Margin-debt balances have risen once again to levels seen just before significant market corrections. No news flash there as Twitter
(NYSE:TWTR) users and the broad media have been talking about it for several weeks now. I'm not cavalier enough to suggest that this time is different, but before jumping headfirst into the “short” pool, there are a few things to consider.
Not all margin debt is created equal. While almost everyone is focused on margin debt against equity positions, typically that is not what causes systemic financial accidents. If there's one thing brokers are good at, it's making margin calls; when they are not met, they result in the ruthless liquidation of stock positions. Margin calls can cause violent drops in stock prices, but they purge accounts of over-leverage just as fast, bringing outsized exposure back into balance. The 1987 crash was, perhaps, the quintessential example of a massive margin call, but as dramatic as it was, it hardly registers on today's charts and certainly did not result in a broader financial crisis. (The 1990 savings and loan (S&L) debt crisis did.)
There are a few reasons for the generally "benign" nature of equity-margin calls, chief among them are the following: (i) Equity markets are probably second in liquidity only to the Treasury and currency markets; (ii) as long as the credit markets continue to function, margin calls simply shift positions from overleveraged accounts to accounts that have the wherewithal to lever up; and (iii) companies hate seeing their stocks dive, and they cherish the opportunity to buy back their stocks on the cheap using cash on hand, or as it has been prevalent over the last four-plus years, by borrowing in the corporate bond market.
The type of margin that historically has caused financial crises hides in the debt piled up against corporate credit positions. Here, too, there are several reasons: (i) Before they implode, credit funds can usually lever themselves up far more than equity funds; (ii) the corporate bond market can be described as illiquid in the best of times, so “forced selling” into a panic tends to be an oxymoron because in those circumstances, there are no buyers at virtually any price; (iii) when the credit markets shut down, they shut down for everyone, so it is much harder -- if not impossible -- for "healthy" accounts to find enough credit to poach the merchandise being jettisoned by weaker hands; and (iv) the more and more prevalent use of credit derivatives, such as credit default swaps (CDSs) -- which are, themselves, intrinsically highly leveraged animals -- adds a layer of pro-cyclicality to credit implosions.
In my humble opinion it's critical to distinguish between troubles caused by equity-margin debt versus troubles with margin on corporate credit. This is what determines whether a market drop should be viewed as a correction / cyclical bear market / buying opportunity versus the end of a secular bull move and the beginning of a secular / systemically dangerous bear market.
So, in light of the above, where do equity and credit markets stand today? Looking first at corporate credit, most signs suggest that we could not be further away from a margin squeeze. I wrote about my bond market tells in Corporate Bonds, Derivatives, and How They Wag the Equity Markets
, but to recap them:
There is a seemingly endless torrent of new money being allocated to credit. The biweekly Pension & Investment Magazine has a couple of pages dedicated to new investment allocations by large buyers of corporates and other debt-related assets; if anything, over the last couple of months, the pace of fresh cash allocations to debt is actually accelerating.
While it is somewhat difficult to find data on the level of margin debt in the credit markets, anecdotally there are new credit funds popping up everywhere, which suggests that we are still early in the levering-up process.
Using the Barclays US Corporate High Yield Index as a proxy, yields on junk bonds are within 50bps of the all-time lows, despite higher Treasury rates and almost $1.6 trillion of new issuance in 2013.
It's a similar story for spreads on CDSs of large US financial institutions.
Margin calls are typically triggered by a fall in the price of the leveraged asset; when asset prices are steady or actually rising, the trigger for a margin squeeze is missing. As you can see from the charts below, there are a lot of profits built in to the junk-bond market.
Even the most recent buyers already show profits.
I am aware that this may sound somewhat circular, and that when margined positions move in one’s favor, they tend to lead to even larger and more leveraged books. But, be that as it may, if prices don’t drop, and/or investors have profit cushions, margin calls simply are not going to happen.
Lastly, for the here and now, consider the behavior of corporate bonds in just the last couple of days: (i) The first two days of the January corporate bond issuance period have tallied $22.7 billion of news bond sales; (ii) Banco Santander (NYSE:SAN) sold a $1 billion asset-backed security (ABS) of junk auto loans; (iii) FedEx (NYSE:FDX) sold $2 billion of bonds explicitly to buy back its stock; and (iv) Italian bank Intesa Sanpaolo (OTCMKTS:ISNPY) (and we know how healthy Italian banks tend to be) sold $2.5 billion of 3-year and 10-year bonds at spreads of +175 and +240.
There will be a day of reckoning for all this debt, but there are no indications it is around the corner.
As for margin debt levels on equities, they are high. In fact, the first chart suggests that they have never been higher as an absolute dollar number.
But when looking at debit balances as a percentage of credit balances in margin and cash accounts, you can see that we are still a ways off from the peaks reached in the late ‘90s.
Consider the latter measure in rather simple terms: Regulation T allows most accounts to lever up stock positions 2:1. So it makes sense that when in 1998 and 2000, margin as a percentage of free balances reached almost 2x, once the market turned, margin calls exacerbated the drop and quickly purged the excesses. In other words, there was no place to go but down. (For those familiar with portfolio margining, I am leaving that aside for now since it’s unclear to me whether the structure of the added leverage matters in a downdraft).) It doesn’t mean that today’s margin levels won’t fuel a violent drop, if and when a correction gets going. We saw that happen in the summer of 2011 when the energy group (represented by the Energy Select Sector SPDR ETF
(NYSEARCA:XLE) and the SPDR S&P Oil & Gas Explore & Prod. ETF
(NYSEARCA:XOP)) led a 20% drop in the S&P 500
(INDEXSP:.INX). But accounts are not yet at the point where there is no room for error.
In sum, the concerns around current equity-margin debt are valid, particularly for those accounts that are heavy on margin. There’s enough leverage out there to amplify an eventual shakeout and make it pretty scary. But given the state of the credit markets, it’s far more likely than not that the purge will remain an equities-specific issue, that it will not have systemic implications, and that for patient and healthy accounts, it will prove to be yet another buying opportunity for yet another eventual move to new highs.
Position in SPX.
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