Margin Debt – What and Why
If you’ve been listening to CNBC or reading any of the main financial publications, you’ve probably heard talk about the significance, (or insignificance based on the speaker’s perspective) of margin debt. Last week the NYSE released its latest data on margin debt which increased for the seventh straight month. January was also the fifth straight month that margin debt hit a record high. This is unsurprising in a market that has run up so much.
Margin debt refers to the amount of money investors borrow against their investment portfolio in order to invest even more money. For example, I have $1,000 invested in shares of company X. I borrow $400 from Schwab against that investment and put the $400 into an ETF. Now if my shares of Company X drop in value enough, Schwab may issue a “margin call” which means I need to put more money into my account so that the ratio between the value of my account and the amount of money I borrowed stays at or below a specified value.
You can think of margin debt a bit like a home equity loan. During the housing boom of the later 1990s and 2000s, home prices kept going up like views of Ellen DeGeneres’ Oscar selfie. Homeowners took out home equity lines of credit, refinanced with a larger mortgage or took out a second mortgage to exchange their increased levels of equity for cash. This eventually made home price more volatile as many people had less than even 5% equity in their home so that when their home’s current market price dropped by more than 5%, they had nothing invested and many chose to walk-away.
The concern with rising levels of margin debt is that a downturn in the markets can induce higher volatility and make for an even sharper downturn as investors race to sell investments to cover their margin calls. With a margin call, an investor can’t just walk away the way many did with their homes. They have to keep a specified amount in their account, like being required to maintain a minimum of 15% equity in your home. Here’s how it works:
| Home Value | Debt | Equity | Equity Ratio | |
| Buy a home for $100, borrowing $80 (for simplicity assume an interest only mortgage) | $100 | $80 | $20 | 20%=20/100 |
| Home values rise the following two years by 25%. | $125=(100*1.25) | $80 | $45 | 36%=45/125 |
| Borrow extra $20 against the home. | $125 | $100 | $25 | 20%=25/125 |
| Home prices fall 12% | $110=(125*0.88) | $100 | $10 | 9%=10/110 |
| Additional funds paid to bank to return minimum ratio | $110 | $93.5 | $16.5 | 15%=16.5/110 |
The homeowner would have to give the bank an additional $6.50 to get the ratio back to the required minimum. This is essentially how margin debt works.
Bottom Line: While the specific level of margin debt or the fact that the metric has reached a new high may not be a direct indicator of a bubble in security prices, it is indicative of two things:
1. The belief that security prices are more likely to rise than fall in the near future. (A reasonable person wouldn’t borrow an additional $20 against their home if they thought the price was going to fall significantly.)
2. A downturn in prices is likely to be more volatile than it would be with a lower level of debt as investors are forced to sell to cover their margin accounts.
This warrants portfolio construction that is suited to help minimize such volatility.
