Stocks Crashed the Last Two Times This Happened

“Your largest wealth creator for the top end has been inflation in financial assets,” Charles Peabody, a bank analyst at Portales Partners, told the Wall Street Journal. “You’re now seeing wealth destruction,” he said.

On Wednesday, the S&P 500 soared nearly 4%, its largest percentage gain since 2011, after having spent a whopping two days in a correction, its first since 2011.

On Monday, I’d written, “We’re expecting a rally topped off by a majestic short squeeze in the near future.” And we’re getting that. But the index is still down 5.8% year-to-date, and 3% for the 12-month period. Quite a change from the relentless double-digit uptrend of the past several years.

Margin debt is a big force behind stock prices. It’s the great accelerator, on the way up and on the way down. When investors buy stocks with money they don’t have and that the broker creates for them, it drives up stock prices, and makes room for more margin debt as higher stock prices allow investors to borrow even more against the same number of shares. It’s wonderful.

But when stocks tank, already spooked investors may be forced to sell to pay down their margin debt to stay within the limit. Forced selling drives down prices further, which begets more forced selling. Some of that happened last week, and particularly this Monday when the Dow plunged over 1,000 points at the open.

Margin debt has a nerve-racking habit of running up sharply and then peaking right around the time stocks crash. In the last sixteen years, there have been three majestic spikes, each greater than the prior one.

In March 2000, margin debt hit a record of $278.5 billion, just as stocks had begun to crash. Then a few years later, with memory about crashes being short-lived, margin debt spiked again, peaked at $381.4 billion in July 2007, and fell off. Thus stocks embarked on their epic crash.

Momentum stocks got killed first. As their values dematerialized, brokers sent out margin calls to their frazzled clients, and forced selling set in, and the selloff turned into a rout.

Now margin debt has spiked again.

In June, it hit another record high of $504,975, as reported by the NYSE. It’s the highest ever even if adjusted for inflation (Doug Short runs an excellent series on this) and even as a percent of GDP, at 2.85% compared to 2.60% and 2.73% for the prior two peaks.

This is the classic margin debt. But there are other forms of margin debt, including loans backed by portfolios of stocks, bonds, mutual funds, ETFs, and other securities. The loans can be used not to buy more securities, but to buy man-toys, make a down-payment on a mortgage for a home or an investment property, start a business, blow on a big vacation, or whatever.

This type of loan allows investors to draw money out of the markets without having to sell securities. The Wall Street Journal reported that, “according to lending executives at brokerage firms and analysts,” clients would be allowed to borrow “40% or less of the value of concentrated stock positions or as much as 80% of a bond portfolio.”

It was a good deal for everyone.

Investors loved it because, as asset prices were getting inflated year after year, they could borrow more and more against their very same portfolios, draw the money out, and live the good life. Financial advisors love it because they get paid a fee for their clients’ assets in their account, regardless of the loans drawn against those assets, and this fattened the fees. And banks and brokerages loved it because they scooped easy interest income off the loans, and they marketed them aggressively.

With all entities eager to do these loans, nothing stopped margin balances from ballooning into dangerous proportions. At Morgan Stanley, these types of loans have shot up 37% year over year, to $25.3 billion as of June 30. At BofA Merrill Lynch these loans soared by 14.2% year over year to $38.6 billion. At Wells Fargo’s wealth unit, these loans and classic margin loans combined soared 16% to $59.3 billion.

According to the Journal, “the biggest brokerage firms have all reported higher securities-based loan balances or higher client-loan asset totals, each quarter for more than two years.” These client-loan asset totals include both securities-based loans and the classic margin accounts.

These securities-based loans have become so popular, have been marketed so aggressively, and entail so much risk for clients that the Financial Industry Regulatory Authority (FINRA) has put them, as the Journal put it, on “its so-called watch list for 2015.”

Then the equation fell apart.

Energy stocks and bonds crashed, even those of some large companies like Chesapeake. Some have reached zero. All kinds of other stocks and bonds have gotten eviscerated over the past few months, even tech darlings like Twitter or biotech giant Biogen. Portfolios with a focus on the wrong momentum stocks took a very serious hit.

And margin calls went out. The Journal:

Some lenders, including Bank of America Corp., are issuing margin calls to clients after the global market drubbing of the past week, forcing investors to choose between either putting up more money or selling some of the securities underlying the loans.

Other banks too sent out margin calls, including U.S. Trust, Morgan Stanley, and Wells Fargo, according to the Journal. With margin calls mucking up the scenario, spooked investors are trying to lower their leverage before they’re forced to, and the boom in securities-based lending appears to be over. And the wealth units of the banks that gorged on these loans are likely to see their profits dented.

If that continues, a much crummier thing happens: margin balances reverse. And the last two times they did after a majestic record-breaking spike, the stock market crashed.

But for most Americans, the rosy scenario has already gotten tangled up in reality. Read… Americans’ Economic Outlook Plunges