Table of Сontents
- What is Margin Debt?
- What is a Margin Balance?
- Effect of a Black Swan Event
- What Can High Margin Debt Lead to?
- What Margin Debt Says About The Market Cycle
- Current Aggregate Margin Debt & What It Means
- Bottom Line
An investor uses margin debt, or money borrowed from a broker, to buy stocks. The total margin-margin debtamount of margin debt held by all investors serves as a closely-watched proxy for market risk and trend. Find out what margin debt is and why it’s significant.
What is Margin Debt?
Investors can borrow money through margin accounts from their brokers and use either recently acquired or existing shares of stock as security. Investors can initially borrow up to 50% of the value of their assets in this way.
As long as investors have enough equity in their accounts to cover collateral obligations, they are permitted to carry this debt forever. They may even continue to make payments on the loan even if the value of the shares pledged as security falls. According to FINRA regulations, stock prices may drop up to a point where margin debt represents up to 75% of the account’s entire stock value. Individual brokers, though, could be more cautious, allowing margin debt to be only as high as that.
What is a Margin Balance?
Any individual’s outstanding sum in their margin accounts that is owing to their broker is considered to be their margin debt balance at any one moment.
Like a traditional loan, margin balances do not have payments attached to them. You pay $5,000 and borrow $5,000 from your broker if you use margin to purchase shares worth $10,000. There will always be a $5000 debt due until it is paid off or you sell the shares. However, interest will be charged at a rate agreed upon by you and your broker on that debt.
What Can High Margin Debt Lead to?
At some point, margin debt must be repaid, and this usually happens through sales of the securities used as security for the loan. When margin debt is substantial, stock price declines may result in margin calls, which then spur additional selling. Deleveraging brought on by margin calls can so readily worsen broader market drops, potentially resulting in cascade declines like in 2008.
Margin debt is not just used by individuals to acquire leverage. Margin debt is a popular kind of leverage used by hedge funds, and excessive leverage was a factor in some of the most dramatic collapses of these firms. The most well-known was Long Term Capital Management, a hedge fund founded by seven economists who won Nobel Prizes and collapsed in 1998.
What Margin Debt Says About The Market Cycle
Margin debt often grows as prices increase and investors gain more assurance. That would link margin debt to the market cycle’s markup stage. The present part of the markup process has been ongoing for a decade. Investors who tend to stay stretched far into the distribution phase due to long increases may get complacent because they believe they can wait to sell until the market genuinely declines.
Investors may also feel that margin debt is more appropriate at the moment because the current stock surge has been accompanied by the lowest interest rates in recent history. An investor just has to earn more than that to make a margin purchase since margin interest rates might be as low as 2-3% annually.
One can see from the graph above that the market peaks in 2000 and 2008 generally corresponded with the maxima in margin debt. While this cannot foretell the coming significant downturn, it does imply that there is at least a connection between high-margin debt and the market cycle’s distribution stage.
Current Aggregate Margin Debt & What It Means
The aforementioned chart appears to provide adequate visual proof that margin debt is strongly associated with the overall market’s price level and that its peaks and troughs coincide with those of the market. However, there is not enough information to determine if margin debt is fundamentally merely coincidental or whether it is a leading predictor of the market.
Analysts noted the $882 billion peak in margin debt in June 2021 and the subsequent decrease to $844 billion in July as potential indicators of a market peak. Margin debt, however, stormed back to another record in August at $912 billion, fell slightly in September to $903 billion, and then soared to still another high in October.
Fortunately, black swan episodes are uncommon. But when they do, market prices suffer severe reductions as a result. Investors should construct their portfolios with the worst-case scenario in mind.