What on Earth is a margin call?
One of the key features of the US stock market is the ability to invest in securities using borrowed money. Anyone can secure a loan using the stocks in their existing portfolio as collateral and then use those borrowed funds to invest in more stocks.
This is what’s known as margin trading. Hedge funds, crypto traders, and rambunctious retail traders all participate in margin trading. If you expect a stock to bounce considerably at some point, you can expand how many shares of that stock that you own by a much wider margin than the cash you have on hand.
Brokers who let you trade with their money realize that it’s risky to give money to someone who could lose it all in the stock market. They don’t just offer such loans based on your credit score. They require investors to put up some of the stocks they already own as collateral for the loan.
Let’s take a chance on the market.
Historical margin calls
1929: The stock market crash preceding the Great Depression is triggered in part by a massive increase in margin borrowing followed by a tightening of margin requirements.
1987: The Dow Jones Industrial Average crashes by more than 22% on a day now called Black Monday. Record levels of margin calls cause the price changes, with the margin calls on this day reaching about 10 times the normal average at the time.
1997: Margin calls induce the sale of securities from emerging markets, even ones that have highly rated debt, in what leads to the Asian Financial Crisis.
2008: The housing bubble bursts and the financial crisis sees numerous margin calls. Investment banks and hedge funds face severe liquidity crises.
2020: Margin calls play a part in the pandemic stock market crash. Central clearing parties ask for $300 billion in more initial margin from investors.
Explain it like I’m 5!
Margin call deets
Under Regulation T in the US, brokers usually require that you put up at least 50% of the cash or stocks required to cover the trades you want to make. Then they cover the other 50% as a loan, with interest.
You have to put up at least $2,000 in cash or stocks and the amount has to cover at least 50% of the trades you plan to make. This is called an initial minimum. Then you need to make sure that the collateral you’re holding doesn’t ever drop below 25% of the current market value of the total amount of securities you invested in using the loan. This is your margin maintenance requirement, and it’s set by the Financial Industry Regulatory Authority (FINRA) in the US.
So if you wanted to buy 1,000 shares of a stock at $50, you’d put down $25,000 while your broker also puts down $25,000. This first $25,000 is your initial margin. Then let’s say your broker is a little bit stricter with the terms, so she puts a margin requirement of 30% on the transaction. If the value of your investment drops and your own contribution becomes less than 30% of the total, you need to add more money or stocks to bring it back up to at least 30%..
So what happens if there’s a tiny dip? Like the company you invested $50,000 in says there’s going to be a seven-day delay on the FDA approving their miracle drug? Let’s say the share price falls from $50 a share to $40 a share. Then your overall investment drops to $40,000. The broker isn’t taking that hit, you are. So your stake in this $40,000, is now $15,000 while the broker’s stake remains $25,000 (because this broker is lending you money to invest however you want to).
Trading on the margins can be stressful because of the variety of issues that can trigger a margin call. The market can be volatile on a day when the Federal Reserve hikes rates unexpectedly, when another economically significant country goes into a recession, and when natural disasters overwhelm investor expectations, such as the covid-19 pandemic.
Your broker can also change margin requirements at any time. Say things start to get super shaky out there, your broker doesn’t want to be the one holding losses. So she raises the margin requirement to 40% or 50% and soon you get a margin call knocking.
Quotable
“Warren and I are chicken about buying stocks on margin. There’s always a slight chance of catastrophe when you own securities pledged to others. The ideal is to borrow in a way no temporary thing can disturb you.”
—Charles Munger, Berkshire Hathaway vice chairman
Pop quiz
What does a broker usually do when you get a margin call?
A. Send you a bouquet of roses, with a note about considering your portfolios’ marginal returns
B. Book you a luxury vacation for you to think about your margin of life enjoyment
C. Call you with an offer to be the keynote speaker at their annual “It’s margin, not butter” conference
D. Demand that you deposit additional funds or securities to cover the shortfall in your margin account
Invest in reading the rest of this email—the answer at the bottom is a bonus.
Memory lane
📊Remember Archegos Capital Management?
Archegos was heavily exposed to media company ViacomCBS using swaps, an agreement that allows two parties to share liabilities or cash flows from two different financial instruments.
Archegos had pulled out a margin loan to trade swaps on ViacomCBS and other stocks. Its banks got nervous when ViacomCBS fell by 30% over the course of two days in March 2021 and made a margin call. Archegos didn’t have the funds to meet the call.
So the head of Archegos—former Tiger Asia manager Bill Hwang—got his bankers on the phone and tried to keep them from selling the stocks he purchased using their loans. The now defunct Credit Suisse and a few other banks were keen to hold, but Goldman Sachs didn’t want to wait. Goldman started with ViacomCBS, Baidu, and Tencent Music Entertainment Group. Morgan Stanley and Deutsche Bank followed Goldman.
The selling was so intense that it brought down stocks in the media sector and other parts of the market. Credit Suisse and Nomura both lost billions. The market impact was so significant that US Treasury Secretary Janet Yellen restarted a regulatory working group to study the risks that hedge funds pose to the financial system.
Given how little the markets can see into the kind of margin trading that hedge funds engage in, the margin calls that banks make are sometimes the only time that the public can see how reckless someone is with other people’s money.
In the case of Archegos, Hwang was able to hide his massive positions in various stocks because those positions were hidden in derivative contracts instead of being revealed by Hwang holding the stock directly.
🚀 Why it matters now
- A margin call nearly took down Robinhood in the summer of 2022. The retail stock trading app invented payment for order flow, which involved margin loans from market makers like Citadel and Two Sigma Securities.
- A margin call might have tanked business software firm Microstrategy’s big bet on bitcoin. But the lender, Silvergate Bank, went out of business before Microstrategy did.
- Genesis Global had nothing to margin call on a subset of its loans. Genesis (along with several other crypto lenders) extended loans for margin trading without any collateral.
- In 2022, Elon Musk could have lost Tesla to a margin call.
Watch this!
Intro to margin calls
FXTM is a foreign exchange firm that also offers educational videos on trading. Learn more about the basics of margin calls here.
Solutions
What to do about margin call risk?
Since the Great Financial Crisis centered around credit default swaps, banks now have to clear more derivatives through central counterparties (CCPs). Whether you trade derivatives directly on an exchange as an individual or over-the-counter (OTC) as an institutional trader, collateral often has to be posted for both. The Dodd-Frank Act ensured that collateral had to be required in the risky swap market. Prior to this law, banks had uncollateralized swap trades with banks, hedge funds, and pension funds.
The issue of margin calls comes into play in almost every corner of the financial markets. After seeing the volatility of US Treasurys in the market panic of 2020, finance experts like Josh Younger, managing director for US fixed income strategy at JP Morgan, suggested that “cross-margining,” in which margin requirements are set based on overall market risks versus individual risks, might make margin calls less devastating to the overall market even in a crisis.
Poll
What’s the riskiest thing you’ve ever done?
- Bought a house with a 7% interest rate
- Invested heavily in meme stocks
- Gave myself bangs
It’s not risky at all to answer our one-question poll.
💬 Let’s talk!
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Today’s email was written by Nate DiCamillo, and edited and produced by Annaliese Griffin.
The answer to the pop quiz is D. Your broker will ask you to show them the money.