Margin debt is at a record high in US markets
The Federal Reserve has to be concerned about financial stability. When the credit markets become an integral facet sustaining asset markets, markets and the economy become interwoven in a bad way
According to the US Financial Industry Regulatory Authority, investors have borrowed a record $642.8 billion against investment portfolios. The leverage from this margin debt is a bid to increase returns. But it leaves investors vulnerable if asset prices decline. And they may have to sell into a falling market.
February’s Market Correction
If we look back to the 1200 point fall in the Dow Jones Industrial Average earlier this month, increased leverage was an amplifier of volatility. When the crash happened, many commentators blamed the events on a short volatility trade. Volatility in US markets had been low for so long that many were betting it would continue. The spike in volatility forced people out of those positions, amplifying the volatility more still. That was the narrative.
But the increasing leverage investors are using could also have played a role in amplifying volatility during the market correction. Indeed, records show a large net sale of equity funds in the week of the correction.
According to Goldman Sachs, net margin debt was 1.31% of the value of all shares on the New York Stock Exchange when the correction hit. That’s the highest level in their records back to 1980, eclipsing even the tech bubble peak of 1.27%.
Minsky Moment coming?
Put simply, we have a lot of speculative borrowers in US asset markets. And if you recall how Hyman Minskky talks of business cycles, an increase in speculative and Ponzi investors over hedge investors is an end of cycle signal. And a lot of this is psychology. The more stable the economy is, the more risks borrowers and lenders are willing to take. As Minsky put it, stability breeds instability.
And we can see this in the anecdotes from the Wall Street Journal about traders caught in the market correction’s margin debt vise. And here, margin debt and short vol trades came together
Many of the hardest-hit investors were those who had used exchange-traded products to wager that low volatility would persist and stock prices would remain stable.
Harvey Hajiyan, a 35-year-old financial adviser who lives in Toronto and has been investing for more than a decade, assumed stocks would continue to grind higher this year, similar to the gains the Dow and the S&P 500 had posted for much of the past two years without a pullback.
“All of the strategists agreed the market would go up,” said Mr. Hajiyan.
At the end of January, he placed an ill-timed bet and used only margin to fund a large position in the ProShares Short VIX Short-Term Futures exchange-traded fund (SVXY), which rises as long as stock prices remain stable. When the S&P 500 fell into correction territory to erase one of its best starts in years, Mr. Hajiyan’s investment in the ProShares fund tracking expected market swings was nearly wiped out, forcing him to liquidate hundreds of thousands of dollars of securities to answer the margin call.
“I was in denial,” said Mr. Hajiyan after he realized he lost about 600,000 Canadian dollars (US$472,260) worth of his C$1.1 million investment portfolio.”
Margin Debt Financial Stability Concerns
So what happens in another market downdraft? Have the short volatility traders been chastened?
The large volume of margin debt is clear evidence that many speculative borrowers are still vulnerable. So the question now is whether the recent correction is a one-off event. If it is and the market grinds higher, we should expect more margin lending. If not, perhaps the volatility will be enough to cut the negative financial stability implications from leveraged investing.
Either way, this is where the Federal Reserve will have concern about financial stability. When the credit markets become an integral facet sustaining asset markets, a sustained fall in asset prices can boomerang back onto the financial system. And once a fall in asset prices damages the financial system, markets and the economy become interwoven in a bad way. This is what the Fed wants to avoid. It will be interesting to hear what the new Fed Chairman Jerome Powell has to say about margin debt.