E China On Margin

In the U.S., brokerage firms can lend up to 50% of the stock purchase price. After, they require investors to maintain from 25% to as much as 40% equity in the account. “Equity” is the same as equity in your home: its sales price today minus mortgage outstanding. Your brokerage account equity is the value of your securities (“house”) minus the margin loan from your broker (“mortgage”).

Now assume that Rocket Stock, as often happens, returns to earth. Instead of rising to $24,000, your stake declines to $12,000. Your equity is $4,000 ($12,000 value of stock minus the $8,000 margin loan). You exceed a 25% maintenance requirement, which would be $3,000. Good. But if the requirement at your brokerage firm is 40%, or $4,800, you lack enough equity. In that case, you will receive a “margin call” to deposit cash or securities into your account to return to the 40% equity level.  

The deeper the decline, the more investors receive margin calls. With everyone selling to raise equity, stocks plummet and bring further margin calls, sales and losses. Before you can say “Time for Netflix!” you’ve got a full-fledged screaming bloody crash on your hands. People, financial institutions and the whole economy are devastated.  

In China, massive borrowing has fueled speculation in real estate and stocks, where new profits have fueled more debt, and round and round. Eventually lending will freeze and debt-fueled profits will evaporate, as they did in our housing bust. With an unregulated shadow banking system of unknown size, the government fears a crash will not only have nuclear bomb-like repercussions, but has no idea how many bombs may fall or where.

Charles Kindleberger laid it out masterfully in Manias, Panics and Crashes: A History of Financial Crises. All manias are fueled by credit, and all panics become crashes when the debt comes due. China is no exception. Margin may look good today, but it can kill you tomorrow.

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Tom Jacobs is an Investment Advisor for separately managed accounts with Dallas’s Echelon Investment Management. You may reach him at more

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George Lipton 5 years ago Member's comment

Great job simplifying a not so simple concept. What is happening in China is not so surprising after reading this.

Tom Jacobs 5 years ago Author's comment

Thank you George. I'm a former high school teacher so I like to try to do this. I appreciate your comment.