Data Brief - What Wealth Evaporation Looks Like

What Wealth Evaporation Looks Like

Saturday, November 1, 2008

Whenever we suffer a large downdraft in the market, much of the blame usually falls upon short sellers and margin clerks. The former supposedly try to manipulate prices lower to make a profit while the latter indiscriminately sell stock in order to protect their brokerage firms.

Both are over-rated as an influence.

I used to manage the operations of a top 10 discount brokerage firm, part of which was the margin department. Unlike what's portrayed in the media, we did not automatically sell stocks at 3:30 in the afternoon to cover margin calls. Maybe it's different in the institutional world, but few retail brokerage margin departments have set times at which they sell out customer accounts.

Especially now with advances in real-time tracking of equity levels, margin departments have a minute-by-minute handle on where their customers stand in terms of their equity requirements, and with the extreme volatility we've seen, they will not wait to sell out a customer if their equity dips too low.

Defining The Terms

Just to be clear on terminology, "margin debt" is the amount of borrowing by customers. It refers to loans that use equities in a brokerage account as collateral. As long as the stocks in the account are valuable enough to support the loan, the customer is in fine shape. But if the stocks' value decline enough to drop below the minimum requirements laid out by the brokerage firm (or the government), then the customer gets a "margin call", at which time they have anywhere between, oh, RIGHT NOW and three days to either wire in more cash or sell stock to reduce their debt burden.

"Free credit" in a cash account is simply the amount of actual cash sitting in the account. In a margin account, "free credit" refers to the excess amount that a customer is free to withdraw for whatever purpose (usually used to buy more equities).

For example, if a customer deposits $100,000 worth of marginable securities into their account, then borrows $30,000 from the brokerage firm, they are free to borrow another $20,000 (bringing their total margin debt to $50,000, or 50% of the value of the underlying collateral). So in this case, the customer has $20,000 worth of free credits.

A Look At The Latest Data

There will probably be a big focus on how customers that buy on margin have fared in the recent swoon. The latest data from the NYSE was just released, showing account activity through the end of September. October was an even worse month, but September wasn't exactly roses.

What we see is very odd. Common sense would suggest that as prices fall, customers (or their brokerage firms) would sell stocks or raise cash in order to reduce overall debt balances. For the most part, that has been the case since last August. Margin debt has been on a steady march downward while free credit balances have risen. During the crash of 1987, margin debt dropped precipitously while free credits soared, pretty much in line with what we would expect.

The chart below shows the interaction between the S&P 500, total margin debt and free credits over the past 18 months. The bottom (red) line is the month-over-month change in free credit balances.

While stocks tumbled in September, total margin debt actually increased. This means that in aggregate, there was no reduction in the amount of debt held by customers. While some accounts most certainly were sold out to reduce or eliminate their loans to the brokerage firms, overall there was no gigantic margin call.

What did happen was that all of those excess free credits that were sitting around got wiped out. In August, customers had about $185 billion in "available cash" - total free credits (assets) minus total margin debt (liabilities). That was enough to buy about 2% of the entire S&P 500.

In September, that was eliminated. Wiped clean. Gonzo. By the end of the month, that $184 billion surplus turned into a $240 million deficit.

The rate of change in free credits is absolutely astounding. In one month, it changed by a negative 37%, by far the largest monthly drop since 1932. Over the previous 76 years, the prior largest monthly decline was -18% in November 1987.

What It Means Now

So what does that mean for us now? Well, most importantly it removes a layer of potential buying power.

Not that that helped a whole lot on the way down, but the bottom line is that these brokerage firm customers had $184 billion less to spend by the end of September than they did the month before. That's $184 billion that can no longer be used to buy more stocks, or cars, or vacations or whatever else they might have wanted to buy.

Dramatic monthly drops in free credits have not been a very good predictor for what to expect going forward, so I'm not sure how much we can read into the data in that respect. And there is no precedent for the destruction that we just saw, so relying on historical context is out the window.

October should have been even worse, but I suspect what we will see with the next release is a dramatic drop in margin debt, and not so much in free credits. While it's delayed by a month, that would probably be a better contrary indicator than September's report.