More About Margin

Many readers emailed me today and told me they wanted to get copies of Steve Galbraith's excellent margin work. Those are the property of Sanford Bernstein and I have no authority to give them out.

But recently Steve, who covers the brokerage industry -- and has made me a ton of money both as a broker analyst and as a food analyst in a different, more-boring incarnation -- recently testified in front of Congress on the growing abuses of margin debt by individuals.

That's public information, so I thought I should share some of the thoughts with you because they directly contributed to my thinking that we were headed for some real trouble.

First, understand, excessive margin is a red flag that has historically caused grave, but quick, selloffs in the market. The 1998 downturn in stocks came directly from the abuse of margin by some hedge funds, most notably Long Term Capital.

When Steve sent me the stuff earlier this month about excessive margin it rang a bell with me. I misjudged the importance of the stress of margin to the system in 1998 and I wasn't going to do it again.

First, margin debt as a percentage of total consumer credit has skyrocketed in the last year. It is way out of whack with where it has been historically.

Second, the margin-debt growth has all been in the hands of individuals. Firms that routinely handled wealthy institutions and individuals haven't seen much of a pickup in use.

Third, the people using margin are new to the game. They haven't seen or been through a downturn, so we don't know what stress tolerance they have.

Finally, despite this radical change in the use of margin, the problem hasn't been examined in a very long time. Despite the rising risk profile, there has been no change in initial margin requirements in over 25 years.

Like the debates after Long Term Capital blew up in 1998, I suspect that in a few months we will have big debates about excessive margin among individuals. We dodge a big bullet in this decline because mutual funds bent on stopping redemptions came in and bought their favorites.

That prop-up, the so-called hidden hand of buying -- is no stranger to those of us who short stocks. But there is a difference this time. The people who got crushed today weren't members of the mutual-fund club. They were risk-takers who thought that the dip would allow them to hang on. The completion of their close-outs allowed the mutual funds to create a short-term bottom.

Nevertheless, until this margin debt goes back to normal levels -- UNTIL WE SEE AN ACTUAL DECLINE IN ITS USAGE -- we are going to see many selloffs like we saw today.

Better get used to them. I will be there. I hope you will be, too.

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