October 30, 2008
Why Margin Requirements Made Sense in 1934
Posted by Mike Guttentag

In an earlier post I endorsed the adoption of restrictions on margin lending as an imperfect, but fundamentally sound, legislative response to the stock market crash of 1929.  This endorsement relied on the claim that investing on margin destabilized market prices in precisely the same way that the widespread adoption of portfolio insurance led to the stock market crash in October 1987.  In this post I will explain why restricting margin lending is consistent with the three principles I offered for regulating portfolio insurance: do not panic, supervise the sale of insurance products, and do not rely on the sophistication of investors. 

My first regulatory principle based on a review of portfolio insurance and its role in the ’87 crash was: “don’t panic.”  An important lesson from the ’87 crash is that stock market prices can drop (or rise) dramatically for reasons that have nothing to do with the usual suspects, which include, but are not limited to, complexity, fraud, fear, greed, illiquidity, and failed corporate governance (in deference to Gordon).  Dramatic price changes may solely be a consequence of the widespread adoption of an investment strategy in which stocks are sold as prices fall.  While such an investment strategy may be potentially destabilizing, the dramatic price drop alone does not justify regulatory intervention.  The crash of ’87 made institutional investors keenly aware of the fact that the cost of creating a synthetic put to “protect” their portfolio’s depended on future volatility.  As a result, the problems that led to the 1987 crash were largely self-correcting.  Most investors learned the shortcomings and expense of portfolio insurance.  As with portfolio insurance, the widespread use of borrowed funds to purchase stock can lead to a situation where the aggregate demand for equities is upward sloping, creating Giffen goods, disparate equilibrium prices, and leading to market volatility.  But margin lending does not require regulatory intervention just because it may contribute to market volatility.

The second regulatory princple I espoused in the context of portfolio insurance was the need to regulate insurance products. Insurance products need not cause a market failure; however, history has shown, when left unregulated, those selling insurance products often misjudge the necessary amount of reserves.  To understand the relevance of insurance regulation to margin lending, we need to return to the decomposition of a margin loan.  Recall that a margin loan actually involves the sale of two different financial instruments: a loan, and the “writing” of a put on the collateral which backs the loan.  The put component of a margin loan results from the fact that if the price of the collateral falls below the loan value, then the bank takes ownership of the collateral (in many circumstances).

My recommendation in the context of portfolio insurance was that the insurance component of that product should be regulated to insure accurate pricing and the maintenance of adequate reserves.  The case for regulating the insurance component of the margin loan is even stronger than the case for regulating the insurance component of portfolio insurance.  When an investor adopts a portfolio insurance trading strategy, the put is also written by the investor.  If an investor “purchases” portfolio insurance and prices decline suddenly, the investor bears the increased cost of pursing this strategy.  But when an investor purchases a risky asset using borrowed funds, the put is written by the lender.  In the case of a margin loan, the costs of asset price volatility are borne by the lender, and it has proven difficult for lenders to properly price the value of the put embedded in a margin loan.  Peter Fortune, an economist at the FED who studies lending practices, concludes that even today, most banks do a poor job of pricing the put embedded in the loans they make [link].  To price this put the banker needs to correctly estimate the volatility of the underlying asset; however, the typical, mistaken assumption is that the price of an asset will rise or fall steadily, rather than occasionally jumping between disparate equilibrium prices.  Restricting the percentage of funds that can be used to finance the purchase of risky assets, such as stocks, is one way to limit the extent to which lenders misprice the insurance component of their loans.

The third regulatory lesson I inferred from the market crash of ’87 is that a regulator should not rely on the sophistication of investors.  This regulatory principle also supports the ’34 Act restrictions on margin lending.  A prohibition on high margin loans is not as draconian as it might appear, because there are other means by which investors can create leveraged investments in equities.  A prohibition on high margin loans would work more like a strong nudge, rather than an outright ban on highly leveraged investments in risky assets.  A strong regulatory nudge is appropriate once it is recognized that a highly leveraged investment in risky assets is unwise for most investors.  A regulator need not facilitate the practice of buying stock mostly with borrowed funds just because investors are eager to link the amount of risk in their portfolio to small changes in the nominal value of certain risky assets.

The three principles I offered for regulating portfolio insurance (do not panic, supervise the sale of insurance products, and do not rely on the sophistication of investors) support the margin regulations established in the ’34 Act as a response to the Crash of 1929.  In the next post I’ll show how these regulatory principles apply to the current financial crisis.

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