When you and I decide to buy 200 shares of stock on margin, that concept means we are paying for 100 shares and borrowing money to buy 100 shares. Interest will be charged against our margin position, and our account will be debited on a regular basis. Dividend income will offset some of the margin fees, but those fees still will hurt us unless our stock is rising in value. We need appreciation in our stock to justify the creation of our original margin position.
When our stock drops in price, we usually have a cushion between the 50 percent original equity position we hold and the 30 percent minimum equity position we must maintain. When the price drops below our 30 percent equity level, we receive what is known as a “margin call”, a request to commit more cash to our position.
Actually that request is a demand. We have a couple of days to submit the cash, and then the firm has the right to sell off a portion of our position to raise the cash if we are unable/unwilling to do it ourselves. Each firm will require you to give it enough personal financial information to determine whether or not you can afford to have a margin account. Fair enough.
What happens in the publicly traded derivatives markets, such as futures and the sell side of options, when prices trend in the opposite direction of where we thought they would go? We get margin calls. We can buy bonds on margin as well but, when the prices drop, we still can get margin calls even though those bonds have actual maturity dates. So what happens in the private, more illiquid, derivatives markets when an exponentially leveraged hedge or outright speculative contract drops in value? You’re absolutely right. Those institutions get margin calls……………..and big ones!
Look back seven years ago. The credit/mortgage industry was struggling. Credit default swaps, written against the probability that a mortgage pool would either drop in value or default (and historically they rarely defaulted), were getting hammered. Those contracts had no public markets in which to trade, and determining a realistic price under those circumstances was extremely difficult. Those derivatives from yesteryear are still with us….and so are a bunch of new ones.
So what happens when these institutions have to continuously come up with cash to bolster contract requirements? These big boys have to endure bank stress tests today. The FED wants to know how well or how poorly these firms will survive a future downturn and/or the collapse of a trading partner.
Imagine the concern at the FED when these firms still have to deal with the problems they created for themselves several years ago. The Comprehensive Capital Analysis and Review (CCAR) and the Dodd Frank Act (DFA) bring these issues to light. Five years into a recovery, some of these institutions continue to see their ratings downgraded, and the FED is worried about their grades on the stress tests. Shifting current and future derivatives’ risks to the backs of the taxpayers is becoming a reality.
Hang in there with me.