On the management of financial guarantees - Market Microstructure and Corporate Finance Special Issue

Financial Management (Financial Management Association), Winter, 1992 by Robert C. Merton, Zvi Bodie

As guarantors, brokers set two types of capital requirements: initial margin and maintenance margin. The initial margin requirement is the required net worth of the investor's account at the time the margin loan is made and the securities purchased.(15) All the securities purchased by the margin investor remain in the possession of the broker as collateral for the loan, and the broker calculates the market value of these securities daily (and sometimes more often on days when there is unusual volatility in price movements). The net worth of the investor's account is calculated as the market value of the collateral less the debt to the broker. If the net worth of the account falls below a prespecified fraction of the value of the collateral, called the "maintenance margin ratio," the broker notifies the investor that he must add additional equity capital to his account immediately. If the investor does not respond to this margin call, the broker exercises its right to sell the securities serving as collateral and pays off the loan out of the proceeds. The investor receives the remainder, if any.

Brokers find that this system offers them substantial protection despite the fact that the prices of the securities held by investors are often quite volatile.(16) Indeed, the restrictions placed by brokers on securities that may be held in margin accounts are minimal, and brokers typically undertake only a minimal check of the borrower's total net worth. Nominally, the broker has recourse for any shortfall beyond the securities in the investor's account. However, brokers do not appear to rely on recourse to the investor's net worth to any significant extent.(17) Despite the price volatility of the securities held in margin accounts, the implicit fees charged by brokers for their guarantees are quite low. Indeed, we found a local discount broker who charged 50 basis points below the call-money-rate-to-brokers rate quoted daily in the Wall Street Journal.

To summarize, the key elements of this system of monitoring margin loans are: (i) the guarantor has possession of the collateral; (ii) the value of the collateral is recomputed frequently at readily ascertainable market prices; and (iii) the guarantor has the right to automatically liquidate the collateral to pay off the guaranteed liability if the ongoing capital requirement is violated. Each of these elements is essential for the system to function properly. In particular, frequent monitoring of the market value of the collateral would be pointless if the broker does not have the right to seize and liquidate the collateral as soon as the required maintenance margin ratio is violated.

Generalizing from this example of broker loans, we can make some observations about the requirements for an effective system of monitoring. First, the relevant market price to be used in valuing the assets is the price at which they can be sold -- the bid price. Any asset is therefore eligible to be held in a margin account as long as it has a bona fide bid price for the quantity to be sold. As long as assets are marked to market at the bid price, the illiquidity of an asset serving as collateral is not a problem for the guarantor. However, illiquid assets (which by definition have a large bid-ask spread) are not suitable for guarantee systems relying on monitoring because the borrower is vulnerable to having the asset seized and liquidated when the bid price falls, even if the average of the bid and ask prices falls by a relatively small amount.(18) The spread cost from this "bid-ask bounce" is a deadweight loss to the collectivity of the debtor and the creditor. Thus, if it is large and the chances of a violation are not negligible, this form of handling guarantee risk is inefficient for illiquid assets. Therefore, when the underlying assets are illiquid, a guarantee system that relies heavily on monitoring is not efficient.