When preparing to write this blog post I stumbled upon an article by Jason Zweig from The Wall Street Journal titled The Accidental Debt That Wouldn’t Die. This caught my attention immediately, primarily due to the fear it instilled in me. Debt is typically not a good thing, although it can be useful when firms are trying to raise capital, and are facing some sort of liquidity constraint. Debt that will not die seems even worse, and the fact that it was not intentional might be the scariest part of it all.
The accidental debt that this article is referring to was generated by the use of Margin Accounts. Like most people, I had no idea what a Margin Account was or how it worked. Luckily Investopedia can shed some light on this issue.
According to Investopedia, a Margin Account is “A brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock” (Investopedia.com).
This is all fine and dandy, as long as the value of the securities that are used as collateral does not drop significantly.
“In an account that permits the use of margin, you can borrow against the market value of most stocks, bonds, mutual funds or exchange-traded funds. That enables you to leverage a smaller position into a bigger one. If your holdings do well, the margin will magnify your gains” (Zweig, 2015).
Okay, okay. I like the sound of that. Magnifying my gains is something I would enjoy.
“… A margin loan is secured by your investments. If they drop sharply in price, the brokerage firm can invoke a “margin call,” triggering a forcible sale to ensure that the firm will be able to get its money back on the loan it made to you. So margin can magnify your losses” (Zweig, 2015).
This, however, I do not like the sound of.
This seems to be a situation that involves moral hazard. “Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost” (The Economic Times).
The lender may make more risky loans knowing that they can simply invoke a margin call like mentioned above, causing the borrower to bear the entire loss. With seemingly little risk from the perspective of the lender, I believe this creates an incentive for the lender to offer margin loans that is not in the best interest of the borrower. The lender has an incentive to encourage people to leverage securities that they cannot afford to lose. This high risk, from the perspective of the borrower, I believe makes Margin Accounts a dangerous financial instrument. So dangerous that, I believe, Margin Accounts should be altered to increase safety, or eliminated all together.