The role of margin calls in market downturns
The macroeconomic factors driving the current market downturn are clear to all: inflation, rising interest rates and geopolitical uncertainty. But there are other forces at play that don’t receive the same attention. One of the biggest of these is margin financing.
Margin debt refers to money borrowed by investors to purchase stocks, which then act as the collateral for the loan. It’s a tactic that can multiply gains – and losses – by allowing investors to take bigger positions than they could otherwise afford. Notably, surging levels of margin debt have historically been a strong indicator of an over-exuberant market, and therefore also a leading indicator of a coming crash.
Buying on margin magnifies market fragility
For investors, the fear of missing out on further gains is particularly powerful in the late stages of a bull market, making investors willing to take on more risk in search of greater rewards. Margin-fuelled buying helps take the market to new highs. When margin debt levels become very large compared to the historical average, however, the market becomes more fragile.
When the tables turn in such a scenario, even a small decline in the value of the stocks bought on margin can lead to brokers demanding investors deposit more funds into their trading accounts to cover the shortfall. These so-called margin calls are often funded by selling holdings, which can accelerate the market’s decline when sentiment turns bearish.
In some cases, investors unable to satisfy margin calls are subject to forced liquidation – as happened in the 2021 collapse of hedge fund Archegos. Large-scale forced liquidation leads to fire sales that can have destabilizing knock-on effects for portfolios and whole markets. The collapse of Long Term Capital Management in 1998 is another classic example.
Margin debt surges ahead of market crashes
The market crashes following the dotcom bust of 2000 and the 2008 financial crisis were both preceded by surging levels of debt. This time around, margin debt for US stocks reached an all-time high of $936 billion in October 2021 – up 95% from March 2020, when the market was briefly roiled by the advent of the Covid-19 pandemic, before embarking on a heady bull run.
With interest rates rising, the cost of financing these positions is now increasing. This, along with falling prices of equities, has led to sizable margin calls: the most recent data from the Financial Industry Regulatory Authority (FINRA) showed that US margin debt had dropped 27% by June 2022 from the October peak. Though the margin debt overhang has become less severe, it has far from disappeared. Following the previous two market crashes, margin levels shrunk by at least 50% before the S&P 500 began recovering.
Though there is no guarantee that the equity markets will follow that pattern again in the second half of 2022, investors should be aware there is a good chance that margin debt levels could decline quite a bit further before the market stabilizes. The one thing that is clear is that the euphoria stage marked by surging margin debt levels is well and truly over.
Prescription for stability
During periods of market turbulence, investors generally fare better by taking the long view and holding onto positions rather than selling and returning to the market at some point in the future. Several studies show that historically, time in the market beats timing the market.
The typical margin loan, however, often makes that strategy impossible: investors who cannot top up the value of their collateral immediately are at risk of forced liquidation.
In contrast, longer-term securities-based financing offers a more stable source of capital, allowing investors to raise funds for investments and other purposes without sacrificing the upside potential of their core holdings.
With EquitiesFirst’s approach to securities-based financing, accredited investors, sophisticated investors, professional investors, and otherwise qualified investors (who have sufficient knowledge and experience in entering into securities financing transactions) are protected from rising interest rates and from forced liquidation by more favorable terms than those typical in margin financing.
EquitiesFirst’s prudent approach to risk management has enabled it to navigate all market conditions over the past 20 years while protecting the interests of investors and the broader markets. The peace of mind offered by that approach becomes especially valuable in times like these, when heightened economic and geopolitical uncertainty means that little else is certain.
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