FRBSF Economic Letter
2000-09 | March 24, 2000
The recent rise in margin credit has focused attention on the Federal Reserve’s margin requirements for purchasing equities with borrowed funds, which has been at 50% since 1974. In November and December of 1999, margin credit grew very rapidly, outpacing the sizable appreciation in the overall stock market. And in January 2000, it grew further while the stock market’s valuation dropped, leaving the ratio of margin credit to market capitalization at its highest level in the past 29 years. This Economic Letter discusses the recent trend in margin credit and the merits of using margin requirements as a policy tool.
The Securities Exchange Act of 1934 mandated federal regulation of purchasing securities on margin. The margin requirement was motivated by the concern that credit-financed securities speculation helped fuel the run-up in stock prices prior to the stock market crash of 1929. The act viewed the Federal Reserve as responsible for managing the availability of credit in the economy, so the Fed was charged with setting margin requirements for securities purchases. The Securities Exchange Commission was directed to enforce those regulations.
Federal Reserve Regulations T and U govern the extension of credit by broker-dealers, banks, and other lenders to customers for the initial purchase of certain securities, including common stocks. The initial margin requirement represents the minimum amount of funds that investors must put up to purchase stocks on credit. For example, with a 50% initial margin requirement, an investor who wants to buy one share of ABC common stock valued at $100 per share must do so with at least $50 in her own funds or additional collateral. In other words, the maximum amount of credit an investor can obtain from the broker to purchase stocks is 50% of the stocks’ value.
Since 1934, the Federal Reserve has changed the initial margin requirements in stocks 23 times (see Figure 1). The current rate, set in 1974, is 50%.
The Federal Reserve has chosen to set only the initial margin requirement. The maintenance margin, which determines the leverage on a continuing basis, is set by the exchanges and brokers. Currently, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) generally require member firms to impose a minimum 25% maintenance margin requirement on their customers. In practice, the house margins set by individual brokerage firms are higher, and some brokerage firms further differentiate their margin requirements by individual stocks and the trading behavior of their customers. To the extent that the maintenance margin is less than the initial margin, the price of a stock can fall substantially before investors are required to furnish additional funds. In the earlier example, at a 25% maintenance margin, the value of ABC stock can fall to $66.66 before the investor must provide additional funds to the broker. At $66.66 per share, the amount of borrowing, $50, represents 75% of the value of the stock.
We can begin to analyze the question of whether rising credit boosts stock market valuations by looking at data collected by the NYSE on margin credit extended by member firms to customers. Figure 2 gives a long-run perspective on the level of margin credit and the level of market valuation. Clearly, for most of the last 30 years, they have moved fairly closely together.
But a somewhat unusual development began in the last two months of 1999. Between October and December 1999, margin credit extended by NYSE member firms increased 25%, from $182 billion to $228 billion, while the stock market’s value went up by 11%. In January of this year, despite the 4% drop in stock market value, margin credit continued to rise to $243 billion, a 6.5% increase from December.
The recent rise in margin credit is notable because it has outpaced the rise in stock market valuations. Figure 3 plots the ratio of margin credit to total market capitalization from January 1971 to January 2000. The strong growth of margin credit in recent months has pushed this ratio to 1.58%Ca record high during the past 29 years–eclipsing the previous peak of 1.53% set in October 1987 following the stock market crash. Nevertheless, this ratio is still relatively tame compared to the estimated 10% level reached at the height of the speculative fever during the late 1920s.
It is important to note that the NYSE margin credit data have some limitations. First, the data reflect both short and long positions. Since short positions are marked to market daily, any positions showing a loss would automatically result in an extension of margin credit to the customer. (In long positions, margin credit remains constant even when the stock price falls.) Thus, a portion of the growth in margin credit could be associated with mark-to-market losses on short positions as equity prices rose, as in the fourth quarter of 1999. Second, the data include all credit extended against any type of marginable collateral, not just equities. This includes government and agency securities, corporate bonds, and some foreign securities. Hence, the ratio of margin credit to market capitalization is biased upward, and its impact on the recent figures is unclear.
The rapid rise in margin credit raises the question of whether it may be fueling the run-up in stock prices. After all, this is Congress’s main concern in mandating margin requirements in the first place. One way to address this is to conduct a statistical test–called a Granger-causality test–to examine the time-series dynamics between the growth in margin credit and the growth in market capitalization using monthly data from 1971 to 1999. The results find that the growth in stock market capitalization precedes the growth in margin credit, not vice versa. Specifically, both the one- and two-month lagged growth rates in stock market value are significant in explaining the growth in margin credit; the lagged growth rates in margin credit have no explanatory power for the growth in stock market value. While the Granger-causality test does not identify economic causation and only depicts a statistical association, the data do not suggest that, in general, the growth in margin credit fuels the stock market gains. Rather, the data are consistent with investors reacting to a rise in stock prices by borrowing more against stocks and, likewise, reacting to a fall in stock prices by borrowing less.
In recent years, policymakers increasingly have expressed concerns about the possibility of a stock market bubble. While commenting on the level of stock prices is beyond the scope of this article, an important policy consideration is whether changes in margin requirements would be expected to have a measurable effect on stock market activities.
The attractiveness of using the margin requirement as a policy tool is that it can be directed specifically at a certain market. If speculation in the stock market becomes a concern to policymakers, changing the margin requirement can send a signal to the market about their view of equity valuations.
However, the margin requirement poses a number of problems as a policy tool. First, we must realize that when the Securities Exchange Act was passed in 1934, direct buying and selling of stocks were the only ways to profit from stock price movements. Since then, innovations in the marketplace have led to the creation of financial products that allow investors to speculate on stock price movements without actually owning any stocks. For example, significant exposure to specific stocks may be obtained through fully paid for derivative securities, such as options, which by design are highly leveraged. Also, investors can use stock index futures contracts to speculate on broad stock market movements. The margin in futures is set by the futures exchanges and is considered not an extension of credit but rather a performance bond to provide assurance to meet the participant’s future obligations. As an illustration, the initial margin for each Dow Jones Industrial Average (DJIA) index futures contract is $6,750, which is about 6.75% of the contract value (each contract is $10 times the DJIA index, or about $100,000). The long and short positions are marked to market daily, and so are the settlements among the participants.
Second, credit is fungible. Investors can easily substitute other types of credit for margin credit using non-securities collateral, such as a home equity loan. To the extent that investors can obtain credit from other sources to purchase stocks, the margin requirement becomes a non-binding constraint. Thus, changing margin requirements may not have the desired effects on stock market activities.
Given these limitations, it is not surprising that the vast majority of studies investigating the effects of margin changes on securities behavior conclude that there is little evidence that changes in margin requirements have significant effects on the price, volatility, volume, and liquidity of stocks beyond the announcement effect. The only notable exception is Hardouvelis (1990), whose findings were subsequently challenged by the works of Hsieh and Miller (1990) and Pruitt and Tse (1996).
The recent run-up in margin credit has prompted some policymakers to debate the idea of changing margin requirements to stem possible speculative excesses. However, the effectiveness of using margin requirements as a policy tool is questionable. Investors can use financial derivatives to obtain exposure to equities without owning stocks, and they also can substitute margin credit with other types of credit. Finally, the bulk of the research on margin requirements indicates that changes in the requirements do not have a significant permanent effect on the behavior of stock prices.
Hardouvelis, G. 1990. “Margin Requirements, Volatility, and the Transitory Component of Stock Prices.” American Economic Review 80, pp. 736-762.
Hsieh, D., and M. Miller. 1990. “Margin Regulation and Stock Market Volatility.” Journal of Finance 45, pp. 3-30.
Pruitt, S., and K. Tse. 1996. “The Price, Volatility, Volume, and Liquidity Effects of Changes in Federal Reserve Margin Requirements on Both Marginable and Nonmarginable OTC Stocks.” In The Industrial Organization and Regulation of Securities Industry, ed. A. Lo, National Bureau of Economic Research Conference Report series, pp. 317-340. Chicago and London: University of Chicago Press.
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