Investors who borrowed money to bet on stocks helped worsen this past month's stocks selloff and market decline. Due to the correction, such investors were forced to reduce their obligations and sell shares, turning them into cash. Their debt is known as "margin loans." Should margin loans continue to rise at the current pace, large selloffs and stock market volatility may become the norm.
In total, the Financial Industry Regulatory Authority (FINRA) claims that retail and institutional investors have borrowed $642.8 billion against their portfolios. These investors borrow more to preserve larger gains by increasing their stock exposure. But once the Dow dropped, losing over 1000 points over the course of February, these investors faced penalties that worsened their fall. Some experts claim that, by trading on margin, these investors exacerbated the already-severe effects of the market downturn.
Margin loans allow investors to pledge all or parts of a stock and bond portfolio as collateral, enabling them to purchase other securities. However, if the value of their collateral sinks past a certain point, banks will demand repayment. If they aren't paid, then the securities backing the loan are sold, and the borrower becomes responsible for what remains to be paid. This, called net margin debt, constituted 1.31% of the total value of the New York Stock Exchange in 2017.
February's market pullback erased the gains that major stock indexes reaped in January. However, both the Dow and the S&P 500 sit on double-digit returns from past years, keeping investors' portfolios afloat during the decline.
Margin debt has been increasing for years, and is frequently used as a signifier of investor confidence. Simply put, margin debt is money borrowed by investors against existing stocks to purchase new stocks. Investors borrow money using either a portion or all of a portfolio as collateral. Investors are most inclined to do this when markets are rising, and leverage seems like an easy way to amplify gains from the current circumstances. But the moment the market turns down, stock portfolios frequently lack the resources to cover the related debt. Brokers then issue margin calls, demanding more money and liquidating customer portfolios, regardless of whether investors themselves give them permission to do so. En masse, such actions will result in sustained market downturns, creating a "quick, brutal bear market."
Long-term stock rallies push debt levels higher because investors are happier to take out loans against investments with rising value. The only difficulty is that margin debt can also drive steep market downturns, as was the case in the dot-com bubble and 2008 financial crisis. In January, FINRA published an investor alert once the total value of margin loans exceeded $600 billion. They claimed that many investors underestimate the risks involved in trading on margin, and disregard margin calls. In fact, many of the investors who suffered the most during the downfall were those who had made use of exchange-traded products, betting that low volatility would prevail in the markets and allow stock prices to stay stable. This assumption was mistaken, and investors who invested in funds tracking market swings with growth predicated on stability found themselves with massive losses.
Certain brokerages are instituting new policies to prevent such investments from going through. These include Merrill Lynch, the wealth management division of Bank of America (NYSE: BAC) and E*Trade Financial Corp (NASDAQ: ETFC). The latter brokerage decided to raise margin requirements for those who had invested in the iPath S&P 500 VIX Short-term Futures exchange traded note, forcing clients to pay for trades in their own cash.