The US financial system is facing a precarious situation, with margin debt reaching a record $1.1 trillion, marking a $67 billion increase in September alone. Despite the markets being at all-time highs, investors are continuing to borrow money to invest, raising concerns about the level of leverage in the system.
What is Margin Debt?
Margin debt refers to the money investors borrow from brokers to amplify their investments. While this can lead to increased gains if the investments rise, it also accelerates losses if prices fall. Furthermore, if prices drop significantly, brokers may issue margin calls, forcing investors to sell assets to repay loans. These forced sales can quickly spiral into broader sell-offs, posing a significant risk to the market.
The Current State of Margin Debt
At current levels, margin debt accounts for roughly 2% of the total S&P 500 market value, surpassing the levels seen during the 2000 dot-com bubble. This high level of leverage has become a crucial component of the market, with risk appetite continuing to rise. The Securities and Exchange Commission is still undecided on approving 5x leveraged exchange-traded funds (ETFs), which would allow investors to amplify daily returns and losses fivefold.
The Risks of Overleveraging
For example, a 2% move in a stock like Tesla could result in a 10% swing in a 5x leveraged ETF. This level of overleveraging could wipe out investors in a matter of hours if the trade goes wrong. The recent crypto flash crash, which saw digital assets shed $19 billion in value, is a stark reminder of the dangers of cascading liquidation.
The Crypto Flash Crash
On October 10, automated margin calls liquidated over 1.6 million traders, triggering a massive sell-off in the crypto market. While traditional stock markets have protections in place, such as circuit breakers and regulatory supervision, these mechanisms have their limits. When fear sets in, no one can prevent forced deleveraging, and the market can quickly spiral out of control.
Credit Card Debt Follows Higher
The same leverage dynamic is playing out at the consumer level, with Americans now owing a record $1.33 trillion in credit-card debt. Nearly half of US households carry balances month to month, paying an average interest rate above 20%. Despite multiple Federal Reserve rate cuts, borrowing costs remain stubbornly high, limiting the ability of consumers to raise additional cash to mitigate margin calls.
The Risks to Main Street
Any market hiccup could be devastating for Main Street, as credit card indebtedness limits the ability to raise additional cash to mitigate margin calls. Investors are betting borrowed dollars on a market that assumes perpetual calm, but history suggests that when debt piles this high, calm rarely lasts. The current state of the US financial system is precarious, and it remains to be seen how long this delicate balance can be maintained.