Margin Lending and Stock Market Volatility

M argin loans have long been associated in the popular mind with instability in security markets. Galbraith (1954) placed them at the center of the 1929 Crash, arguing that heavy borrowing from brokers exacerbated the rise in stock prices in the late 1920s and the stock price declines during the Crash. More recently, the analyses of the U.S. Securities and Exchange Commission (1988) and of the Presidential Task Force on Market Mechanisms (Brady et al. 1988) gave low margin requirements (albeit in futures markets) a prominent place in the pantheon of reasons for the 1987 break. And even more recently the historically high margin loans outstanding in March 2000 led to congressional hearings on margin lending (U.S. Congress 2000) and to calls by some for a more active margin policy at the Federal Reserve (Shiller 2000). The mechanism by which margin loans are popularly believed to increase stock price variability was described by Bogen and Krooss (1960) as " pyramiding and anti-pyramiding. " 1 Because security credit is cheaper than the cost of investor equity, access to brokers' loans stimulates the demand for stocks, inducing price increases that provide the additional equity that is the foundation of further borrowing to finance additional stock purchases. During this period of pyramiding, stock prices are pushed above intrinsic values. A subsequent reversal of stock prices leads to depyramiding as price declines induce brokers to issue margin calls. Forced sales of stocks further depress prices, inducing additional sales and sending prices to a level below intrinsic values. The amplitude of cycles in stock prices is thereby increased, with a potential for particularly severe price declines. The purpose of this study is to review, and to add to, the evidence on the relationship between margin requirements, margin lending, and the variability of common stock prices. This study differs in several ways from previous studies. Most of the studies reviewed below focus on the relationship between changes in the Federal Reserve System's initial margin requirements (" Fed margins ") and the returns on a stock price index, typically the Standard & Poor's index of 500 common stocks (S&P 500), 4 Issue Number 4 – 2001 New England Economic Review between 1934 and 1974, when an active margin policy prevailed. In contrast, the present study examines the linkage between the level of margin debt and stock returns for both the S&P 500 and the NASDAQ Composite index …