Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man! We have retirements to fund, and precious little time to do it!”
Those that have read me for a while will know that I am an advocate for simplicity, and against debt. Why? The two are related because some of us tend toward overconfidence. We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances. We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.
The topic of the evening is margin loans, and is prompted by Josh Brown’s article here. Margin loans are a means of borrowing against securities in a brokerage account. Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods, or services. Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.
Margin loans seem less burdensome than other types of borrowing because:
- Interest rates are sometimes low.
- They are easy to get, if you have liquid securities.
- They are a quick way of getting cash.
- There is almost never any scheduled principal repayment or maturity date for the loan.
- Interest either quietly accrues, or is paid periodically.
- You don’t have to liquidate securities to get the cash you think you need.
- There is no taxable event, at least not immediately.
- Better than second-lien or unsecured debt in most ways.
But, what does a margin loan say about the borrower?
- He needs money now
- He doesn’t want to liquidate assets
- He wants lending terms that are easy in the short run
- He doesn’t have a lot of liquidity at present.
So what’s the risk? If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:
- Pay back some of the loan, or
- Liquidate some of the assets in the portfolio.
And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.
Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis. But when there is a lot of margin debt, that’s a problem. As I like to say, markets abhor free riders. When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come. And come it will, like a heat seeking missile.
Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action. But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.
A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.
I would again encourage you to read Josh’s excellent piece, which includes gems like:
Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.
He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process. It’s another reason not to take out those loans.
Remember, Wall Street wants easy profits from margin lending. They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.
The Free Advice that Embraces Humility
Just say no to margin debt. Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.
If you have margin loans out now, start planning to reduce them (before you have to). You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your assets to their rightful owners.
Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so. If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.
And after all that… enjoy your sleep, even amid crises.