Margin Debt Up Sharply

As Russ Winter describes the recent runup in margin debt in “Leveraged to the Hilt.” Needless to say, heavy use of margin is considered a sign of speculative excess.

I believe much of the market move can be attributed to synthetic leverage (futures). But now we get more evidence that a parabolic move in the use of margin debt is also playing a factor, jumping 11% to $353 billion at NYSE in May, up from nearly $318 billion in April. Indeed margin debt from March to May has increased by an unprecedented $60 billion. The following chart shows margin debt back in March BEFORE that 20% increase of the last two months.

….It is obvious that the US Fed is aware of the blow out in margin debt, the aggressive speculative lean against the USD, the actions of other central banks, and the aggressive speculation in oil, as they have not monetized a dime since May 3 . But is standing pat, talking tough and releasing phony data exaggerating economic strength going to be enough at this stage?

The Wall Street Journal provides a less colorful take, but adds some background as to how this came to pass:

Investors are borrowing record sums of money to finance trades on the New York Stock Exchange, according to data due out from the Big Board today.

NYSE officials attribute the trend to recent regulatory changes effectively allowing both small and big investors to take on more leverage, or borrowed money, from their brokers. So-called margin debt, a broad measure of leverage, jumped 11% to $353 billion at NYSE in May, up from nearly $318 billion in April…..

Such financing can also amplify losses if investors’ bets go the wrong way. But regulators say that doesn’t necessarily translate into more risk. “I wouldn’t necessarily say that leverage equates to risk,” said Grace Vogel, executive vice president for member regulation at NYSE. “We feel that the amount of margin being collected by the firms is appropriate, given the strategies in [their customers’] portfolios.”

Under the financial industry’s old rules, investors who wanted both to buy shares in a company and use so-called options contracts on that stock to guard against an unexpected drop in the value of those shares would have to put up separate collateral for both the stock and the option. If the shares dropped in value, the customer might get a margin call, or request for additional collateral, from a broker to cover the price of the shares, even if the value of the option had increased.

Under a pilot program that the NYSE launched with eight brokerage firms in April, brokers can assess the portfolio as a whole. So if one part of the portfolio goes down but the other part goes up, the investor won’t necessarily get a margin call. The upshot for investors is they don’t have to tie up as much money on one particularly investment, allowing them to borrow more to make other investments if they want to.

Doug Engmann, a managing director at Fimat USA, one of the brokerages participating in the program, says the change has reduced some of his customers’ financing costs by 80%. He estimates reductions of 25% to 50% are the norm.

“This type of financing is not for everyone, just sophisticated, options-trading customers at this point,” said Mr. Engmann. “As the industry gets used to it in the next few years, I suspect we’ll see it used more widely.”

“I wouldn’t necessarily say that leverage equates to risk.” Anyone who reasons like that shouldn’t be a regulator. Sure, leverage doesn’t create risk as long as prices keep rising.

When I first read about this program, it was clear to me that it was a sop to the brokerage industry, since it would clearly goose prices when it came into effect. Financing cost reductions of 20%-50% are significant. And most of those customers will use the savings to increase their gearing.

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