How Margin Debt Correlates with Market Movement

It is worthy to mention the correlation between margin debt and market movement.  High margin debts show the consequences of over-leveraging and willingness to be more risk-taking.  Usually rising markets attract more investors to put debt to work. Most investors think it is easier to make money. 

Margins can be a double-edged sword. When the market goes up, the brokerage houses are inclined to loan investors money. Thus, investors can increase their buying power and magnify their investment profit. 

Usually the loan from the brokerage house is collateralized by stock holdings (value in the portfolio). When the market unwinds, the share value shrinks. In the meantime, the brokerage houses become more conservative and eager to get the loaned money back.

Often the movement in a market downtrend compels brokerage firms to disallow or reduce clients’ borrowing limit, or curtail the trading on certain risky securities.  They usually establish stricter criteria. For example, they increase margin requirements. Then borrowers are either required to inject more liquidity to keep up with the margin requirement or coerced to liquidate in order to pay back the debt.

This measurement would force borrowers to sell shares in a downward market.  If many investors are executing a margin sell in about the same time frame, it will cause a market crash or collapse.  If borrowers are not willing to dump their shares, the brokerage houses will do it for them relentlessly, which might intensify the market selloff and drop share prices more violently.  Therefore, the margin debt would stimulate the market or accelerate the sell-off. 

On the other hand, since borrowers need to pay margin interest on their debts, their psychological perspective could change! They can’t afford to lose money! Thus, it will have a negative impact on their trading behavior too, since they’re nervous and uneasy.  This factor will disturb the market further. 

The year 1999 was a glory year for the stock market. Everybody was jubilant about his hefty profit, and both brokerage houses and investors were very bullish. Some brokerage houses even loosened the margin requirement from normal 1:1 to 4:1. For instance, if investors had $1 cash, the brokerage houses loaned them $4. 

During the tax season April 2000, many investors needed to pay large amounts of taxes for capital gain. Right before the tax date, the stock market unexpectedly dived. Investors were eager to sell because they owed large sums of tax dollars. In the meantime, the brokerages reversed the loosened margin requirement (1:4) to normal (1:1). It was an infamous “tax selling down-turn” on Wall Street.  The margin sell intensified the selling force in the stock market and caused more fear! This, in turn, caused more selling. The malicious cycle was working effectively.  When it rains, it pours.

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