming as a large amount of margin debt makes the market vulnerable and, potentially, highly volatile. If a drop in stocks causes nervousness for regular investors, it can cause panic among those who rely on stock gains to pay off high-interest loans on margin debt. These loans are collateralized by stock holdings, so when the market goes south, investors are either required to inject more cash/assets or become forced to sell immediately to pay off their loans – sometimes leading to mass pullouts or crashes. None of the statistics shown in this report are cause for panic considering that corporate fundamentals, like earnings, are still relatively strong. But they are worrisome. Comparing press articles around 1999/00 (NM), 2007/08 (GFC) and 2013 YTD reveals an astonishing degree of congruence between the two major equity sell-offs and today, where the discussion on margin debt embedding the peaks in equity markets takes centre stage, again.

The New York Stock Exchange (NYSE) tracks margin debt for the US market. The April 2013 figure of USD384bn marked an all-time high since records started in 1959!. When netting out account credit metrics, such as Free Credit Cash and Credit Balances in margin accounts, total investor net worth just hit a record low since 2000 at USD106bn. In short, investors have rarely been more levered than today!

According to our observations, a m-o-m change in NYSE margin debt >10% has to be taken as a critical signal as we discover astonishing similarities in the sequence of events among all crises (the new technologies market around 1999/00, the Great Financial Crisis around 2007/08) and in 2013. As the S&P 500 just hit a new all-time high, investors might want to ask themselves when it is a good time to become more cautious – yesterday, in our view.

Introduction: Should we fasten our seat-belts for the zero-gravity spot in equities?

Press research can reveal fruitful facts when screening for the combination of words in any given period of time. We observe that the term margin debt offers some interesting cross reads between major financial crisis and stock market sell-offs since the 1980s. Before we go into more detail, we define what is commonly refered to when talking about margin debt.

What is margin debt? Why do global investors have to pay attention?

In its basic terms, (NYSE) margin debt can be explained as the USD value of securities purchased on margin within an account. Margin debt carries an interest rate, and the amount of margin debt will change daily as the value of the underlying securities changes. When setting up a margin account with a stock brokerage, the typical maximum for margin debt is 50% of the value of the account – a threshold that was last adjusted by the US Fed in 1974. In order to prevent a margin call (a request to raise collateral in the account), the margin debt must remain below a specified percentage level of the total account balance, known as the minimum margin requirement (or maintenance margin). Not all securities are available to be purchased with margin debt, especially those with low share prices or extreme volatility.

Different brokers have different requirements in this area, as each may have its own list of marginable securities. Margin debt levels, and their rate of change, are sometimes used as an indicator of investor sentiment because margin debt rises when investors feel good about the prospects in the stock markets. In the past, margin debt levels have peaked before market indexes reached relative peaks. When markets decline in a hurry, a large number of margin calls will usually come due, which can add to already heightened selling pressure.

Since the records started in the late 1950s, we observe margin debt tracked by the New York Stock Exchange (NYSE) rose to an all-time high in April this year.

Most interestingly, margin debt follows the pattern of exponential growth when equity markets surpass previous record historic levels and peaks ahead of the the equity market, i.e. 1/2 month ahead during the “new technologies market” around 1999/2000 and 3 months ahead during the “Great/Global Financial Crisis” (GFC) around 2007/2008. As it is difficult to identify such an absolute peak, we find it useful to look at more sensitive measures, i.e. month-on-month changes. It seems as if a threshold >10% in the m-o-m change delivers meaningful signals when the sequence starts.

In this way, it is most alarming to see that the first signal lit up in January this year.

Market analysts track margin-debt activity as an indication of investors’ appetite for speculative trading. But a potential pitfall for those trading on margin is a sharp decline in stock prices, which can expose investors to margin calls, requiring them to post additional collateral or having their brokers sell their securities.That’s why high levels of margin debt can be worrisome – a wave of margin calls triggered by a sharp market correction could exacerbate the selling pressure on stocks, making matters worse.

Consequently, high margin debts show the effect of over-leveraging and mispricing of risk in our financial system. Particularly worrying in this context is the fact that margin debt is just one tool available to investors seeking leverage. Options and futures make it easier to obtain leverage as well. In other words, the record margin numbers may understate the situation. And did you know? The interest on margin debt is taxdeductible in the US which adds to the incentive to lever up.

Besides, with the bond market weakening, the cost of margin debt is going up which will also trigger liquidation of this debt with an obvious impact on stock prices supported by this borrowing.

Press review: 1999/2000 vs. 2007/2008 vs. today (2013) – Does history repeat itself?

Based on a collection of press articles which were published around the key events during the past financial crises, our key finding is straight forward. Irrespective of the publishing date, the articles read alike throughout the two major crisis periods, i.e. the “new technologies market equity bubble” (1999-00) and the “Great/Global Financial Crisis” (2007-08). Most interestingly, litrally the same content can be found in todays’ press. Universal phrases include:

1. “A rising stock market encouraged more investors to go into debt to buy stocks, sending margin debt levels past their all-time high”.

2. “The National Association of Securities Dealers (NASD) has asked members to review their lending requirements in a sign of increasing concern that rising levels of margin debt could exacerbate a stock market plunch.”

3. “The Fed is concerned about a sharp rise in margin debt but has been unwilling to attack stock market speculation as high levels of leverage do not necessarily translate into high risk. The last time the Fed adjusted the margin rules was in 1974, when when it reduced the down payment required for stocks to 50 percent of the purchase price, from 65 percent.” […] “The Fed should return to its pre-1974 policy of actively changing margin requirements in response to stock market speculation”.

4. “High margin debts show the effect of over-leveraging and mispricing of risk”.

5. “The movements in stocks cause brokerages to stop allowing customers to buy some of the volatile stocks on margin or require clients to put up more cash.”

6. “Either the market rises dramatically to make those loans good or in any down move there is tremendous selling pressure”.

7. “Until recently, most investors ignored red flags raised by regulators”.

Admittedly, with aggressive intervention from central banks following an extreme financial crisis, makes judgement difficult. Critics argue, “it makes sense in this environment to lever up and to take advantage of stronger returns”; “the fact that two things move together [margin debt and the equity market] does not mean that one is causing the other”; “relative to bonds, equities appear faitly cheap”. Depending on the denominator to which the absolute level of margin debt is put into perspective, the judgement on whether critical levels of margin debt have been reached varies case by case (for example, using gross domestic product and total market capitalization).

Relative to US nominal GDP, many quotes in the financial press since the 1980s highlight the critical level of c2.25% as worrisome, a level we just crossed in January this year. In retrospect, we observe that this threshold has been useful to identify the peak in the equity market in 1999/2000 and in 2007/2008. However, it failed to deliver a meaningful signal back in 1987 (albeit marking a record high in those days). The June 2013 figure currently stands at 2.35%.

More interestingly, the ratio of margin debt relative to total market capitalization also works as a meaningful signal when using a c2.25% threshold with the noteworthy difference that the 1987 stock market crash was detected as well. As the current level stands way above this threshold, observers should be alarmed. The June 2013 figure currently stands at 2.66%.

Both the absolute and relative level of margin debt, its month-on-month changes >10% versus the equity market’s all-time record high (S&P 500) deliver an important message (apart from having adjusted any of these time series for inflation). It can be debated quite controversially, whether the current level of margin debt is to be considered as excessive, but findings in this report indicate the time has come to stop debating on pricing levels among equities (being cheap relative to bonds on the one hand side, but fairly valued compared to own historic levels on the other hand side) and start debating on leverage in the system, which has undeniably reached a critical level, once again.

Interestingly, NYSE short interest has come down in a straight line throughout H2 2012 and started to revert its trend from the beginning of February 2013 onwards when we observed the first critical warning signal of a m-o-m change in the absolute level of margin debt >10% in January 2013 vs. December 2012, leading to a level of margin debt relative to nominal GDP above the critical threshold of c2.25%.

A ‘Google Hit’ analysis reveals the awareness among actively operated websites has also increased significantly since January 2013. The recent spike in May 2013 perfectly reflects the increased awareness for this topicwhen data on margin debt for April was published and had marked a new all-time record-high. The matching upward trend between short interest and margin debt is inevitable.

Finally, we point to the fact that not only invesors in equities are subject to this matter but also investors in fixed income products (aside from hedge funds and macro/cross asset funds). The mindset of investors in DM government bonds (especially in US Treasuries and German Bunds) has been shaped by a 30-year long bull market, as long as entire careers for some. As real yields approach the 0 threshold (at least at the lower end of the yield curve), especially those institutions with a guaranteed yield out on their products are struggling to deliver on their promises, could be/could have been inclinded to lever up and turn/having turned to equity markets (depending on wehther their mandate and/or regulatory framework allow them to do so).

In summary, this does not necessarily mean the peak in equities is just around the corner. It means the underlying basis on which prices trade is most fragile and, more importantly, the higher margin debt levels rise, even a less severe sell-off in equities could trigger the sequence of events outlined in detail above. A good acid test of what kind of investor you’ve become is to gauge your gut reaction to these observations. Events over the last few months show that the debate over QE tapering is not yet over and any surprise announcement by the US Fed on unwinding asset purchases might have far reaching implications against the backdrop of findings in this report. This leaves us with the hope that not all the margin calls come at once in case a sell-off in equities occurs. Gold and silver have been first in line to observe selling pressure but plenty of other assets could have to be sold down as well to meet (latent) brokerage margin calls.

Excursus: The sell-off in gold versus a change in margin requirements