April’s Tech Sell-Off Slashes Margin Loans
The technology stock sell-off that climaxed in mid-April drove down investor borrowing against stock assets by a record $26.8 billion last month, the New York Stock Exchange reported Monday--another indication that some of the market’s speculative fuel has been dissipated.
The amount of outstanding “margin”--loans taken out against stock accounts--at NYSE member brokerages dropped 9.6% to $251.7 billion as of April 30, from a record $278.5 billion in March.
In general, margin debt is credit used by investors to buy more stock, though it can be used for other purposes as well. Using credit to buy stocks can magnify an investor’s gains--and also magnify losses.
Just as margin borrowing juiced the tech-dominated Nasdaq market’s rise, helping it to a stunning 86% gain in 1999, the drop in margin use--in many cases, a decision forced on investors in April--has helped steepen the slide in tech stocks since late March.
As stocks plummeted, investors who had borrowed against their accounts were required to put up more cash toward their loans. In some cases that resulted in forced liquidation of stocks, putting more downward pressure on share prices.
Under current rules set by the Federal Reserve Board, brokerages are allowed to lend investors up to 50% of the value of stocks in their account. At the time of the 1929 market crash, by contrast, investors could borrow as much as 90%.
After a loan is made, the value of an investor’s account equity--that is, the total account value minus the amount borrowed--is required to stay above a certain “maintenance” level, which is set by the regulatory arms of the NYSE and Nasdaq.
The minimum maintenance level is 25%, but individual brokerages may require higher maintenance levels for the whole account and for certain highly volatile stocks. Most brokerages now maintain lists of several hundred hot stocks with tightened margin restrictions.
If the account value falls below the maintenance level, the broker issues a “margin call,” demanding that the investor deposit more cash. Assume, for example, that you bought $1,000 of stock with $500 of your own money and a $500 margin loan. If the stock dropped to $650, your ownership stake would be $150, or 23% of the account value. That would trigger a margin call.
Investors who ignore margin calls face having their stock sold directly by the brokerage to cover the loan. Such forced selling magnified Nasdaq’s volatility in the latter half of March and the first half of April, when there were eight one-day plunges of 3% or more over a span of 20 trading days.
Analysts said the April drop-off in margin partly reflected the psychological toll of the slump in the once-golden tech sector. The Nasdaq composite index is down 28% from its all-time peak of 5,048.62 on March 10.
But many investors have stopped borrowing for a more practical reason: They’re tapped out.
Consider Alan Chien, a dentist from Diamond Bar, who doubled his money in two months late last year, mostly buying tech stocks. Despite his success, Chien resisted buying on credit until March, “when I got greedy,” he said recently.
After racking up thousands of dollars in paper gains in his first two days of trading on margin, Chien--and the market--ran into a harrowing run of losses, culminating in the April 14 rout, when the Nasdaq index plunged 9.7%.
Chien was hit with several margin calls in his account to bring his collateral up to the required maintenance level. This forced him to sell stocks he had hoped to hold.
When the dust cleared, Chien had lost $200,000. Now, although he would still consider buying on margin again, he lacks the collateral to resume anything close to his previous level of trading.
As a percentage of total stock market assets, margin debt peaked at 1.54% in March, the highest since current margin-lending rules were adopted in 1974, according to Trim Tabs Financial Services.
The ratio eased to 1.44% in April, but that is still above the previous high-water mark of 1.37% in September 1987, just before the historic crash of October 1987.
Economist John Puchalla of Moody’s Investors Service noted Monday that, despite the sharp one-month decline, margin debt remains 45% above the year-ago level.
“The rapid growth of margin debt still presents a risk to equity valuations that remain lofty,” Puchalla said Monday. “Even if corporate earnings continue to strengthen,” he added, “the upside potential for equities over the next year might be limited by rising interest rates and reduced support from margin borrowing.”
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Pulling Back
Loans outstanding against investors’ stock accounts at New York Stock
Exchange-member brokerages fell sharply in April amid the market’s deep dive. Month-end figures, in billions of dollars:
*
April: $251.7 billion
*
Source: Bloomberg News
