Margin Requirements, Margin Loans, and Margin Rates: Practice and Principles - analysis of history of margin credit regulations - Statistical Data Included

New England Economic Review, Sept-Oct, 2000 by Peter Fortune

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The Board of Governors of the Federal Reserve System establishes initial margin requirements under Regulations T, U, and X. Regulation T applies to broker-dealers, Regulation U applies to banks and other lenders, and Regulation X applies to margin loans not explicitly covered by the other regulations. (1) Prior to 1998, Regulation G applied to nonbank, non-broker-dealer lenders in the United States, but it has recently been rolled into Regulation U. These requirements apply to "purpose credit," defined as credit for the acquisition or sale of securities subject to Regulation T requirements. They set a minimum equity position on the date of a loan-financed transaction.

Recent increases in margin credit, both in aggregate value and relative to market capitalization, have rekindled the debate about using margin requirements as an instrument to affect the prices of common stocks. Proponents of a more active margin requirement policy see Regulation T and its companions as instruments for affecting the level and volatility of stock prices by influencing investors' demand for common stocks. It is argued that an increase in margin requirements will alter the maximum amount of common stock that an investor can buy, thereby affecting investors' demand for stocks.

Other proponents of margin requirement policy see margin requirements as signals of the Federal Reserve System's resolve to prevent bubbles in stock prices from affecting the U.S. economy, believing that the announcement effects of increased margin requirements will stabilize the stock market. Robert J. Shiller takes this position, arguing that an increase in margin requirements will have a stabilizing effect on the stock market and on the economy. Believing that we are in a period of "irrational exuberance," a term attributed to Chairman Greenspan, Shiller claims in an exuberantly titled Wall Street Journal article that the Fed should return to its pre-1974 policy of actively changing margin requirements in response to stock market speculation. This, he argues, will mitigate the "distortions of saving and investment behavior, driven by the public's illusion of stock-market wealth...and the risks of economic dislocations and massive wealth redistribution... if the market continues to soar and then crashes" (S hiller 2000).

The purpose of this article is to discuss the historical background, accounting mechanics, regulation, and economic principles of margin lending. The first section of this study sets the foundation for an understanding of margin loans. It assesses the data available on the volume of margin loans, both in the aggregate and at individual brokerage houses. The second section discusses the history and practice of margin requirements as well as the accounting framework underlying customers' accounts at broker-dealers. Together, the two sections establish the framework for an analysis of margin loans.

The third section assesses the extent to which initial margin requirements restrict the amount of margin lending. We argue that the maximum amount of margin debt is less than would obtain if only maintenance margins were in force, and that the debt limits arising from Regulation T are more restricting in periods of rising stock prices. This leads to the conclusion that initial margin requirements might serve as a mild automatic stabilizer, limiting margin debt more during periods of bull markets than during bear markets. However, the likelihood that this could prevent booms and crashes is extremely remote.

The fourth section addresses the economics of margin loans, demonstrating that they can be interpreted as implicit put options on the underlying securities. This section can be skipped by readers familiar with the economics of equity options.

In the fifth section we develop a simple model for estimating the effect of this implicit put option on the margin loan rates charged by brokers. This model unveils a margin loan rate mystery. While economic theory suggests that margin loan rates should vary frequently with the volatility and leverage of individual accounts, brokers appear to adhere to rigid rate-setting formulas having little reference to the account's characteristics. We show that these rates depend primarily on market conditions and loan size.

Throughout the paper, we focus on margin loans to the customers of broker-dealers, that is, our primary interest is in the implementation and implications of Regulation T. While many of the principles and issues raised also apply to Regulation U, our interest is in the role of broker-dealers as lenders, and in the implications for investor behavior. A fuller account would address the pledging of customers' securities by broker-dealers to obtain loans from financial institutions.

The paper also does not address the important questions surrounding lending by offshore brokers and financial institutions. Nor do we address the important questions raised by the increased flow of money into the U.S. stock market from foreign investors, who are exempt from Federal Reserve margin requirements.