The Debt Problem Nobody Talks About: Margin Debt
As everybody knows by now, the North American economy has been fuelled over the past six years by an around-the-clock, all-you-can-stomach debt bender of historic proportions. And as you've surely noticed, consumers are now enduring the kind of hangover that makes you simultaneously curse heaven and beg for its mercy. What seemed, for all the world, like a virtuous cycle of investment and growth was really an economy built precariously on borrowed money, and living on borrowed time.
As of last September, total household debt in the United States stood at an all-time high of US$13.6 trillion - up 43 per cent in just four years. The bulk of that was made up of mortgages, but consumer credit (car loans, credit cards, etc.) also hit a record last year: US$2.5 trillion, up 19.6 per cent since 2003. An alarming chunk of the mortgage debt went bad over the past year, and not surprisingly, those credit card statements are now looking wobbly as well. If foreclosures were the story of 2007, personal bankruptcies could well be the story of the next six months.
Here in Canada, we like to smugly observe that we're not as careless with borrowing as our American cousins. But it's all relative, and we're gradually catching up. As of November, total household debt in Canada stood at an all-time high of US$1.17 trillion. Consumer debt also hit a record in November: US$365.6 billion. Both figures have climbed a whopping 48 per cent in four years. As of mid-2007 (the most recent period for which numbers are available) the ratio of debt to disposable income had hit a new high of 128 per cent. Meaning for every $100 in take-home pay, Canadians are now carrying $128 in debt. That ratio has been on a steady climb for over a decade.
Amid all this borrowing, one form of debt has been all but ignored, but that could soon change. Over the past few years, people have not just borrowed to buy homes, cars, and flat-screen TVs. People also took out loans to speculate on the stock market. Buying stock with borrowed money is called "buying on margin," and in recent months so-called margin debt has crested to new heights right along with credit card balances.
Margin accounts in the U.S. market hit the high-water mark last July, with US$381 billion outstanding. That amount fell to US$322 billion in December, which should be somewhat reassuring until you realize that even at the height of the dot-com frenzy, when everybody and their brother-in-law turned day trading into a hobby, margin debt hit a then-unheard-of peak of US$278 billion. So, at last count, the amount of borrowed speculative money sloshing around the stock market was US$44 billion more than at the peak of the Internet mania in 2000.
Here in Canada the numbers are not quite so jaw-dropping, but the pattern is the same. As of November, the Investment Dealers Association reported outstanding margin accounts of $15.2 billion, an all-time high, and 29 per cent more than the record hit in mid-2000, just before the tech stock crash.
How do these risky debt loads get so big? Well, until a few years ago, big brokerages like Merrill Lynch and Morgan Stanley actually paid rewards to brokers who loaded up their clients with margin debt. Firms have since cut back on that kind of thing, but the implicit incentive is still there. Brokers make commissions based on how much money their clients invest with the firm. More borrowed money means more trading, and so brokerages are still very much inclined to encourage investors to buy as much stock as their credit rating will allow. And that is why, after a five-year bull market that pushed stock indexes to unprecedented heights worldwide, investors and their brokers were only too eager to lay increasingly aggressive bets in the hope and belief that the good times would never end.
Still, there are some who believe this isn't a problem at all. The steady rise in margin debt has been greeted mostly with a shrug by financial analysts. Exactly one year ago, when margin loans first broke into record territory in the U.S., the New York Times ran a lengthy article arguing that such debts were still at manageable levels when compared to the overall value of the stock market. That's much like saying that a huge debt load is no problem as long as the value of your house keeps climbing. The problem is, when house prices fall sharply, the debt remains, and that's precisely the squeeze many investors have found themselves in over the past few months as the value of the stocks bought on credit plunged.
Margin debt works for stocks much the same way jet fuel does for airplanes: it propels markets higher when all is well, and it creates a blinding fireball in the event of a crash. When a brokerage loans a client money to buy stocks, it keeps close tabs on the portfolio. If those stocks begin to fall, the brokerage starts making "margin calls" - requiring that investors either come up with more cash to deposit into their account, or sell some of their stocks to repay the loan. If the broker can't get hold of the investor, he has the right to simply sell the stocks to cover the loans. That's part of the reason why falling markets tend to pick up steam as they plunge: nervous brokers dump shares into the market to recoup risky loans that probably shouldn't have been made in the first place.
Right now, things have calmed down from the panicked selling of a couple of weeks ago. The U.S. Fed has slashed interest rates an astonishing 1.25 percentage points in 10 days, and stocks have climbed. Call this the "hair of the dog" approach to monetary policy: just like more booze is the favoured hangover elixir of problem drinkers, lower interest rates and cheaper loans are the current solution for a nation mired in debt.
You'd like to think that overextended investors will use this respite to calmly and systematically reduce their debts and play it safe. But when you hand an alcoholic another double bourbon to help get him through the day, is it really a cure, or is it just postponing the inevitable agony?
See also STOCK AND BOND MARKETS.
Maclean's February 18, 2008