Margin Debt and Margin Requirements

Equity markets in the U.S. took a beating in late spring and early summer but have recently shown signs of renewing their upward march through the rest of the year. Prior to the April-May sell-off regulatory attention was being focused on a rapid rise in margin debt and the possibility that it was fueling equity markets toward a speculative bubble. Some policymakers (although not the Federal Reserve Board) signaled a preference for tightening the regulatory limits on margin credit as a solution. The decline in equity prices last spring temporarily relieved the pressure for action. However, as equity prices rise once again, its helpful to examine what economic research has found regarding the potential linkage between margin debt and stock prices.

The Securities and Exchange Act of 1934 tasks the Federal Reserve with regulating the purchase of securities on margin, i.e., through borrowing. Federal Reserve Regulations T and U set the requirements for credit extensions by securities dealers, banks and other lenders for the initial purchase of securities, including stocks. The Fed has chosen to set the initial margin requirement (minimum amount of funds an investor must commit to purchase a security) and to let the financial institutions that hold the accounts set the ongoing maintenance margin. The Fed has changed the initial margin requirement for stocks 23 times since 1934. However, the current rate has been unchanged since 1974 and is set at 50%. To illustrate, an investor wishing to purchase $10,000 of a stock must put up at least $5,000 of his/her own funds and can borrow the balance from a broker by opening a margin account.

Margin debt began attracting attention in late 1999 when, between October and December, the margin credit extended by New York Stock Exchange member firms increased 25%, from $182 billion to $228 billion. Over the same period, the stock market's value rose by only 11%. We should note here that margin credit is not included in the Federal Reserve's consumer installment credit figures and so represents additional obligations of individuals. In January, 2000 the market dropped 4% but margin credit continued to rise to $243 billion, a 6.5% increase from the previous month. By the end of February, margin credit totaled $265 billion, up nearly 50% in just four months and 90% over its level one year earlier. This surge in debt coupled with analyst's increasing uneasiness about stock market valuations prompted calls for new, higher margin requirements.

The primary macroeconomic policy concern is that the rapid growth in margin debt may have been fueling the surge in stock prices, creating a speculative bubble. However, research by economist Simon Kwan at the Federal Reserve Bank of San Francisco found just the opposite. Statistical analysis of the growth in margin credit and stock market capitalization between 1971 and 1999 found that the growth in stock prices precedes the growth in margin credit by one to two months. Kwan found the data were "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."

Another compelling reason for doubting the efficacy of margin requirements as a policy tool is that limits on one form of borrowing can be easily circumvented by borrowing from a different source. Credit is fungible. Home equity accounts, personal loans, or loans against 401(k) accounts all serve as alternative sources for funds that could be put into equity markets. For this reason Kwan concludes that it is no surprise that the vast majority of studies investigating the effects of margin changes on securities behavior found little evidence that changes in margin requirements have significant effects on the price, volatility, or volume of stocks beyond a brief announcement effect lasting just a few days. Federal Reserve Chairman Greenspan apparently agrees that changing margin requirements would not have the intended effect. In a follow-up response to a question asked at a Congressional Hearing last spring, Greenspan indicated that "with regard to margin requirements, studies suggest that such requirements have no appreciable effect on stock prices."

For more detailed discussion of the arguments surrounding margin requirements as a policy tool visit the Federal Reserve Bank of San Francisco's website at www.sf.frb.org and look for prior issues of their newsletter The Economic Letter.