A record surge in margin debt is raising eyebrows as the stock market continues to surge to new all-time-highs.
Investors borrowed $814 billion against their investment portfolios at the end of February, according to data from FINRA cited in a report in the Wall Street Journal on Thursday. That’s a record high reading for margin debt, well above January’s record of $799 billion.
It’s common for margin debt to rise and fall with the stock market, as increased portfolio values afford investors more leverage to take on from their brokers. But the record rise in margin debt is also one of the fastest on record.
Margin debt saw an annual surge of 49% in February, which was the fastest jump since 2007. Prior to 2007, the fastest jump in margin debt was in 1999. Both instances were just prior to an epic melt-down in the stock market, amid the Great Financial Crisis of 2008 and the dot-com bubble unwind in 2000.
Leverage is a double-edged sword for investors, as many take on the debt to buy more stocks. That is a winning strategy in a bull market, but a market correction can spell doom for investors who have too much leverage and need to sell equities or deposit more cash to meet margin calls, which can further exacerbate a downturn in stocks.
Sometimes, stock market investors are able to borrow money from their broker to buy stocks or other securities. This tactic is called buying on margin, or margin trading.
Margin trading increases your buying power and amplifies profits.
But the possibility of encountering a margin call is the big “catch” of margin trading. Basically, it’s a request by your broker to pay back some of the money you borrowed – pronto. If you don’t, the broker can seize some of your portfolio’s assets and sell them.
Before you begin using margin, you need to understand what margin calls are and why they can be so dangerous to your portfolio – and your finances.
How does margin trading work?
But before we get into margin calls, a brief explanation of margin trading itself.
When you buy an investment – stocks, bonds, exchange-traded funds (ETFs) – on margin, you pay some money in cash and borrow the rest, usually up to half of the purchase price. The investment itself is used as collateral for the money you borrow. It’s like when you take out a mortgage for a house: The new home is the collateral, or provides the backing, for the loan.
As with a house, your down payment – the amount of cash you furnished for the investments – is your equity or ownership stake.
To calculate your equity (in dollars), subtract your borrowed amount from the current value of your securities. For example, if you bought $12,000 of securities using $6,000 of cash and $6,000 of margin, your initial equity would be $6,000:
And to find your equity percentage, you’d simply divide your equity by the value of your securities:
$6,000 (equity) / $12,000 (value of securities) = 0.50
Since your borrowed amount never changes, your equity percentage will rise or fall in tandem with the performance of your securities.
What is a margin call?
A margin call occurs when the equity in your margin account falls below your broker’s minimum requirements. There are two types of margin calls:
Federal Regulation T Call: Occurs if you don’t provide enough initial equity during the purchase of the securities
Maintenance margin call: Occurs if your equity falls below the broker’s minimum threshold.
The first type of margin call, the Fed or Regulation T call, will only happen at the beginning of a trade. This call is triggered when investors don’t have enough equity in their account to meet the 50% initial margin requirement as set by FINRA, the Financial Industry Regulatory Authority.
The second, and more common, margin call is the maintenance margin call. This kind of call is issued by a broker when the investor’s equity falls below the maintenance margin requirement (the minimum balance, in either cash or securities, that you’re required to keep in the account). FINRA requires brokers to set their minimum margin levels no lower than 25%. However, many brokers set higher minimums of 30% or more.
The maintenance margin call usually happens because your investments have dropped in price – so far in price that your equity percentage falls below your broker’s minimum.
In effect, your broker’s getting nervous: Your stock (or whatever asset you purchased) seems close to being worth less than the amount they loaned you to buy it. So they want you to put in more.
It’d be like your mortgage lender discovering that, because of declining real estate values, your house had dropped in value – and so it demands that you immediately increase your monthly mortgage payments.
Example of a margin call
Let’s return to the example of an investor who buys $12,000 of stocks using $6,000 of cash and $6,000 of margin. What would happen if the value of the securities dropped to $8,000? As the calculations below show, the investor’s equity percentage would drop to 25%:
Now imagine that the broker requires a maintenance margin minimum of 30% and issues a margin call asking for a deposit of additional cash or securities to raise the equity back to the minimum. In this example, you’d need to add at least $400 of equity to reach the 30% minimum:
$8,000 (value of securities) x .30 (minimum equity percentage) = $2,400 (minimum equity)
There are a variety of ways to meet a margin call – or cover it, as the pros say. One of the simplest ways would be to just add cash to the margin account. In the margin call example above, the investor would need to add at least $400 of cash to meet the margin call.
Depending on your broker, you may also have the option of depositing other marginable securities into your account to satisfy a margin call.
Finally, you could choose to sell some of your securities.
To calculate how many of your securities to sell, divide the margin call amount by the margin requirement. So, to continue our ongoing example, an investor with a 30% margin requirement may liquidate approximately $1,333 of securities to meet a $400 margin call ($400 / .30 = $1,333.33).
What happens if I can’t pay a margin call?
If your broker issues a margin call, you’ll want to act immediately to cover it. Usually, you’re given two to five days.
If you don’t meet the call, your broker has the right to liquidate positions. Sell your assets, in other words (without giving you the opportunity to choose which are sold) to bring your account back up to its margin requirement.
Having securities liquidated to cover a margin call can be devastating to an account. Once depreciated assets have been sold, they no longer have the opportunity to recover any of their value. The “on paper” losses become fully realized and “locked in.”
The financial takeaway
Margin calls are what make margin trading – borrowing money to buy securities – so dangerous.
Ways to avoid margin calls include keeping a sizable cash cushion in your margin account at all times. Regularly monitor your margin positions, to make sure they haven’t dropped in value to dangerous levels.
Or if you want to guarantee that you’ll never face a margin call, you can forgo margin trading altogether – and fully pay for all your securities with cash.