buying on margin definition us history

buying on margin definition us history

The Impact of Buying on Margin in US History

1. Introduction to Buying on Margin

The ability to buy on margin was restricted in 1934 with the US government’s securities legislation. An important takeaway from this is that the actual performance of the market went through issues every time margin threats escalated. Such issues include panics, dilution of stocks, general confusion, etc. The restrictions introduced with the establishment of the New York Stock Exchange and through the Securities Act of 1933 required that a minimum of 50% of the purchase price for a stock had to be paid in cash. Furthermore, not all stocks could be traded on margin. In spite of this, price volatility did not diminish. These actions, however, did limit the broker’s loan percentages to trade obligations, so the fallout from the stock market did not affect the economic performance of the US. During crashes in the thirties, margin calls were rife and had a much greater impact, and some of the established brokerage companies were put into ruin.

Buying on margin is essentially purchasing an asset by borrowing funds from a third party, using the asset itself as collateral (for example, borrowing money to trade stocks by using these same stocks as collateral). Essentially, this works as such: a customer puts up some portion of the price in the form of securities, and the broker provides the rest of the financing. A margin call is made should the equity value in the account fall below a value set by the broker. In the case of stocks in the US, for most of its history, the margin is 50% (in 1972 it was 90%). Buying on margin makes the market dependent on the expansion of lending and the increase in leverage, something which is potentially explosive if too much speculation causes the market to fall abruptly.

2. The Roaring Twenties: The Rise of Buying on Margin

On October 29, 1929, the stock market crashed and the prices of stocks collapsed. As a result, people lost all their money. The event directly led to the Great Depression.

People were able to invest in the stock market by buying stock on margin. A person could buy stock with cash. Specialized brokers helped and became known to finance the rest while only using 10%-20% down. Any loan would be paid back with the profits. As a result of buying on margin, everyone was a stock owner and an investor. It created a mindless buy and increased collective insanity. A large portion of the people who went bankrupt were unable to successfully pay their debts back.

After the war, the popularity of the automobile and consumer goods resulted in a world filled with American products. Not only in the United States but all over the world, people were greatly influenced by the American lifestyle. Factories and other businesses experienced huge profits. Real wages increased and both workers and businesses expanded. The stock market also became a major part of the economy. In the 1920s, the stock market was euphoric. Stocks exploded, and people profited from both investing and participating in the market.

After World War I, the US economy boomed. The automobile and consumer goods industries expanded, and the demand for electricity increased. The 1920s was a time of industrial modernization. Factories and cities grew at a fast pace. These expanding industries and the people who invested in them became the focus of the economy.

3. The Stock Market Crash of 1929: A Consequence of Buying on Margin

According to this analogy, today’s financial market would be less susceptible to a crisis of liquidity like that of 1987 or of extreme volatility like that of 1989, because there is more supervision by these entities. However, this does not mean that dangerous positions are not being built up: companies incurring huge debts or creating risky financial assets. Moreover, this theory assumes that the physical value of the company influences its financial value, that they are correlated. If, however, financial assets are issued without any kind of guarantee that the revenues that feed it change significantly, the possibility that their prices will reflect expectations increases.

One of the causes of the sudden downturn in the US economy at the end of the 1920s was the structure of the stock market. It was then a typical behavior to buy shares in large quantities and without sufficient capital to cover margins guaranteed by banks. These loans were always provided by banks or brokers and were used as a guarantee for credit for buying shares. When stock prices started to fall, these loans became liabilities. Faced with the level of debt, many small investors entered the spiral of withdrawal and forced liquidation of the shares. The delinquency level of the banks and brokers was then insurmountable, leading to bankruptcies.

4. Regulation and Reforms: Addressing the Risks of Buying on Margin

There was widespread agreement that abuses connected with the trading of securities on margin did contribute to price instability and that new legislative action was required. And yet, the regulatory response to the crash and the underlying real problems of our capital markets was relatively slow in developing. For nearly three years prior to the passage of the Securities Act of 1933, reform legislation idled on Capitol Hill. Similarly, twelve months would elapse before debate on the Securities Exchange Act of 1934 would culminate in its passage.

Historically, regulations and reforms have not been effective in curbing the consequences of buying on margin during bull markets. Oversight and enforcement have generally been lax, and brokerage houses and banking interests, which garner great profits from margin financing, have been able to prevent significant restraints from being applied. Indeed, in 1929 there were actually fewer controls than in most previous speculative booms. Although several causes were influential, there is agreement that buying on margin was a major factor in the rapid stock price increases of 1928 and 1929 and the eventual crash.

5. Conclusion: Lessons Learned from the History of Buying on Margin

From the historical record, we may draw several kinds of lessons. The first of these results from the historic existence of unmarginable securities. In the U.S., many of these unmarginable securities were the shares of closed-end investment companies that were largely unlisted. The unmarginable securities that develop in some markets are specific to those markets. The characteristics of the U.S. unmarginable securities suggest they were the results of incomplete information about the features of Regulation T. Moreover, the features that made these securities unmarginable resemble the features of securities that in some ways made them difficult to monitor and regulate in other ways.

The shared history of unmarginable securities and the regulatory tools used to prevent the overextension of credit for the purchase of securities on margin demonstrates that there are important differences in the way that individual investors, firms, and banks use various types of credit. Buying on margin has been criticized as opening speculative excess, particularly in bull markets, where more and more investors are willing to buy stocks using margin, creating the fear of maturity problems. Yet banks correctly fear the problems that would result in a bear market from large numbers of margin customers forced to sell stock in declining markets if forced liquidation cannot meet the call for additional margin.