Here, I'll do my best to explain margin calls and how they are affecting the markets and stock prices. Some of the biggest funds (the one's that determine market prices) borrow money from their brokers because they can borrow at a lower rate compared to the rate of return they expect to receive from their investments. Everyday investors like you and me can set up a margin account where we can borrow up to 50% of our portfolio's total equity (usually). If I had a $50,000 portfolio, I could borrow up to $25,000 making my portfolio's value $75,000. Some of the big funds, though, can borrow up to 15-25x the amount of cash (or cash equivalents) in their portfolio. Carlyle Capital, the company that has been in the news lately because of margin calls, is rumored to be levered 30x, i.e. they were borrowing 30x the value of deposits that had been given to them by investors.
Now, why do funds borrow money? It allows you to make much more money if you can play the game correctly. For example, a hedge fund will borrow cash at an 8% interest rate, but the fund expects to earn 15% on its investments, so it makes 7% extra because of borrowing. Sounds great, right? That's assuming they are making a greater return on their investments compared to the interest they are paying on their borrowed funds. It also helps when the market is good and trending upward. This is a very risky strategy with the potential for fabulous returns, but only the biggest funds are allowed to be highly levered. You call this fund "levered" because they are using borrowed money to increase their purchasing power so they can invest in more stocks – by borrowing they create power, or leverage, over the returns they are capable of generating.
However, we are running into a problem with the current financial markets because prices are declining. Funds have to maintain a minimum "maintenance" balance, i.e. they have to have enough equity to use as collateral to support their borrowing. So, let's set up an imaginary hedge fund to show what happens when a portfolio's value declines and a fund is faced with a margin call.
In July 2007, the company has $1B in equity (cash from its investors tied up in stock) and $1B in borrowed funds (cash from its creditors tied up in stock). Like I said before, big funds can be much more "levered," but for simplicity sake, we'll use a 1 to 1 ratio. When you borrow funds you need to put up collateral, and these funds use their equity (stock purchased using their investors’ money) to borrow more money (which will be used to buy more stock). A brokerage house loans $1B to this hedge fund and according to the borrowing contract the fund cannot let debt exceed 60% of the total value of their portfolio – this is their "maintenance" balance. If the value of the equity in the portfolio dips below 40%, the fund will be forced to liquidate (sell) some of its assets or come up with more cash to give to the banks. These maintenance (or margin) requirements are how the banks try to protect themselves.
Now it's January 2008 and stock prices have declined significantly since July. The portfolio's value has declined by 10% so its total value is now worth $1.8B. But how does this break down? Well, they still have a $1B loan outstanding that they have to pay back, so their total stakeholder equity is now $800 million, a 20% loss. This is why borrowing to invest is so risky. When a fund is 1x levered, the equity portion of the portfolio increases or decreases 2x the amount of the portfolio's performance. Gains or losses are exaggerated based on how much the fund is borrowing. There is no margin call just yet.
Now it's March 2008 and stock prices have gone down even further. The portfolio's value has declined by 20% so it is now worth $1.6B. They still have the $1B loan so equity is worth $600M. The equity portion has actually declined by 40% because the fund still owes the lender $1B. Debt now makes up 62.5% (1,000/1,600) of the portfolio, so the fund will be forced to sell (sometimes the broker will liquidate assets without letting the fund know, the broker will always do that for you and me) or "de-lever" in order to get back to the contractual agreements of the loan. Everything they sell goes to pay off the loan. The fund currently has a total portfolio value of $1.6B. To get back to the maximum 60% debt threshold they have to sell at least $100M of their holdings leaving them with $600M of investor capital and a $900M loan (900/1,500).
So you've seen how taking on leverage creates power. It can substantially boost your returns both up and down (remember, a portfolio levered 1x sees actual appreciation/depreciation of 2x their equity value), but too much leverage can also cause forced selling of securities. Forced selling then forces lower prices, which may cause a margin call on someone else, which would cause more forced selling, which would cause lower prices...are you seeing the vicious cycle? That's why when you start hearing about major mortgage calls, it's a real risk.
Why did agriculture and energy stocks struggle at the end of last week? We were getting margin calls. Ag and energy have had a huge run, so they're the easiest to sell, so you saw them get beat down a little bit because of redemptions to give funds more liquidity.
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