the big three Las Vegas casino companies

My post last Friday outlined the upcoming IPO for MGM China, which will show us the Hong Kong market’s view of the value of MGM’s Macau exposure.  At the top of the price range for the IPO (already specified by the HKSE), and based on last Friday’s closing prices, a 51% stake in MGM China would be worth about $4 billion (all amounts are in US$) and would represent just over half of MGM’s market capitalization.

A reader asked what the rest of MGM–its Las Vegas interests–might be worth.  That’s not an easy question to answer.  So I thought I’d write about what I think are the significant issues for all three of the big casino operators in the Las Vegas market.

the basics of the big three Las Vegas gambling companies

All three have subsidiaries in the booming Macau market.

All three are situated on the Las Vegas Strip, where about half the city’s 149,000-odd hotel rooms are located.

In addition to their expansions into Macau, all three have made major hotel/casino capacity additions in Las Vegas over the past few years–just as the economy was peaking.  These were all multi-billion dollar projects, funded primarily with debt.

three points about Macau

1.  This market is already many times the size of Las Vegas, measured by the amount of money bet in the casinos.  So far this year, Macau gambling is expanding at a 40%+ rate.  I think the market will get to at least double the current size before it gives any sign of maturing.

2.  The obvious source of profits to each of the Las Vegas parents is its share of the Macau subsidiary’s profits.  But that money isn’t readily available for use in the US.  For one thing, it will likely remain in Macau to fund expansion there.  For another, the way shareholders receive income from their stocks is through dividends, which have to be declared by the management (only Wynn Macau has done so) and would be subject to US corporate tax if repatriated.

3.  WYNN, LVS and MGM all receive management fees from their Macau operations, in return for their operating expertise and for the use of their brand names.  This is the partents’ major source of cash from the subsidiaries.  In 1Q11 these fees amounted to $34.5 million for WYNN, $23.8 million for LVS and $38.0 million for MGM.  (The LVS number seems too low to me, but that’s what’s in the company release.)

the Las Vegas problem

It’s hotel room overcapacity, specifically in the high-end rooms on the Strip where the big three are.

In 2006, the Las Vegas market had 132,600 hotel rooms and served 38.2 million visitors.  By last year, visitor numbers had shrunk to 37.3 million, but expansion projects had increased the number of hotel rooms to 140,429.  Together, the need to repay construction debt and the fact that the out-of-pocket costs to a hotel from having a room occupied for a night are less than $20, mean price competition to sign up guests has been wicked. The Strip accounts for about half the room base, but virtually all the expansionso the trouble has been most acute there.

Although the situation for the big three is gradually improving, I think it could be several years before the market grows into the existing capacity.

valuing the big three (all capitalization figures are as of the close on 5/20/2011)

  • WYNN:  The company’s market cap is $18.1 billion.  Its Macau holdings have a market value of $12.6 billion, leaving a $5.5 billion value assigned by the markets to the Las Vegas operations.  In 1Q11, WYNN was right around breakeven in the US, with $60 million in cash flow.  IN the US, WYNN has $87 million in cash on the books and $2.6 billion in long-term debt.
  • MGM:  The company’s market cap is $7.5 billion.  Its Macau holdings are likely worth $4 billion, leaving $3.5 billion in value assigned by the markets to the US operations–which are all over the place, but mostly in Las Vegas.  In 1Q11, MGM operated at a loss but had positive cash flow from operations of about $24 million.  The balance sheet showed $431 million in cash and $12.1 billion in long-term debt.  Until the IPO documents are available in the US, we won’t know how much of either of the last two figures is attributable directly to MGM China.
  • LVS:  The company’s market cap is $30.4 billion.  Its Macau holdings have a market value of $15.1 billion, leaving $15.3 billion in value assigned by the markets to Singapore + the US.  In 1Q11, US operations appear to me to have made a loss but hovered around breakeven on a cash flow basis.  The balance sheet shows $3.1 billion in long-term debt against US operations and just under $800 million in preferred stock.  The biggest issue with LVS is how to value the Singapore operations, which are in their infancy and which are wholly-owned by LVS–so there’s no separate market quote.  A very simple approach would be to say that Singapore is earning about 20% less than Macau, and apply a Macau multiple to Singapore operations.  Since LVS owns 100% of Singapore vs. about 70% of Macau, this would imply all the $15.3 billion is being allocated to Singapore and the US is in effect worth zero.

my thoughts

Take WYNN first.  It’s the strongest company of the three, with its finances under much better control than the other two.  Still, are the Las Vegas operations, generating $250 million in cash flow at an annual rate, but servicing $2.6 billion in debt, worth paying 22x cash flow for?  I’d prefer 10x.

I see two possible justifications for the current WYNN valuation:  the consensus expects a faster recovery in Las Vegas than I’m thinking, or (more likely, in my view) US investors regard WYNN as a more liquid and easier to buy version of Wynn Macau, and are willing to pay a premium to the Hong Kong price, simply to get exposure.

MGM.  If you’ve read any of my previous posts about gambling in Macau, you know I find having to be a business partner with the Ho family to be a deal-breaker.

The hedge fund Paulson & Co has recently become a large shareholder in MGM, apparently betting on the large upside leverage MGM will have as/when Las Vegas turns for the better.  After all, the company owns a ton of Strip real estate.  Over the years, it bought the former Mandalay Bay as well as Mirage Resorts, and has built the gigantic CityCenter complex.  Still, $12 billion in debt and cash flow of $110 million a year are a very risky cocktail to be involved in.  Too risky for me.

LVS.  This company’s financials are almost as complex as MGM’s, but I find it much more intriguing.  Depending on how you value the Marina Sands in Singapore, you could think–as I suggest above–that the present stock price gives you the US operations for free.  …less than that, if you buy the argument that LVS should trade at a premium to the value of its Asian holdings because its the only liquid and convenient way for Americans to buy them.

Yes, there’s $3.1 billion in debt linked to the US casinos + construction obligations that were suspended during the darkest days of 2008.  But management fees from Macau and Singapore seem to me to be potentially large enough to service the debt, even without an uptick in the US business.  Not for widows and orphans, however.

By the way, I own WYNN, Wynn Macau and a little bit of LVS.

LinkedIn IPO: sign of a second internet bubble? three reasons I don’t think so

the LinkedIn IPO

Class A shares offered

Social networking company LinkedIn (LNKD) went public last Thursday, offering 7.8 million Class A shares.  According to the preliminary prospectus, 4.8 million of them were new shares sold by the company;  the rest were secondary shares sold by existing stockholders.

LinkedIn also has Class B shares, which differ from Class A mostly in that each has 10 votes while Class As have one apiece. This is a standard device used by family-owned or other closely held firms to raise public money and have a listed stock, while retaining complete control over operations.  News Corp., Hershey and Google are other US examples.  In the case of LNKD, the insiders who own Class Bs still muster 99.1% of the corporate votes, making the class As, in my mind, more like preferred shares than common.  For Thursday and Friday, though, no one cared.

pricing and initial trading

Underwriters initially talked of an offering price in the low thirty-dollar range–maybe $32.  But as they saw the strength of investor demand for the issue, the number gradually rose to $45.

The opening trade for LNKD was $83.  The day’s low was $80, the high $122.70.  The stock closed at $94.25, on volume of 30+ million shares–meaning each share changed hands 4x on average during the day.

I was in PA

I was driving to Pennsylvania while this was going on, listening to the Bloomberg Surveillance program on satellite radio.  The reporters on the broadcast commented a number of times that this felt to them like Internet-Bubble activity of late 1999-early 2000.  When I got home, I read similar comments in the Wall Street Journal and the Financial Times.

How quickly they forget!

Yes, there are some similarities.  Both then and now are periods of very easy money policy, and extra money sloshing around the system invariably gets into speculative mischief.

But the late-1999 Fed had the money taps wide open in spite of economic strength, not like today when the central bank is fighting to reduce sky-high unemployment (how effective today’s Fed policy can be is another question).


If you recall, the Fed’s big worry back in 1999 was Y2K–the possibility that every computer in the world would shut down at midnight on 12/31/99, stopping commerce everywhere dead in its tracks (kind of like the Lehman failure did in 2008, only worse).  That would supposedly have left us with blue screens, warm refrigerators, stuck elevators, dead machine tools and ATMs that refused to give out cash.  All our financial information might be wiped out.

In 1999, Amish farmers couldn’t replace worn out horse-drawn plows, because survivalists preparing for this potential Armadeggon bought them all up.  Silver coins were trading at 10x face value, on the idea that paper money would be worthless as developed economies fought to avoid sinking back into pre-industrial chaos.

The Fed injected a lot of extra money into the system to help ease any Y2K damage–none of which occurred.

three big stock market differences:

1.  cult of the internet back then

In late 1999-early 2000, the US stock market was flooded with internet-related IPOs.  Many of these firms had no actual businesses and little more than business plans (sometimes, not even that).  In normal circumstances, they would be looking for venture capital financing.  At investor meetings, which had a cult-like quality to them, company executives focused on concept, not near-term business prospects.

Even a survivor of the subsequent meltdown like Amazon didn’t make money back then.  The company wouldn’t turn profitable until 2003, and had negative net worth until two years later.  In my opinion, Amazon only made it because it had large follow-on offerings of stock and bonds.  But very many more, like eToys or, went out of business as soon as they burned through their IPO proceeds.

It wasn’t just crazy IPOs, either.  At the peak of the frenzy, media conglomerate Time Warner traded half its assets for a near-worthless AOL.

In contrast to the hundreds and hundreds of highly speculative transactions in 1999-2000, in 2011 there have only been two questionable ones that I see:  the first-day price of the LinkedIn IPO, and Microsoft’s purchase of Skype.

2.  wild overvaluation in 2000

…in the TMT sector…  internet-related stocks as a group were known as Technology-Media-Telecom (TMT) stocks.  They made up a significant chunk of the overall US stock market, even before the buying frenzy began.

As I mentioned above, many e-commerce stocks had no earnings at al–and therefore no meaningful PEs.  More mature companies did have earnings, though.  And they were priced through the roof.  At the peak, Qualcomm was trading at 177x its 2000 profits; smaller chipmakers traded at even higher multiples.  Staid, slow-growing, highly cyclical communications equipment providers, like Ericsson and Alcatel traded at 137x and 110x respectively.  Similar “hot” names like Nortel no longer exist.

Brokerage house analysts like Henry Blodget (since barred from the securities industry and now a blogger) and Mary Meeker (now in vc) whose horribly inaccurate forecasts helped justify the mania, acted like–and were treated like–rock stars.

…and in the stock market as a whole

In March 2000, the S&P 500 peaked at about 28x earnings for 2000.  This compares with a ten-year Treasury yield at that time of about 6%, which would justify a stock market PE of 17.  Relative to bonds, then, stocks were 65% overvalued.

In contrast, the S&P is trading today at under 14x the consensus estimate of 2011 profits.  The ten-year Treasury is trading at a 3% yield, implying a stock market multiple of 33x.  So stocks are 60% below the level implied by bond yields.  Put another way, if stocks are fairly valued, bonds are trading at well more than twice the price history would say they should be.

3.  real rocketship IPOs back then

Yes, LNKD did double from the IPO price on its first day.  So what.  Renren (social networking in China), a first-day star a couple of weeks ago, is now trading $1 below its initial offering price of $14.

If you want to see real IPO action, take a look at UTStarcom (which still exists today).  It debuted in March 2000 at an IPO price of $18.  It closed that day at $68, up 277%, after having reached an intra-day high of $73.  It then proceeded to run up to its all-time high of $93.50–5x the IPO price–before the end of that month.  (It closed last Friday at $2.09–but, hey, it survived, which is more than you can say about most of the dot-com names.)

my thoughts

Yes, there may be overvaluation in today’s financial markets, but I don’t think it’s in publicly traded stocks.  Maybe  privately-traded equities are too expensive.  But that’s a relatively small market whose failure wouldn’t have severe negative consequences for the US economy.  For my money, if you want to see expensive, look at bonds and commodities.

MGM China’s IPO in Hong Kong

the IPO details

According to Bloomberg, details, including pricing, for the IPO of MGM China, have been set.  MGM China is currently a 50/50 joint venture between MGM Resorts International and Pansy Ho, daughter of Stanley Ho.   The stock is going to debut on the Hong Kong Stock Exchange–presumably next week–through a secondary offering of 760 million shares by Ms. Ho.  The IPO price will be set by underwriters at between HK$12.36 and HK$15.34.

If we assume that the high end of the range represents a 20x multiple on expected 2011 earnings per share, which is where I view Wynn Macau as trading today, that would mean MGM China could earn HK$.75-HK$.80 this year.

timing of the offer is very favorable

The Macau gaming market is booming.  The publicly traded stocks have been exceptionally strong performers, year to date.

the IPO means cash for Pansy Ho, not MGM

In this respect, the offering is different from the listings of WYNN’s and LVS’s Macau gambling subsidiaries, where the shares sold in the offering came from the US-based parent.

a bit of history

Stanley Ho, Pansy’s father, controlled the monopoly casino company in Macau when it was a Portuguese colony.  After the handover to China in late 1999, the government of the new Macau SAR decided to end the monopoly.  It issued a new gaming concession to Mr. Ho, but also awarded one to Wynn Resorts and to Galaxy Entertainment.  Subsequently, each of the three was allowed to sell a sub-concession to another party.  Mr. Ho chose MGM.  He originally proposed a 50/50 joint venture between himself and MGM.  The Nevada gaming authorities apparently told MGM this was unacceptable because of Mr. Ho’s alleged underworld connections, and Pansy Ho replaced her father as the Ho family partner.

structure of the sale

Pansy Ho will provide all the stock being sold.  1% will go to MGM, giving it a 51% stake and making it the majority owner of MGM China.  Another 20% will go to the investing public (Paulson & Co. and Kirk Kerkorian, the largest shareholders of MGM, are together putting in for about 8% of the issue)It also appears that Ms. Ho has agreed to a 3% overallotment, meaning that the underwriters can increase the size of the issue by that amount, if demand is strong.

So, rather than having a large cash inflow from selling stock, MGM will pay Ms. Ho about US$75 million to gain legal control of the venture.

The news isn’t really so bad for MGM, however.

Not content with keeping the transaction simple, Ms. Ho has apparently agreed to invest several hundred million dollars of her IPO proceeds in securities of MGM Resorts.

Also, pricing at the top end of the range (which is where I would guess the IPO will end up) implies that MGM’s stake in MGM China is worth just under US$4 billion, or about half of the parent’s market cap.  From now on, we’ll probably see the same sort of “tail wagging the dog” effect on MGM shares as we’ve witnessed over the past year with WYNN and LVS.  Given the still parlous state of the Las Vegas market, this is perfectly understandable.  I interpret the recent strength in MGM shares as the start of this behavior.

Pansy Ho’s role in MGM China?

The IPO will confirm Ms. Ho’s status as a multi-billionaire.  Other than that, your guess is as good as mine–maybe better.

As I wrote in more detail a little while ago, in a bizarre sequence of events earlier this year, control of the Ho family gambling concession–by far the largest in Macau, accounting for about a third of the market–appears to have been taken away from Stanley Ho by, among others, Pansy.  Press reports suggest Pansy has resigned from the board of MGM China–though I understand the IPO documents say otherwise.  As I indicated in my earlier post, my reading of the situation is that Ms. Ho wants to present herself as a passive investor in MGM China while she fights for control of the family company.

It’s ironic if the IPO is the vehicle Ms. Ho is using to distance herself from MGM China.  That’s because the IPO seems to me to undermine the argument of the New Jersey gaming authorities that Ms. Ho is completely financially dependent on her father–and therefore unsuitable to hold a casino license.

My guess is that a smaller role in MGM China by Ms. Ho will make little operational difference, and may make both MGM and MGM China more palatable to US investors.

Macau gambling, Macau gaming stocks: May 2011

the Macau gambling market continues to boom

It’s really late in the month for me to be writing about the recent strength in the Macau gaming market.  Nevertheless, here are the latest figures from the Macau Gaming Inspection and Coordination Bureau:

     * 1 HKD = 1.03MOP (Unit:MOP million )
Monthly Gross Revenue from Games of Fortune in 2011 and 2010
Monthly Gross Revenue Accumulated Gross Revenue
2011 2010 Variance 2011 2010 Variance
Jan 18,571 13,937 +33.2% 18,571 13,937 +33.2%
Feb 19,863 13,445 +47.7% 38,434 27,383 +40.4%
Mar 20,087 13,569 +48.0% 58,521 40,951 +42.9%
Apr 20,507 14,186 +44.6% 79,028 55,137 +43.3%

Another (ho-hum) stunningly strong month for the market in April. Another all-time revenue record, surpassing March’s high water mark even though April has one fewer day in it.  Early market chatter for May is that business is, if anything, better this month than last.

not all the stocks are following suit

Here’s the month-to-date performance of the US- and Hong Kong-based stocks:

S&P 500     -1.9%

WYNN     -1.4%

LVS     -12.0%  (disappointing(?) 1Q11 earnings)

MGM     +15.5%  (IPO of MGM Macau priced–more on this tomorrow)

Hang Seng H-shares     -5.1%

SJM     +7.8%  (reported strong 1Q11 results–up 85% yoy)

Galaxy     +7.4% (opened a new casino, to mixed reviews)

Sands China     -7.2%

Wynn Macau     -7.5%

what to make of this?

The US first:

I don’t see any general pattern, other than possibly the market misinterpreting what casino revenues are, that is, that they’re casino winnings, not revenues, and thus can fluctuate randomly, quarter to quarter, around a longer-term average.

MGM is a star performer, on the idea that when we have a publicly traded yardstick to value its Macau holdings, the US parent will benefit.  We’ll see.

I haven’t read the LVS 10Q carefully enough yet (although I bought a small amount on the selloff after the earnings report), but the market may be mistaking bad luck during 1Q11 for weakness in the company’s business.  The earnings report is the main reason, I think, for the poor performance of LVS.

WYNN, in contrast, is benefiting from a misreading of its phenomenal good luck in 1Q11 in Las Vegas as being the new norm.  That may be the reason the stock hasn’t been hurt by the fall in Wynn Macau shares.

In Hong Kong:

Here, I do see a pattern.  There’s an enormous (around 15%) difference between the weak performance of the higher quality companies, Wynn and Sands, and the strong gains of the lower tier ones, Galaxy and SJM.  Although I would find it hard to buy either of the latter two (I might be able to stomach Galaxy, but certainly not SJM), the fact that demand for gambling is so super-strong means that there’s a lot of business to be had by everyone in the market.  So it’s hard to find too much fault with the market rotating into the lower multiple names.  It’s also unreasonable to expect multiple expansion to continue for 1128 and 1928 without at least a sympathetic response from the others. 

My sense is that the correction in Wynn and Sands is just about over.  Still, while I perceive a quality difference worth paying up for in 1128 and 1928, the Hong Kong market disagrees.

what I’m doing

I’d sold about 10% of my 1128 holding at HK$27.  I tried, unsuccessfully, to buy it back two days ago, below HK$24.  Fidelity won’t let me buy 1928, and I won’t touch the others, so I’m going to do nothing for now.

I regard WYNN as the best company, but I think it’s a little pricey at the moment.  I’m trying to work though the huge amount of data in the LVS 10K, to see if it might be a way to get slightly different exposure to Asia, exposure that includes Singapore.  My biggest concern is LVS’s net US$7 billion in debt, and a repayment schedule that goes into high gear next year.  Most of the borrowings are linked to the properties in Macau and Singapore, where all the cash flow is, so matching assets and liabilities isn’t an issue.  At first glance, absent another recession, likely gross cash flow seems more than adequate to meet mandatory repayments.  It’s the continuing large capital spending bill that I haven’t quite gotten my arms around.

speculation: stabilizing or destabilizing?

In the Panglossian world of academic finance, all markets are self-regulating and all participants are rational economic agents with the same information and motivations.

Commodity trading, where there are two different classes of market participant, with different knowledge levels and goals, really doesn’t fit in this model,.  On the one hand, farmers and miners, who are typically large corporations, want to guarantee a minimum level of cash flow for their operations.  They do so by selling a certain portion of their output for future delivery through any of a variety of kinds of commodity contracts.  The firms are deeply knowledgeable about the products they produce and sell, and they employ highly paid professional traders to do their commodity trading.  These are the hedgers.

And then there’s everyone else.

An obvious question is why someone would take the other side of the hedgers’ trades, given their superior information and high degree of trading skill.  Clearly, however, someone does, since we know that companies are routinely able to hedge their output.  Academics call these counterparties speculators.

To the academic world, it follows that speculators are a stabilizing influence.  They help to regularize the cash flows of potentially highly cyclical companies; commodities futures/forwards prices would also be higher than they are if speculators didn’t step in to take the other side of the hedgers’ trades.

In its most basic form, that’s the academic theory.

One trouble with the theory is that it’s just a generalization of the way commodities markets worked a generation ago, mixed in with the semi-religious belief in an “invisible hand” that ensures a favorable outcome in economic affairs. Worse, the basic metaphor no longer fits the facts–if it ever did.  Two examples:

1.  the silver market.  The broadening of commodities trading access to large numbers of private individuals, and the rise of commodities-oriented ETFs that give indirect access to a larger, less-affluent group, mean that some commodities markets are no longer dominated by hedgers. The “other guys” are now running the show.  And their recent behavior in silver is, to my eye, anything but stabilizing.

2.  the oil market.  Oil is an extremely economically important commodity.  Demand is highly inflexible.  Supply and demand are finely balanced.  As a result, it’s possible for speculators–whether private individuals, hedge funds or the commodity trading arms of commercial and investment banks–to be only a small fraction of all trading but still exert enough upward pressure on prices to make them, say, 10% higher (or lower) than they otherwise would be.  Prices might be stable in the sense that they don’t fluctuate much.  But a movement of this size means a major redistribution of wealth around the world.  Great for oil-producing countries, not so hot for everyone else.

In these instances, at least, speculators are a destabilizing force.

The recent ad hoc action of commodities exchanges in raising margin requirements appears to have pricked speculative bubbles in a number of commodities.  But I think it would be better for all of us if we had better regulation and a coherent framework for action.

commodities trading and margin: why volatility now?

commodities vs. stocks

Early in my career internationally, my boss gave me the assignment of studying the palm oil and soybean markets as a step in taking over responsibility for investing in the publicly traded plantation companies in Malaysia.  One of my first stops was a visit to the head of commodities trading for Merrill Lynch in Chicago.

It was like stepping into a parallel universe.

As an equity investor, I talked about remaining calm, not acting hastily and doing thorough research.  He talked about being in tune with the rhythm of the markets, reading the charts, developing good instincts, making decisions on gut feel and having lightning reflexes.  I spoke about hiring professional researchers; he said he looked for good high school or college athletes, regardless of academic accomplishment.

margin differences

Why the difference in outlook?  It may have something to do with the difference between dealing with global demand for natural raw materials vs. the actions of managers in highly complex, but focused, corporations.  But I think it has mostly to do with the, by equity standards, extraordinarily high levels of margin leverage that commodities market participants routinely employ in their investing/speculating.  It’s cold comfort to have the long-term trend absolutely correct but to be wiped out by a 10% price fluctuation in the wrong direction later on this week.

other quirks (from an equity investor point of view)

Two other characteristics of commodities trading to note:

–exchanges typically set the margin rules

–exchanges also typically set maximum daily price movements, both up and down, for a given commodity.  One consequence of this is that there are days when the price moves to the upper/lower limit without any sellers/buyers appearing.  In this case, the market can close for the day at limit up/down, but no trade.  So you can be “trapped” in a position you want to liquidate but can’t.  Another reason to act fast on new short-term developments.

greater interest in commodities

In recent years, there’s been a lot more interest in commodities than previously.  I see several reasons for this:

–the rapid economic advancement of countries like China and India, with large populations and at a stage of development where they use increasingly large amounts of farming and mining commodities.

–the rise of hedge funds, many of which are run by traders who are familiar with commodities and who are more comfortable “reading” charts than researching companies.

–the development of exchange-traded funds based on commodities, which give individuals easy access to commodity investing they didn’t have before

–the end to almost two decades of gigantic, price-depressing overcapacity in most mineral commodities created by overdevelopment in the late 1970s- early 1980s

–the increasing complexity of finance and the concomitant development of financial derivatives.

what’s going on now?

Why the sharp recent decline in mining and food commodities?

As I mentioned in my post yesterday on margin in general, a margin call can happen in two ways:

–either the value of your account can fall below the minimum margin level, or

–the market regulators can raise margin requirements.

margin requirements rising

The second hit the commodities markets late last month.  As the New York Times reported recently, that’s when officials at the CME (Chicago Mercantile Exchange) became concerned about the near doubling in the price of silver over the prior half-year.  The CME  immediately increased in the margin requirement for silver contracts.   When that had no immediate effect on the silver price, the exchange announced a series of increases that would rapidly bring the first-day margin needed to support each contract to $21,000+.

Each silver contract is for 5,000 ounces, or about $235,000 at a $47/oz. price.  Prior to these actions, the required first-day margin was $12,000-, meaning a market participant could leverage himself by 20x in buying silver.  (Actually, the allowed leverage was higher, since maintenance margin is lower than first-day, and because exchange members are permitted to use more leverage than speculators.)

Silver now trades for $34/oz., a decline of almost 30%, mos of the fall occurring in the first week after margin requirements were changed.

Other commodities have followed suit, though not to the extent of the decline in silver, as regulators have lifted margin requirements for them as well.

why act now?

Maybe the CME is just doing its regulatory duty.  A cynical person might speculate–à la the Hunt brothers–that pressure came from exchange members on the losing side of the trade.  Another (better, I think) guess is that there was pressure from Washington, where a new regulatory framework for commodity trading is now being developed.

margin trading

I want to write about two related topics:  what’s going on with violent gyrations in commodities markets (tomorrow) and the more general issue (Wednesday) of whether speculation can be destabilizing as well as stabilizing (academics deny the first is possible).  Today’s post on margin trading lays a foundation by discussing the tool–financial leverage–many speculators use to try to enhance their returns.

the basics

what margin is

In its simplest form, a speculator/investor trades on margin when he borrows money, usually from the broker or other counterparty he is transacting with, to buy securities.  He uses the value of these securities + additional cash or securities he has on deposit with the counterparty, as collateral for the loan.

Margin trading is a global phenomenon, both in the sense that it occurs in all the countries I’m aware of where securities are traded, and in the sense that it occurs over different classes of securities–stocks, bonds and commodities.  The precise rules and regulations differ from country to country, and the mechanics may differ in a given country, depending on the type of security.

the margin calculation

The ground-level calculation in margin trading is the “margin,” or net collateral, figured as a percentage of the gross collateral.  That is:

(value of the collateral in the account minus the amount of loans secured by the collateral)  ÷  the value of the collateral.

For example, if I deposit $10,000 with my broker, borrow another $10,000 from him and use the money to buy $20,000 of XYZ stock, I am trading on margin of 50%.   ($20,000 in securities – $10,000 loan  =  $10,000 ) ÷ $20,000 value of XYZ shares  =  50%.

minimum margin requirements

Typically, a country’s central bank or some other finance-related authority sets out a general framework for margin trading in stocks and bonds in that country.  A commodities exchange may serve the same function.

Some countries actively change margin requirements as a tool of economic policy.  The US did this in the early twentieth century, but not today.  (The Federal Reserve has a curious formula for stocks.  Generally, margin must be at least 25% (maintenance margin); however, on the day of purchase, the margin for new buys–but not the account as a whole–must be 50% (first-day margin).)

While your counterparty can’t offer easier credit terms than the general guidelines allow, it can, and usually does, set more stringent requirements.

Things also get more complicated if you have both long and short positions.  But in this post, I’m not going to worry about that.


Not every security can be used as collateral.  Typically, small capitalization or illiquid stocks, or stocks traded on foreign exchanges, are not marginable. 

what makes it attractive

For the broker, the answer is easy.  He makes a spread between his cost of funds and the broker loan rate, what he charges you in interest on your margin loan.  In addition, he earns more on the additional trading you do.  And he typically can earn fees by using your collateral in securities loan programs.

The investor/speculator can leverage his insights into securities markets with a larger pool of investment funds, provided the ideas earn more than the interest payments on the borrowed money.

Guess who usually gets the better side of the bargain?

margin calls

What happens if the margin in your account falls below the minimum requirements?

It’s important to note that this can happen in two ways:

1.  your stocks can decline in value, and/or

2.  the margin requirements can be changed, either by the regulator or by your broker.

The popular perception is that a margin call means that someone reaches you by telephone, tells you that your account has dipped below the minimum margin requirement and gives you time to add enough new collateral to restore your margin to the minimum level.

Notifying you, or even attempting to notify you, however, is not a legal requirement, at least in the US.  In fact, in the margin agreement you sign, you acknowledge that you understand the broker can change margin requirements without letting you know, and that he can sell securities in your margin account to repay enough of your margin loan to restore the minimum margin–again without notifying you.

If your broker begins to sell securities in your account, you have no control over which ones he sells.  Because his primary obligation is to protect his firm from facing a loss on its margin loan, he will typically sell as much as he can as fast as he can.  In other words, the most liquid stocks go first and he won’t spend a lot of time “working” the order to get the most favorable price for you.  Nor will he let you set limits.

From watching from the sidelines, I can tell this is not a pleasant experience.

Even worse, if your entire securities account is liquidated in the process, but there’s still a loan balance outstanding, you’re obligated to pay this as well.

On that cheery note, I’ll end for today.  Commodities tomorrow.