It’s possible, in every market in the world I’m aware of, and in any asset class–stocks, bonds, derivatives–to borrow money from your broker to fund investments that are collateralized by the “equity” you have in your investment account.

The minimum amount of collateral you have to have to support a given level of borrowing is set by regulation in each country and varies by the type of assets you own in the account.  Brokers are usually free to apply more stringent standards to their customers and to change those standards as they see fit.  In some countries the financial regulator has the power to change margin requirements as a way of regulating the rise and fall of asset markets, much as regulators routinely do in changing short-term interest rates to try to control the credit markets.  This isn’t common, but the US did this routinely in the first half of the last century, Japan in the second.

The main characteristic, for good or ill, of margin buying is that it amplifies returns.  Let’s say you have a $1 million margin account that’s $500,000 of your own money and $500,000 of borrowings.  If the assets you have bought double overnight, then you have $1,500,000 of your own money and $500,000 in borrowings.  Your equity has tripled.

If, on the other hand, markets decline by 25%, you have $250,000 of your own and $500,000 in borrowings.  Given that the emotional tendency of most investors is to buy high and sell low, this latter outcome is more common.

If your “equity” declines enough in value that it reaches, or breaks below, the required minimum, you receive a “margin call”  from your broker, apprising you of the situation.  You have two choices:  either add enough assets to the account to restore the minimum equity balance, or have the broker liquidate enough assets to do so.  If you opt to add assets, you may have anywhere from a few hours to a day or two to accomplish this.

If you choose the second option, your broker will immediately begin to liquidate assets.  He will not be a careful seller.  His main concern is to reduce the margin debt exposure his firm has to you as quickly as possible.  He will simply dump the assets on the market to get whatever price he can.  Since every other margin account is probably in the same position, a massive wave of relentless selling will hit the market all at once.  Because this selling will depress asset values, the liquidation itself will likely engender more margin calls the following day.

This is a really ugly process to be caught up in, but is usually washes out any excesses in the markets where this happens.

One more thing:  selling doesn’t necessarily occur in the assets that caused the problem.  When the idea is to raise cash quickly, you sell:  (a) stuff you own, and (b) what is most easily salable–namely, commodities and  stocks.  By the way, I’ve always thought that, following the unconscious suicidal tendencies that margin traders exhibit, they never sell the “bad” assets that have caused their problems; they liquidate the “good” ones they own.  Sort of like–your dog keeps you awake all night with his barking, so you give away your cat.

Why am I writing about this?

Margin call liquidation is what the trading in global equity markets over the past week or so reminds me of.

In today’s world, the main margin participants are hedge funds, not individuals.  Their assets under management are very large.  Therefore, any forced selling would be correspondingly big.  It would also likely come as a result of changes in brokers’ rules on extending credit, rather than clients’ hitting statutory minima.  Also, given that the EU, and Germany in particular, are blaming their current woes on hedge funds and beginning to legislate/regulate against them, it would be very surprising if they weren’t privately telling the banks under their control to cut back on the supply of ammunition they are supplying to this enemy.

I have no direct evidence that this is the case.  But the current selling seems excessive to me.  In particular, yesterday’s trading–massive early decline followed by recovery–doesn’t seem to me to have been driven by fundamentals (yes, recent escalation of tensions between the two Koreas always causes an immediate selloff in Asia, but that should only create minor ripples elsewhere).  As you cross off more and more items on the list of possible reasons for selling, forced margin-related selling appears to me to be prominent among the reasons left.

Margin liquidations typically don’t last very long.  Rebounds are typically sharp.