China's Stock Market Woes - A Warning to Margin Investors

In order to protect its stock market, China recently clamped down on the use of margin financing, a move that has resulted in a precipitous decline in the value of China's two main indices in Shanghai and Shenzhen which have dropped by a third in value over the past month.  On Monday July 6 alone, Bloomberg notes that traders cut 93.6 billion yuan ($15 billion) worth of shareholdings that were purchased using margin and, according to the Financial Times, the cumulative effect of this unwinding has led to a total of $3.2 trillion being wiped off the value of China's stocks as borrowers look to unwind their positions.  This has also created a situation where hundreds of companies have halted trading in their shares to prevent further price collapses.  In light of the situation in China's stock market and the fact that falling share prices have triggered margin calls, it seems pertinent to revisit a posting on margin in the United States that I had last discussed in October 2014.

For those of you that may not be aware of how margin works, here is a bit of background information.  Margin is used by investors to purchase shares that they cannot afford to pay cash for, allowing them to lever a small amount of money into a much larger volume of shares.  According to the Securities and Exchange Commission, there are a set of rules that must be followed when using margin.  Here is some background information on the amounts that can be borrowed and how much is required to maintain margin:

1.) Initial Margin: "According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the "initial margin." Some firms require you to deposit more than 50 percent of the purchase price. Also be aware that not all securities can be purchased on margin."

2.) Maintenance Margin: "After you buy stock on margin, FINRA requires you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the "maintenance requirement." In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent, and sometimes higher depending on the type of stock purchased.

The risks of using margin are as follows:

1.) You can lose more money than you have invested.

2.) You may have to deposit additional cash or securities in your account on short notice to cover market losses.

3.) You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities.

4.) Your brokerage firm may sell  some or all of your securities without consulting you to pay off the loan that it made you."

Option 4 is particularly concerning to many investors since it means that you lose total control of your own portfolio.

Here's an example of how margin works  from the SEC:

"Let's say you purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in your account will fall to $4,000 ($12,000 - $8,000 = $4,000). If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000). In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40 percent, you would not have enough equity. The firm would require you to have $4,800 in equity (40 percent of $12,000 = $4,800). Your $4,000 in equity is less than the firm's $4,800 maintenance requirement. As a result, the firm may issue you a "margin call," since the equity in your account has fallen $800 below the firm's maintenance requirement."

Ah, the dreaded margin call.  I can remember people that I worked with not answering the telephone during significant stock market corrections, attempting to avoid the inevitable margin call.

Now, let's look at how much margin is being used in the United States.  Thanks to the NYSE, we have a complete record of outstanding margin debt all the way back to 1959.  Here is a graph showing the amount of margin outstanding since the beginning of 2000 and how quickly it has risen over the past six years:

You can quite easily see how the amount of outstanding margin debt rose in 2006, peaked at $381.370 billion in July 2007 just before the Great Recession took hold and then fell to a Great Recession low of $177.170 billion in January 2009 as investors fled the stock market in droves.  In April 2015, margin debt reached a new record of $507.153 billion, up $69.99 billion or 13.8 percent on a year-over-year basis.  This is 2.86 times the margin debt outstanding at the Great Recession low point and 33 percent higher than the pre-Great Recession peak of $381 billion.  Is this a cause for concern?

Interestingly, back in 2013, the Financial Industry Regulatory Authority or FINRA released this investor alert:

   

"Investing with Borrowed Funds: No "Margin" for Error

With investor purchases of securities "on margin" averaging more than $406 billion for the first nine months of 2013 (a 27 percent increase over the same period last year), we are re-issuing this alert because we are concerned that many investors may underestimate the risks of trading on margin and misunderstand the operation and reason for margin calls. Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors."

It is interesting to see that FINRA was concerned enough about the level of margin when it was just above $400 billion that it released a warning to investors.  Right now, margin debt levels are hovering around the $500 billion level, 25 percent higher than the level that concerned FINRA back in 2013.

Unfortunately, retail investors have been, once again, lulled into believing that stock market returns are secure since there has been no significant and persistent correction in the U.S. market since 2008.  In the desperate chase for yield in the Federal Reserve's zero interest rate environment (an environment that also makes margin debt look quite affordable), investors are taking on far greater levels of risk than they might otherwise be willing to expose themselves to.  As we can see from China's example, markets have a funny way of "eating their own", turning on investors out of the blue, particularly impacting those that are vulnerable because they have used margin debt to lever their holdings.