THE USE OF. MARGIN CREDIT IN. THE. TRADING 0F SECURITIES

Thesis for the Degree of Ph. D.
MECHEGAN STATE UNIVERSiTY
JUHE‘é D. STUFFELS

1969 -

 

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L I B R A R Y
Michigan State
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This is to certify that the

thesis entitled

THE USE OF MARGIN CREDIT IN THE

TRADING OF SECURITIES

presented by

John D. Stoffels

has been accepted towards fulfillment

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ABSTRACT

THE USE OF MARGIN CREDIT IN THE TRADING
OF SECURITIES
By

John D. Stoffels

Margin requirements are the only existing selective control over
the demand for credit in the economy. Since the Federal Reserve Board
maintains regulatory authority over the supply of credit to finance
security transactions, through both general monetary controls and
specific controls over the stock-secured loan activities of bank and
non-bank lenders, margin requirements cannot be justified as a means to
prevent the excessive use of stock market credit relative to the resources
of the banking system. Instead, this selective control is rooted in the
concern that excessive use of credit is disruptive to the stock market
per se. 0n the one hand, higher required margins than were common prior
to the 1929 stock market crash are justifiable in order to reduce the
disruptive influence of wholesale liquidations of securities from margin
accounts which occurs when declining market prices eliminate customers'
equity. 0n the other hand, changes in margin requirements are justifi-
able as a reSponse to rapid growth in outstanding margin credit if such
growth is evidence that bank credit is being used to finance speculative
stock market activity which amplifies, rather than stabilizes, stock
price swings. The results of this study support the hypothesis that
margin trading evidences speculative, price-oriented strategies which
destabilize stock prices by adding buying pressure throughout market

upswings and selling pressure throughout market declines.

 

 

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John D. Stoffels
Two approaches were utilized in testing the hypothesis. First,
a model of the demand for margin credit was developed to explain changes
in the aggregate amount of credit extended to margin customers by
brokers. Second, the purchase and sale transactions in a sample of
individual margin accounts were analyzed in terms of the riskiness of
securities traded, the frequency of trading, and the reSponse of trad-

ing to stock price changes.

Evidence of Speculative Behavior in Margin Trading

Contrary to investors, whose demand for stocks is based on the
value of stocks reflected in discounted expected future returns,
speculators base their demand on expected near-term price movements in
stocks. Consequently, the degree of speculative influence on margin
trading can be measured by the extent to which activity in margin
accounts is explained by movements in stock prices.

An aggregate monthly model of the demand for margin credit was
tested with data on credit extended by large brokerage firms between
January, 1965 and May, 1968, in order to identify the relative influence
of stock prices on margin credit change. The stock price variable was
significant at the .001 probability level and was the most influential
variable in the model, accounting for 34 per cent of the average absolute
impact of all variables. An almost equal percentage of the average
impact of all variables was provided by expectations regarding future
earnings and inflation, that is, the value of securities. The remainder
of the impact was provided by changes in purchasing power in margin
accounts (10 per cent), interest rates (13 per cent), and credit

availability (6 per cent).

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John D. Stoffels

Calculated on a monthly rather than an average basis, the impact
of stock prices in the model varied considerably. In twelve of the
thirty-nine periods studied, stock price movements accounted for more
than 40 per cent of the impact of all variables, and each of these cases
occurred during or near a period of sharp stock price movement. Margin
credit changes thus reflected a substantial Speculative sensitivity to
stock price changes, on the average, over the period studied. And in
periods of rapid price movement, the influence of speculative, price-
oriented behavior on margin credit was highly significant.

Evidence of substantial speculative margin trading activity is
confirmed through analysis of actual purchase and sale transactions in a
sample of individual margin accounts. The sample includes 418 accounts
selected at random from the accounts of one of the largest national
brokerage firms, and it covers one period of sharp stock price fluctua-
tions, from February 28, 1966 through June 17, 1966. A simple model was
tested in which the net dollar value of stocks traded in the sample each
day was regressed on stock price changes, with all other influences on
the demand for stocks implied in an error term. It was found that on
the average over the 78 day period tested, 50.8 per cent of the dollar
value of market activity was accounted for by stock price changes. On a
daily basis, stock prices alone explained 18.1 per cent of the total
variation in net stock purchase activity. Moreover, study of the sample
accounts provided evidence of a Speculative orientation through
characteristics of the stocks traded and the frequency of trading.
Sample accounts traded only 858 different stock issues, or 32.5 per cent
of the total number of issues listed on the New York Stock Exchange or

the American Stock Exchange. These stocks, weighted by the dollar

anon:

John D. Stoffels
amount of trading, varied 47.5 per cent from their average price during
the first six months of 1966, compared with a variation of 39 per cent
for the weighted average of all trading in listed stocks. Similarly,
when stocks were ranked according to the stability and growth in their
earnings and dividends, stocks traded by the sample had an average rank-
ing of 2.72, on a scale of zero through seven, some twenty per cent
lower than the ranking of 3.35 for all trading in listed stocks. And
the rate of turnover of dollar value of shares was 27 per cent per month
in sample accounts, but only 1.83 per cent in all listed stocks. Each
of these three comparisons is consistent with the finding that margin
trading is speculatively oriented. Speculators would be expected to
concentrate their purchase and sale activity in issues likely to provide
the greatest short-term capital gain, including those stocks which are
subject to the greatest price variability as well as those whose earnings
are subject to wide fluctuation and thus to considerable variability in
both expectations and market prices. And the short-term orientation of
the Speculator should be evident in a higher turnover of shares than

would be the case with long-term investors.

Evidence of Destabilizing Behavior in Margin Trading

If margin traders functioned in the normal economic role of the
speculator, there would be little cause for concern over the use of
credit to support speculative margin activity. In such a case, margin
speculators would stabilize the stock market by reducing the amplitude
of stock price swings. To perform such a stabilizing function profitably,
margin traders could adept either of two patterns in their long trading

of stocks. First, they could buy stocks when prices are falling but

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with

John D. Stoffels
below their mean value level and sell them when prices rose above this
level. Second, they could buy stocks when prices are rising but below
their mean level and sell them when prices began to fall but were above
the mean.

In order for the first of these stabilizing patterns to be con-
firmed, stock price changes would necessarily have to bear an inverse
relationship to margin trading activity. Both of the models tested in
this study, however, indicate that stock price changes are directly
related to margin trading activity. In the test of both the aggregate
monthly model of margin credit change and the daily model of the dollar
value of sample account stock purchases, the coefficient of stock price
change was positive and significantly different from zero at better than
the .001 probability level. Thus both margin credit and market
purchases of stock increase with increasing stock prices and decrease
with declining stock prices.

Given that margin traders do respond directly to stock price
changes, they could still be a stabilizing influence if they ceased
buying stocks when prices exceeded their mean value level and ceased
selling stocks when prices fell below this level. In other words, margin
trading would be stabilizing if concentrated in the early stages of
either price advances or declines. It is evident, however, from a
graphical analysis of both monthly aggregate margin credit movements and
daily sample purchases and sales, that margin trading adds buying
pressure throughout price upswings and selling pressure throughout price
downswings. Consequently, the evidence develOped in the study indicates
that margin trading is destabilizing because it amplifies fluctuations

of stock prices around their mean value levels.

THE USE OF MARGIN CREDIT IN THE

TRADING OF SECURITIES

By

John D. Stoffels

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

1969

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To Julie Ann
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ACKNOWLEDGMENTS

The writing of this dissertation benefited greatly from the
helpful comments and suggestions of a number of people, including
Professors Myles S. Delano and Thomas G. Moore, who served as members
of my dissertation committee, and Ann Pike Ulrey and Edward C. Ettin,
both of whom are associated with the Board of Governors of the Federal
Reserve System. I am particularly appreciative of the interest,
patience, and wisdom provided by Professor Roland 1. Robinson, the
chairman of my dissertation committee. A special note of acknowledg-
ment is due the brokerage firm and the manager of its margin department,
whose anonymity they wish preserved, for their most valuable cooperation
in providing access to the confidential data which underlie the analysis
of individual margin account activity. I am grateful for the resources
and generous financial support provided initially by a research fellow-
ship at the Federal Reserve Bank of Chicago and subsequently under
released time at the Board of Governors of the Federal Reserve System.
Finally, my thanks to colleagues in the Capital Markets Section at the
Federal Reserve Board, especially again to Edward C. Ettin, who assumed
the bulk of my reSponsibilities while the dissertation was being
completed. The conclusions which follow do not necessarily reflect the
position of the Board of Governors of the Federal Reserve System nor of

any members of its staff other than myself.

iii

haptet

I. I

11.

III.

TABLE OF CONTENTS

Chapter Page

I o I NTRODUC TI ON 0 o o o o o o o o o o o o o o o o o o o' o o o o 1

Background of Security Credit Regulation . . . . . . . . 2
Early Regulation of Security Credit. . . . . . . . . 3
Attempts to Control Security Credit during the 1920' s. . 5
Legislative Action Following the 1929 Stock.Market

Crash. . . . . . . . . . . . . . . . . . . . . . . . 8

Economic Rationale for Security Credit Regulation. . . . . 13
Effects on the Volume of Credit Available for Trade. . . 14
Inability to Prevent Massive Expansion in Security

Credit . . . . . . . . . . . . . . . . . . . . . . . . 19
Controls on Aggregate Security Loans are Insufficient. . 20
Support for Existing Regulation. . . . . . . . . . . . . 23

Existing Research. . . . . . . . . . . . . . . . . . . . . 24

Need for Research. . . . . . . . . . . . . . . . . . . . 27

Hypothesis and Plan of Study . . . . . . . . . . . . . . . 31

II. A MODEL OF AGGREGATE MARGIN CREDIT CHANGE. . . . . . . . . . 34

Factors Affecting the Demand for Margin Credit . . . . . . 34
The Supply of Listed Stocks: S. . . . . . . . . . . . . 35
Expected Future Growth in Earnings: Ee. . . . . . . . . 36
Expected Rate of Inflation: Ie. . . . . . . . . . . . . 37
The Cost of Borrowing: R. . . . . . . . . . . . . . . 37
Extent and Direction of Change in Market Prices: P. . . 38
Existing Borrowing Power in Margin Accounts: B. . . . . 40

Factors Affecting the Supply of Margin Credit. . . . . . . 42

Regression Test of the Model . . . . . . . . . . . . . . . 43
Specification of the Regression Test . . . . . . . . . . 51

Performance of the Model . . . . . . . . . . . . . . . . . 53

Empirical Support of Hypothesized Margin Trading Behavior. 61
The Average Impact of Stock Prices . . . . . . . . . . . 65
Stock Price Impact during "Critical Periods" of

Stock.Market Activity. . . . . . . . . . . . . . . . 67
Summary of Supporting Evidence from Aggregate Model. . . 70

III. SECURITY TRADING BEHAVIOR IN A SAMPLE 0F MARGIN ACCOUNTS . . 72
Description of the Sample. . . . . . . . . . . . . . . . . 73
Differences Between Active and Inactive Samples. . . . . 76

Representativeness of the Sample . . . . . . . . . . . . 78

iv

Chapt

IV.

Chapter

Characteristics of the Account Sample. . . .
Evidence of Speculative Destabilizing Behavior in
Sample Account Trading of Stocks . . . . . .
Speculative Selection and Trading of Securities.

Response of Sample Account Trading to Market Prices.

Summary of Evidence of Speculative Destabilizing
Behavior in Sample Accounts.

IV. SUMMARY AND IMPLICATIONS OF STUDY. . . . . . . .

Evidence of Speculative Behavior in Margin Trading .

Evidence of Destabilizing Behavior in Margin Trading .

Limitations of the Study . . . . . . . . . . . . .
Implications of the Study for Margin Regulation. . .

BIBLImmm I O O O O O O O O O O O O 0 O O O O O O O O O O

APPENDICES

A. THE INADEQUACY OF HISTORICAL MARGIN CREDIT DATA SERIES .

B. SIMPLE CORRELATIONS BETWEEN TRANSFORMED VARIABLES IN
THE AGGREGATE MARGIN CREDIT MODEL. . . . . . . . .

C. TEST RESULTS OF AGGREGATE MARGIN CREDIT MODEL FOR
DISTRIBUTED LAG FORMULATIONS 0F EARNINGS AND
INFLATION EXPECTATIONS VARIABLES . . . . .

Page
82
91
92
97

110
113
114
116
118
119

121

126

132

133

 

Tab

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I

13,

Table

10.

11.
12.

13.

14.

15.

LIST OF TABLES

Page
Demand for Margin Credit at Brokers . . . . . . . . . . . . . 54
Demand for Margin Credit at Brokers -- Revised Model. . . . . 56

Illustration of the Impact of Stock Price Growth on Margin
Credit Growth . . . . . . . . . . . . . . . . . . . . . . . 59

Impact of Coefficients in Revised Model . . . . . . . . . . . 66
Size Comparisons: Active vs. Inactive Accounts . . . . . . . 77

Geographic Distribution of Sample Accounts and Total
Shareownership. . . . . . . . . . . . . . . . . . . . . . . 79

Relationship of Sample Account Balances to Estimated Balance
in All Margin Accounts. . . . . . . . . . . . . . . . . . . 31

Absolute Impact of Various Transactions on Sample Account
Margin Debt Change. . . . . . . . . . . . . . . . . . . . . 33

Absolute Impact of Various Transactions on Sample Market
value Changes 0 O O O O O O I O O I O O O O O O O O O O O O 85

Summary of Statistics on Trading of Securities in Sample
Accounts. 0 O O I O O O O O O O O O O O O O O O O O O O 0 O 87

Stocks Eligible for Margin Traded by Sample Accounts. . . . . 39
Stock Issues Most Traded by Sample Accounts . . . . . . . . . 90

Security Selection and Turnover: A Comparison between
Sample and Market Trading . . . . . . . . . . . . . . . . . 96

Regression Tests of the Model of Aggregate Daily Share
Purchases in Sample Accounts. . . . . . . . . . . . . . . . 101

Impact of Stock Price Changes on Daily Share Purchases in
sample Accounts 0 O O O O I O O O O O O I O O O O O O O O O 107

vi

LIST OF FIGURES

Figure Page
1. Margin Credit and Stock Price Movements . . . . . . . . . . . 63

2. Variation in Impact of Stock Prices on Margin Credit Change
in the Aggregate Model. . . . . . . . . . . . . . . . . . . 69

3. Cumulative Daily Purchases and Sales in Sample Accounts
and Stock Price Movements . . . . . . . . . . . . . . . . . 104

vii

main

CHAPTER I
INTRODUCTION

A study of transactions handled on the floor of the New York
Stock Exchange on October 19, 19661 showed that 18 per cent of the
number and dollar amount of shares traded were either bought for or
sold from margin accounts maintained by individuals with member firms
of the Exchange. On this same date, 47 per cent of the total dollar
volume of trading by all individuals (excluding exchange members,
banks and institutions) originated in margin accounts. Since these
data do not include the trading of securities for customers who
maintain regulated securities loans with banks, margin trading is
an even more significant factor in the exchange of securities than
these data indicate.

Furthermore, the debt associated with margin trading is subject
to substantial growth. At the end of January, 1966, the first date
on which a revised data series became available, the aggregate in-
debtedness of individual margin investors to member firms of the New

2

York Stock Exchange was estimated to be $5.02 billion. By the end of

May, 1968, estimated margin credit had grown by over 32 per cent to

 

1New York Stock Exchange, Public Transaction Study, 1966, (New
York: New York Stock Exchange, 1967), pp. 5-11.

2Ann P. Ulrey, "Margin Account Credit," Federal Reserve Bulletin,
LIV (June, 1968), p. 472.

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$6.64 billion; over the same period, the New York Stock Exchange
Composite Index advanced 10 per cent.

Margin trading, and the debt which arises from it, is a
public policy responsibility of the Federal Reserve Board, which
sets initial margin requirements. This responsibility was placed
with the Board by the Securities Exchange Act of 1934, a law which
implemented broad powers of the Federal Government over the trading
of securities and the operations of exchanges. This act, and the
Banking Act of 1933 which preceded it, reflected the vigorous
determination of the Congress to curb what it considered dangerously
Speculative and manipulative practices in the use of credit in
securities trading. The root of this Congressional determination
can be found in the events leading to and following the onset of
the stock market crash on October 29, 1929. A review of earlier
attempts to regulate margin credit and of the events leading to
passage of the Securities Exchange Act of 1934 will clarify the
rationale for margin regulation, the intent of Congress in
establishing the regulation, and the interest of the Federal Reserve

Board in implementing the regulation.

Background of Security Credit Regnlation
Concern over disruptive Speculation using borrowed funds
preceded the events of the 1920's. In its report to the Senate in
1912, the National Monetary Commission indicated the strong influence
which security trading on credit had on the stock market during
periods of financial crisis as early as 1873. The report concluded

that much of the problem was a result of concentration of idle funds

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in New York,1 and the subsequent commitment of these funds to highly
liquid and impersonal call loans. Such funds could be withdrawn

from the market whenever commercial loan demand required or whenever
market price declines threatened the security of loans. It was the

latter action -- wholesale withdrawal of funds from the market in

market declines -- which caused particular concern, since the call of
loans led to forced sales of securities to permit repayment, feeding

the downward pressure on prices. Even at the personal urging of President

Theodore Roosevelt, Congress failed to act on requested legislation.

Early Regulation of Security Credit

The Federal Reserve Act of 1913 contained the first legislative
attempt at reducing stock speculation with borrowed funds. A provision
of the act prohibited banks from rediscounting with the Federal Reserve
Banks any note resulting from the purchase or carrying of securities.
Furthermore, by decentralizing the banking system from large New York
banks, the creators of the act expected that funds would be more evenly
distributed among geographic regions for local commercial and in-
dustrial development, rather than remaining in New York banks where
it was thought that "pyramiding of the bank reserves for gambling
purposes on the stock exchange,"2 had occurred.

Also in 1913, the New York Stock Exchange adOpted its first

formal rule governing the trading of securities on margin. The

 

1 . . .
U.S., Congress, Senate, Nat1ona1 Monetary Comm1ss1on, 8. Doc.

243, 62nd Congress, 1912, p. 8.

2U.S., Congress, Senate, Committee on Banking and Currency,
Banking and Currency, Pt. 1, S. Rept. 133, 63rd Cong., lst Sess.,
1913, p. 7.

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exchange passed a resolution providing for suSpension of a member
broker for up to one year for permitting customers to purchase or
carry securities in an account without "prOper and adequate margin."1

These early attempts to control the use of credit for security
trading were difficult or impossible to enforce. Banks which wished
to both borrow from the Federal Reserve and at the same time provide
substantial credit for stock purchases through the call money market,
could do so by discounting other paper which was acceptable to the
Federal Reserve. Country banks who at times found the call money
market more profitable than loans to foster local commercial develop-
ment, were still free to channel their funds into New York where a
ready market continued to exist. And because of the uncertain
language of the stock exchange rule, little if any guidance or
instruction was given to brokerage firms in the handling of their
margin business.

Furthermore, the only effective indirect action which could
be taken as a means to reduce security credit under existing legislation
proved unworkable in its first test. When it became clear in 1919 that
substantial stock market activity continued to be carried out with
borrowed funds, the Federal Reserve was unable to reduce bank lending
capability through increases in the discount rate, because at the
same time the Central Bank had committed itself to maintaining money
market conditions favorable to the flotation of Treasury debt to

support war costs at low interest rates. The social judgment that

 

1State of New York, Report of Governor Hughes Committee on
Speculation in Securities and Commodities, 1909, p. 817ff.

 

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easy money policy was desirable for support of war finances could not
be reconciled with the social judgment that erratic stock price swings

accompanying credit-using stock speculation were undesirable.

Attempts to Control Security Credit During the 1920's

Free of its reSponsibilitieS to the Treasury in late 1919, the
Federal Reserve sought to curb excessive Speculation through the dis-
count mechanism. Between November, 1919, and July, 1920, the discount
rate was raised progressively from 4 to 7 per cent. Accompanying the
initial increase was a statement by the Federal Reserve Bank of New
York indicating that action was being taken because as war finance
demands were reduced, borrowing was "being diverted to Speculative
employment rather than to reduction of bank loans."1 The action, of
course, affected total credit, not just stock market credit. Al-
though it was only partly the result of central bank policy, the
subsequent contraction in the economy in late 1920 and 1921 prompted
substantial criticism of the Federal Reserve. The dilemma of cir-
cumstances was clear: the Federal Reserve could not control
Selectively with a broad instrument.

With no additional regulatory authority, the Federal Reserve
was even less prepared to face the phenomenal growth in security
credit which occurred during the decade of the 1920's. Between 1922
and the market peak in 1929, the Standard and Poor stock average rose
over 250 per cent and loans by brokers increased over 450 per cent,

from $1.5 billion to $8.5 billion. In the three months prior to the

 

10.8., Congress, Senate, Agricultural Inggiry Hearings, before
the Joint Commission of Agricultural Inquiry, under S. Concurrent Res.
4, Vol. 2, 67th Cong., lst Sess., 1921, p. 712.

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October 29th collapse, brokers' loans were increasing at an annual rate
of $6 billion. Even had the Federal Reserve been able to control
selectively the extension of bank credit for the purchase of securities,
they would still have been unprepared for the flood of call money which
was provided by corporations and other non-bank lenders. Stock prices
were expanding so rapidly, and demand for credit was so high, that it
became profitable for corporations to issue new shares and lend the
entire proceeds in the call market.1 Before the long bull market had
run its course, brokers' loans from sources other than banks accounted
for over $6.5 billion, more than 75 per cent of the total outstanding.

Although the Federal Reserve noted in its Annual Report of
1925 that the growth in reserve bank credit seemed largely due to
increasing demand for loans on securities,2 their reSponse was
limited to warnings to member banks that Federal Reserve resources
were not to be used to aid stock Speculation. In addition, previously
confidential data on loans made to brokers and dealers by weekly
reporting banks were made public for the first time, and the New York
Stock Exchange began to collect and publish information on borrowings
by their member firms. By informing the public of the high levels of
security credit, it was hoped that the demand for security loans would
be moderated.

Progressive increases in the discount rate from 3-1/2 to 5 per

cent during 1928 failed to stem the rapid flow of credit into the stock

 

1Lewis H. Haney, Hyman S. Logan, and Henry S. Gavens, Brokers'
Loans (New York: Harper & Brothers, 1932), p. 156.

2U.S., Board of Governors of the Federal Reserve System,
Annual Report, 1925, p. 16.

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market, not because the discount mechanism failed to reduce bank credit,
but because this effect was overwhelmed by growth in call money provided
by other lenders. Between January and September of 1928, while loans
to brokers from New York City banks declined by $670 million, loans by
other lenders than banks increased, at an accelerated rate, by $1.7
billion.

Early in 1929, a policy of direct pressure by the Federal
Reserve replaced further Shifts in the discount rate. Reacting to
the "interference by reason of the excessive amount of the country's
credit absorbed in Speculative security loans," the Board concluded
that it was "its duty to inquire into [conditions] and to take such
measures as may be deemed suitable and effective in the circumstances
to correct them; which, in the immediate situation, means to restrain
the use, either directly or indirectly, of Federal reserve credit
facilities in aid of the growth of Speculative credit."1 Although
this policy led to considerable diSpute within the system over both
the possibility of identifying security loans and the propriety of
refusing to grant them, it did result in some reduction in loans to
brokers by New York City banks. However, the effect was again
swamped by more rapid growth in loans to brokers by other lenders
than banks, and total brokers' loans continued to soar higher.

Finally, in reSponse to continued requests from the Federal
Reserve Banks, the Board allowed the discount rate to rise, this

time from 5 per cent to 6 per cent, on August 9, 1929. The change

 

1U.S., Board of Governors of the Federal Reserve System,
Annual Report, 1929, pp. 2-3.

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did not slow the eXpansion of brokers' loans by others; nor did it
slow increases in Stock prices.

The aftermath in the credit markets of the stock market
break on October 29, 1929, was painful. In the first week following
the break, $2 billion in credit was called by other lenders and an
additional $800 million by out-of—town banks. New York banks tried,
however unsuccessfully, to Shore up the market by increasing their
loans to brokers by $1 billion and buying securities as well. By
yearend, total brokers' loans had fallen from $8.5 billion to $4
billion, and stock prices had declined some 36 per cent. Of the
total credit shrinkage, lenders other than banks withdrew $4 billion
and banks outside of New York withdrew the remainder. New York banks
maintained slightly higher brokers' loans at the end of the year

than they had outstanding prior to the market break.

Legislative Action Following the 1929 Stock Market Crash

The great ease of obtaining credit for security trading during
the 1920's, coupled with the enormous withdrawal of funds from the call
money market when prices began to decline, was thought by many to have
been a major influence in accentuating the Stock market crash. The
choice of means for preventing such a disruptive influence from
occurring again was the subject of almost constant debate during the
next four years. The Spirit of reform which developed in the Congress
culminated in the enactment of The Banking Act of 1933, and the highly
controversial Securities Exchange Act of 1934.

A number of the provisions of the Banking Act of 1933 were

designed to increase the ability of the Federal Reserve Board to

direct
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Cthe:

9
directly control the extent of securities lending by member banks, and
to prevent practices which had contributed to the severity of the 1929
experience. First, member banks were forbidden to serve as agents in
arranging brokers' loans except for other member banks. This pro-
vision greatly reduced the influence of out-of-town banks and of other
lenders by limiting the uncontrollable and rapid flows of credit into
and out of the call market from these groups. Second, the payment of
interest on demand deposits was prohibited for several reasons, one of
which was to reduce deposit flows into New York banks, where funds
might then in turn be lent excessively in the call market. Third,
the Federal Reserve Board was empowered to stipulate, for each Federal
Reserve District, the maximum allowable preportion of bank capital and
surplus which could be represented by securities loans. Finally, banks
which channeled reserve borrowings into securities loans in spite of
official warnings were made subject to total suspension of borrowing
privileges.

The Securities Exchange Act of 1934 contained provisions which
restricted or controlled the use of stock market credit by individuals
as well as brokers and dealers. The erratic influence of lenders
other than banks, which the Banking Act of 1933 sought to reduce, was
eliminated almost entirely by the 1934 Act which prohibited borrowing
by brokers and dealers from essentially any source other than banks
who are members or c00perating non-members of the Federal Reserve
System. Control over the ability of individual investors to borrow

money for stock purchases took the form of flexible margin requirements,

"[flor

purpos

under

banks

Regula
securf
indiv:
Regule
in a :
Simile
and U.
market
(inclt
atd me
Since

hamks

10

"[f]or the purpose of preventing the excessive use of credit for the
purpose of purchasing or carrying of securities."1

Until recently, the authority of the Federal Reserve Board
under the Securities Exchange Act was limited to control of loans by
banks through Regulation U, and by brokers and dealers through
Regulation T, for the purchase and carrying of registered, non-exempt
securities. More effective control over security credit extended to
individuals by other lenders is now achieved through newly imposed
Regulation G.2 Under new authority granted by Congress, transactions
in a selected group of over-the-counter securities which are most
similar to listed securities will be governed by Regulations G, T,
and U. However, many unregulated transactions in the securities
markets involving the use of credit still occur. Government bonds
(including state and local issues) are exempt from margin rules,
and many industrial bonds (except convertibles) are unregulated

since they are traded over-the-counter. Furthermore, loans by

banks which are not both for the purpose of purchasing and carrying

 

1U.S., Securities and Exchange Commission, Securities Exchange
Act of 1934 as Amended to August 20, 1964 (Washington: U.S. Government
Printing Office, 1965), p. 5.

2U.S., Board of Governors of the Federal Reserve System,
Regulation §,_Effective March 11, 1968, (Washington, 1968), p. 1.
The regulation requires that any person who during any calendar
quarter extends $50,000 or more, or has outstanding $100,000 or
more, in credit which is collateraled in any part by registered
equity securities, must file a report with the Federal Reserve
Board and must adhere to the currently applicable margin require-
ments for these loans. This regulation seeks to control the
activities of all active lenders, primarily finance companies,
savings and loan associations, factors, and some individual
lenders, who have not previously been covered by regulations T
and U.

secur
Regul
faith

SECUI

to co
stock
littl.
three
and 1
the p

value

11

securities ang_collateralized by listed securities are not subject to
Regulation U. Such loans are eligible for generally higher "good-
faith” loan values, and an unknown proportion of them are in reality
security loans which evade regulation.1

Prior to the 1929 decline, credit was available in many cases
to cover as much as 90 per cent of the purchase price of common
Stocks.2 At this 10 per cent margin level, a drOp in price of as
little as 10 per cent would eliminate the customer's equity,3
threaten the security of the loan from the broker's point of view,
and lead to calls for additional collateral. As a means of reducing

the potential danger of forced sale from this loss of collateral

value, initial margins4 under the Securities Exchange Act were set

 

1A further discussion of such loans is contained in Appendix A.

2The official (but unwritten) New York Stock Exchange require-
ment which existed during 1929 was 25 per cent, according to testimony
of Richard Whitney, president of the exchange, in U.S., Congress,
Senate, Committee on Banking and Currency, Stock Exchange Practices,
Hearings, before the Committee on Banking and Currency, Senate, on
S. Res. 84, Pt. 1, 72nd Cong., lst Sess., 1932, pp. 207-08. A re-
collection that the prevailing margin required in practice by
brokers was 10 per cent and in some cases even lower, is provided
by Herbert H. Lehman, Senator from New York on the Banking and
Currency Committee at the time of, U.S., Congress, Senate, Committee
on Banking and Currency, Stock Market Study, Hegringg, before the
Committee on Banking and Currency, Senate, Pt. 1, 84th Cong., lst
Sess., 1955, p. 278.

3Equity in a customer margin or loan account is the difference
between the market value of securities contained in the account (or ‘
held as collateral by the bank) and the debit balance in the account.

4Margin is the percentage of the net purchase price which must
be provided by customer equity, either in cash deposited or in loan
value of securities not already supporting other debt. Loan value
is one minus the margin requirement.

at a rate
requirenen
Govemors
margins we
time, the
higher the
80 per cer

A:
only to it
the New Y;
25 per cer
be PTOViClr
that 30 pt
drOPS bell
if the adr

to liquid;

12
at a rate varying between 25 and 45 per cent. Since 1934, margin
requirements have been changed eighteen times by the Board of
Governors of the Federal Reserve System. For a brief period in 1946,
margins were set at 100 per cent (no borrowing allowed). Since that
time, the margin requirement has not been less than 50 per cent, nor
higher than 90 per cent. The current requirement (May, 1969) of
80 per cent has been in effect Since June, 1968.

As they are currently applied, margin requirements relate
only to initial purchases of securities. Once purchased, rules of
the New York Stock Exchange permit equity to drop to as little as
25 per cent of market value before additional margin collateral must
be provided. In practice, however, most brokerage firms insist
that 30 per cent margin be maintained. If the borrower's equity
drops below this level, the broker will call for additional margin;
if the additional margin cannot be provided, the broker is empowered
to liquidate the account without further notice.

Statements regarding reasons for changing margin requirements
indicate that the Board, in almost all cases, has based its decision
to change requirements partly on the volume of security credit out-
standing. Other bases for judgment have included the volume of
Speculative activity, economic and credit conditions, and the be-
havior of prices in the stock market.1 In most cases, increases or

decreases in margin requirements have apparently had the effect of

 

1For a summary of the reasons stated by the Federal Reserve
Board in changing margin requirements in the post-war period, see
Jacob Cohen, "Federal Reserve Margin Requirements and the Stock
Market,” Journal of Financial and Quantitative Analysis, I (September,
1966), 32.

slowing
outstand
thus dii

institut

of propc
the re gr

are:

l3
slowing or stimulating the growth in regulated security credit
outstanding.1 The pattern of regulated security credit usage is
thus different from what it would have been had no regulation been

instituted.

Economic Rationale for Securitinredit Regulation

 

In Section 2 of the Securities Exchange Act of 1934, a number
of propositions are set forth in order to establish the necessity of
the regulation. Those which relate to the use of security credit
are:

1. Transactions in securities involving the use of credit

". . . directly affect the financing of trade, industry,
and transportation in interstate commerce, and directly
affect and influence the volume of interstate commerce;
and affect the national credit."

2. "Frequently the prices of securities on . . . [stock]
exchanges and [in over-the-counter] markets are sus-
ceptible to manipulation and control, and the
dissemination of such prices gives rise to excessive
speculation, resulting in sudden and unreasonable
fluctuations in the prices of securities which . . .
cause alternately unreasonable expansion and un-
reasonable contraction of the volume of credit available
for trade, tranSportation, and industry in interstate

commerce."

 

1For a summary of the effects on outstanding security credit of
changes in margin requirements, see Jules I. Bogen and Herman E. Krooss,
Security Credit (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1960),
pp. 117-119.

These prop
SUSEESt se'
flow, the

i;.
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Fi
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obtained;
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Act

11'.
of 193A

14

3. "Such sudden and unreasonable fluctuations in security
prices, prevent the fair valuation of collateral for bank
loans, and/or obstruct the effective operation of the
national banking system and the Federal Reserve System."

4. "National emergencies . . . are precipitated, intensified,
and prolonged by manipulation and sudden and unreasonable
fluctuations of security prices and by excessive specula-
tion on such exchanges and markets, and to meet such
emergencies the Federal Government is put to such great
eXpense as to burden the national credit."1

These propositions, coupled with the actual form of the regulation,
suggest several underlying assumptions about the nature of credit
flows, the demand for and supply of security credit, and the behavior

of margin investors.

Effects on the Volume of Credit Available for Trade

First, it was assumed that rapid growth in loans on securities,
such as that which occurred in the late 1920's, made bank credit
unavailable to some borrowers in the amount they otherwise could have
obtained; consequently, resource allocation was upset to the extent
that economic growth did not occur in the sectors where it was most
desired. In the years preceding and immediately following the depression
era, several theories were popularly advanced in this regard which are

notable for their emotional appeal more than for their accuracy.

 

1U.S., Securities and Exchange Commission, Securities Exchange
Act of 1934 as Amended to August 20, 1964, pp. 1-2.

grow:
accep
accou
broke
cost

by re
to th
the a
that

block
The t
of se
of th
Proce
for c

15

The most prevalent view was that expansion in stock credit
resulting from stock exchange Speculation diverted capital from
"productive” uses, that is, absorbed credit and prevented economic
growth through commercial and industrial eXpansion. The general
acceptance of this view was presumably the result of taking into
account only the purchase side of margin transactions, wherein
brokers might lend to their customers 80 per cent of the purchase
cost of a block of securities and subsequently borrow this amount
by re-hypothecating the securities at a bank. Credit was absorbed
to the extent that the borrowing of the broker increased. What
the absorption theorists failed to consider, however, was the fact
that on the other side of the transaction was a seller of this same
block of securities who received cash for the amount of the sale.
The transaction can be made more complex by presuming that the seller
of securities was also a margin trader (so that at least a portion
of the proceeds were used to reduce his debt), or that the cash
proceeds were immediately reinvested in other securities purchased
for cash, or that the proceeds were used as margin for the purchase
of additional securities on margin. In any event, as long as the
amount owed by margin traders increases, somewhere in the chain of
transactions there mggg be a seller who is not on margin, and the
proceeds of his sale are available for deposit in the banking system.
Ignoring the effect of taxes, commissions, and profit or loss on
securities trading, margin debt can increase only if margin traders
are net purchasers of securities from cash investors. The proceeds
of these sales by cash investors are unavailable for credit ex-

pansion only if they are held in currency.

16

Another view regarding the disruption of resource allocation
caused by security credit expansion, was that because of the concen-
tration of securities lending in New York, and because of the
accessibility and profitability of the call money market to out-of-
town banks, deposits from outlying banks flowed into the New York
call market and business and industry in these regions were denied
access to bank credit for expansion. In the study of security
markets by the Twentieth Century Fund, Wilford Eiteman developed
some evidence for this view through an analysis of reserve flows
from 1927 through 1929.1 Assuming that the proportion of total

banking reserves held outside of New York Should have remained un-

 

changed from 1927 to 1929, there was a net drain of funds toward New
York of $65 million during 1928 and $33 million during the first nine
months of 1929. In terms of the relative flow of reserves held out-
side of New York City, outlying districts transferred 6.3 per cent
of their average net reserves to New York in 1928 and 4.1 per cent
of average net reserves during the first nine months of 1929. While
these flows are not insignificant relative to the resources of out-
lying banks, only about one per cent of the peak $8.5 billion in
brokers' loans were made with funds which otherwise might have re-
mained in outlying banks. Since the analysis makes the crucial
assumption that the bank reserve distribution at the end of 1927 is

both representative and appropriate, it cannot be conSidered conclusive.

 

1Wilford J. Eiteman, "Brokers' Loans and the Absorption of
Credit," in The Securigy Markets, (Findings and Recommendations of
a Special Staff of the Twentieth Century Fund), ed. by Alfred L.
Bernheim and Others (New York: Twentieth Century Fund, Inc., 1935),
pp. 312-320.

5P

as

CO

th

5P

Ull

St

TE

17
In any event, this evidence does not indicate that a substantial
volume of reserves flowed into New York City at the height of
Speculative stock market fervor.

A third view consistent with the resource misallocation
assumption was that some industries or companies within industries
could potentially achieve diSprOportionate growth as a result of
the Speculative phenomenon in the stock market. For example,
Sporadic increases in the demand for luxury goods may result in
unreasonable outlays by manufacturers of such goods for new plant
and equipment. By classifying consumer goods into the broad (and
necessarily arbitrary) categories of luxuries and necessities,
Simpson determined that the value of luxury goods produced in 1929
increased by over 20 per cent from 1927, while the increase between
the four year period 1923-27 had been only slightly more than 10 per

cent}

In contrast, between 1927 and 1929, production of necessities
increased only 5-1/2 per cent. Misallocation of resources would not
be suggested by the growth in luxury goods output alone, but by the
possibility that the primary influence on this growth could be
rapidly mounting and transitory paper wealth generated by wideSpread
stock price Speculation rather than by Optimistic expectations
regarding future economic expansion. The rapid increase in luxury
good demand in 1928-29 thus could have been influenced substantially
by stock market conditions. Furthermore, capital availability to

large companies, who easily floated large new issues of stock in the

hectic market of 1928 and 1929, was far greater than to smaller

 

1Kemper Simpson, The Margin Trader (New York: Harper &
Brothers, 1938), pp. 101-105.

10m

int]

And

CI€(

in!

fro:

18
businesses which generally had to rely upon banks for expansion capital.
Even though commercial loans did not become less available to small and
medium-sized businesses because of the attraction to banks of the call
money market, such loans clearly became more expensive as a result of
increases in the discount rate during the second half of the decade.
And these increases were made because of concern over the flow of
credit to the stock market,1 not over excessive inflationary demand
in the general economy; the price level remained virtually constant
from 1926 through 1929.

In summary, while some of the popular assumptions regarding the
effect of stock market borrowing on credit available for other uses can
be Shown invalid, there might have been reasonable justification for
concern over regional imbalances in credit availability as well as
over potential misallocation of resources among industries and between
large vis a vis small businesses. Provisions of the Banking Act of
1933 attempted to deal with regional imbalances by (l) preventing
future payment of interest on demand deposits (a practice which had
attracted funds to New York), and (2) allowing the Federal Reserve
Board to stipulate maximum security loan to bank capital ratios
separately for each Federal Reserve District. Less subject to pre-
vention through Specific controls on the banking System, the likeli-
hood of resource misallocation justified in part the broader selective

controls of the Securities Exchange Act of 1934.

 

1Supra, p. 7.

1
Ina:
“

in F
brok
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that
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the e

the e:

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bIQREI

:r-
r J
r?

19

Inability to Prevent Massive Expansion in Security Credit

One of the clearest lessons of 1929 was that even sharp changes
in Federal Reserve policy were ineffective in slowing the growth in
brokers' loans once real Speculative fever had taken hold. The reason
was not that the banking system failed to reSpond to restrictive policy
(the discount rate was raised from 3 per cent in early 1928 to 6 per
cent on August 9, 1929), but that the overwhelming influence of non-
bank lenders completely counteracted reductions in bank lending. The
'great expense” to the "national credit"1 referred to by the 1934 Act
in meeting emergencies like that of credit conditions in 1929, was
that non-bank lenders could apparently be influenced only by central
bank policies so restrictive as to halt economic growth entirely. Such
action, however, also destroyed confidence in near-term gains in the
stock market, so the cost of stOpping the dramatic upswing in stock
prices and credit was to precipitate a decline. As the aftermath of
the stock market crash so well demonstrated, this bludgeon technique
had consequences far beyond the drastic shrinkage in equity values;
the effects of faltering public confidence reverberated throughout
the economy.

More direct control over aggregate security credit was sought
as a result of this experience, and this control took the form of the
provision in the Securities Exchange Act of 1934 which prohibited
brokers from borrowing funds from any lender other than member or

c00perating non-member banks of the Federal Reserve System. Lenders

 

1U.S., Securities and Exchange Commission, Securities Exchange
Act of 1934 as Amended to August 20,g1964, p. 2.

 

insensiti
from the

prohibite

Controls
H.
cooperatir
lending bl
and the at
reasonable
Federal Re
credit to
Reserve th
with nonet
influence
f“ flexib
contro1s,
be Support

1.

20
insensitive to the Federal Reserve's monetary controls were eliminated
from the market, with the exception that non-bank lenders were not

prohibited from making loans directly to individuals.

Controls on Aggregate Securigy Loans Are Insufficient

Having limited the sources of security credit (only banks
c00perating with the Federal Reserve), the flow of funds for securities
lending between banks (limitation on payment of interest on deposits),
and the ability of the banking system to expand security credit beyond
reasonable limits (power to set maximum lending ability for each
Federal Reserve District), the insensitivity of the supply of security
credit to control through discount rates was reduced. The Federal
Reserve thus should have had a sufficient arsenal of weapons to use
with monetary policy in pursuing orderly economic growth through
influence on all credit markets. Therefore, the further provision
for flexible margin requirements, which, unlike any other credit
controls, directly influences the demand for security credit, must
be supported by the following additional assumptions:

1. Restrictions on the supply of margin credit cannot prevent
the "quality" of credit from deteriorating in a market
where high loan values are given to stocks at inflated
prices; consequently the danger remains of forced sale
of securities in declining markets as equity values
disappear.

2. Restrictions on the supply of margin credit cannot
effectively discourage Speculative activity by margin
traders which becomes "excessive" because of its impact.

on the stock market.

Beca
secu

lend

were

COHI

Foul:
IEQuj
ducir
wont:

costs

21

Because of the low margins which were required in the 1920's on
security loans, the borrower's equity could be eliminated, and the
lender's security threatened, by a very small decline in the price of
margined stocks. Even if excessive expansion of total margin credit
were adequately prevented in the future through aggregate controls,
continuation of low margins might still allow substantial declines

in margin credit, and downward pressure on stock prices, in the event
of a price break. The apprOpriate means of preventing this eventuality
would be to create a greater equity cushion by establishing higher
required margins than those which were common in the 1920's. By re-
ducing the potential gain from leverage, a higher margin requirement
would also make the demand for margin credit more sensitive to interest
costs of borrowing.

In making margin regulations under the Act subject to
flexibility by authority of the Federal Reserve Board, the additional
assumption was necessary that the level of margin appropriate at any
time could be adequately judged by movements in security credit. For
a number of years, the Federal Reserve had indicated strongly that it
was neither preper nor feasible for it to become the judge of the
"appropriate" level of stock prices.1 However, the Board had committed
itself equally as strongly to the position that in critical periods of
market activity margin credit was used in rapidly increasing quantities
to support stock Speculation. That is, margin traders bought and sold

securities in reSponse to their short-term price movements rather than

1U.S., Board of Governors of the Federal Reserve System, Annual
Report (washington, 1929), pp. 2-3.

in reSpon
dividends
belief th
swings an

a stabili

per se, 1-
credit is
mrgin tre
that margj
of activit
are indica
margin cre

To
thElI inve
assertion
monetary c

diIth C011

22
in reSponse to eXpectationS regarding their future earnings and/or
dividends. Such price Speculation was undesirable because of the
belief that margin trading added buying pressure during price up-
swings and selling pressure during price declines, and was thus not
a stabilizing influence on the market.

In order to avoid judgments based on stock market behavior
per se, it must have been assumed that the rate of growth in margin
credit is a guide to identifying the intensity of Speculation by
margin traders. A rapid growth in margin credit is thus a signal
that margin credit is potentially ”excessive" in terms of its support
of activity which destabilizes stock market prices.1 Higher margins
are indicated under such conditions than in periods when growth in
margin credit is less rapid.

To assume that users of margin credit are destabilizing in
their investment and borrowing activity is quite different from the
assertion that the supply of margin credit is insensitive to general
monetary control and consequently must be subjected to stabilizing

direct control, different because the latter assertion presumes no

 

1If the Federal Reserve were to make the judgment that margin
credit was excessive in relationship to bank loan portfolios or total
bank resources, the pr0per reaction would be to invoke its authority
over the supply of margin credit, either through shifts in monetary
policy or through lower maximum security credit to bank capital
ratios. It is possible to avoid the assumption that flexible margins
imply the goal of regulating the presumed Speculative activity of
margin traders. To do so, an alternate assumption must be made that
flexible margins were instituted as a matter of convenience in regulat-
ing the growth in security credit extended by banks. However, evidence
of the reasons underlying changes in margin requirements suggests that
the Federal Reserve hag attempted to counteract Speculative activity
in the stock market (See infra, p. 30.).

informati
changes :
has been
margin t:
activitir

tend to i

change i]
fitted t.
(more Sp:
farm inp‘
SPetulat:
and short
Consider;
the {mm
tive “CC
is 110 inc‘
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failEd tC
Ronald hav

I“?
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credit emt

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23

informational content about the degree of Speculative activity in
changes in the level of security credit. Furthermore, little evidence
has been developed to either substantiate or refute the belief that
margin traders are substantially more Speculative in their investment
activities than those who deal with cash, or that their activities
tend to destabilize by amplifying market price swings.

Eiteman, in the Twentieth Century Fund study found little
change in the amplitude of oscillation of prices around trend lines
fitted to stock prices in 1925-27 (less Speculative) and in 1928-29
(more speculative).1 In an analysis of price variations of three
farm implement stocks, identified as speculative, moderately
Speculative, and non-Speculative on the basis of share turnovers
and short positions, he determined that the Speculative stock had a
considerably larger average and standard deviation of price around
the trend. While this analysis presumably determined that Specula-
tive stocks were subject to wider, not narrower, price swings, there
is no indication of the extent to which margin traders might have
dominated the trading of these stocks. Also, since the most Specula-
tive stock was also the one with the greatest short position, Eiteman
failed to consider the possibility that price swings in the stock
would have been wider had not short sellers (Speculators) been

present to partially counteract price movements.

Support for Existing Rggulation
Through enumeration of the propositions relating to security

credit embodied in the Securities Exchange Act of 1934, and an analysis

 

1Eiteman, "Margin Buying," in The Securitngarkets, pp. 287—293.

of tl
founr

SECUI

Supp
mech.
secn

indi

Stack

(Find
Fentu
Haney

24
of the assumptions which presumably underlie them, support has been
found for most of the existing provisions to regulate the flows of
security credit. Restrictions on the supply of security credit include
(1) limiting broker borrowing to banks, (2) regulating the competition
for bank deposits through interest rates, and (3) restricting inter-
regional flows of funds through regulation of security loan to bank
capital ratios. These have all increased the sensitivity of the
supply of funds for brokers' loans to control through the monetary
mechanisms of the Federal Reserve. The restriction on the demand for
security credit, both on the part of brokers and on the part of
individuals arranging securities loans at banks, can be justified in
part. If margin requirements were established at a 13321 higher than
that prevailing during the 1920's, greater shrinkage of collateral
values could occur without destruction of customer equity and loss
of stock market stability through wholesale liquidation of under-
margined loans. But the rationale for flexible margin requirements,
and its underlying assumption about the Speculative, destabilizing
behavior of margin investors, remains relatively unsupported and

subject to further test.

ExistingiResearch

 

Three studies of security credit appeared in the wake of the

stock market crash of 1929.1 All of these studies considered in

 

1Alfred L. Bernheim and Others, ed. The Security_Markets
(Findings and Recommendations of a Special Staff of the Twentieth
Century Fund)(New York: Twentieth Century Fund, Inc., 1935);
Haney, Logan, and Gavens, Brokers' Loans; and Simpson, The Margin
Trader.

reconn-
credit
credit
quite '

exchan

appear
has oc
1D add
with t
tradin

tradin

25

detail the activities Of margin traders and the relationship of
security credit to credit markets, the stock market, and economic
activity. The Twentieth Century Fund and Haney studies included
recommendations for new regulations governing the availability Of
credit for stock market transactions. In addition to security
credit and margin trading, the Twentieth Century Fund Study dealt
quite broadly with the economic role and Operation Of security
exchanges.

An extremely thorough history of security credit regulation
appeared in 1958.1 It provides documentation of each change which
has occurred in margin requirements since the inception Of the Act.
In addition, it deals specifically, although in a qualitative manner,
with the effects of margin changes on security prices, volume of
trading, volume of security credit outstanding, and the "quality of
trading" in security markets.

In a study underwritten by the New York Stock Exchange,2 Bogen
and Krooss traced the deve10pment of security credit regulation, pre-
senting the Opposing points of view on the need for qualitative and
quantitative credit controls. They also investigated the importance
of security credit vis a vis other types of lending, the availability
of unregulated credit, and the apparent effects of changes in margin

requirements on price and volume of trading Of securities.

 

1

Robert E. Harris, Federal Margin Requirements: A Selective
Instrument of Monetary Policy (University of Pennsylvania, Ph.D.
Dissertation, 1958).

 

2
Bogen and Krooss, Security Credit.

requirehex
excess fl.
protectiO‘
(3) the I
each case

and quest

which see
associate
0f the BC
effECt 01
credit ar
dEtermine
as Oppose

l

adopts U

'c
53 ».
H r—4-
00 n
- (D
5; an
r—4 0?

Harket ,,

the StOc

26

Moore1 discusses and evaluates the "success" of margin
requirements in meeting presumed goals: (I) the prevention of an
excess flow of credit toward the purchase of securities, (2) the
protection of investors from becoming overburdened with debt, and
(3) the reduction of fluctuations in stock market price levels. In
each case, he concludes that regulation has been less than successful
and questions the justification for continued regulation.

A somewhat different approach is taken by Cohen2 in a study
which seeks to isolate the criteria for margin change most closely
associated with actual changes in margin requirements, irreSpective
of the Board's announced reason. In addition to an analysis of the
effect of margin requirement changes on volume of bank security
credit and market prices of securities, an attempt is made to
determine the extent to which credit flows into securities markets
as opposed to other financial and non-financial uses.

A recent dissertation in the area of security credit3 again
adopts the goal of studying the effects of margin changes on stock
prices and volume of trading. The study also seeks to identify

margin levels in terms of their monetary effect.

 

1Thomas Gale Moore, ”Stock Market Margin Requirements," Journal
of Political Economy, LXXIV (April, 1966), 158-167.

2Jacob Cohen, "Federal Reserve Margin Requirements and the Stock
Market."

3Richard Lovell Bolster, The Relationship of Monetary Policy to
the Stock Market: The Experience with Margin Requirements (The American
University, Ph.D. dissertation, 1966).

the

whi

he.

ane

n
\V‘

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be

b84

tr;

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9

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27
Need for Research

Studies of security credit and margin trading conducted during
the 1930's were partly successful in supporting the rationale for
margin regulation as it currently exists. In considering the effect
which margin traders had on the changing fortunes of the stock market,
however, the approach of these studies was not supported by empirical
analysis. Instead, logical arguments were presented which first
assumed that margin traders were Speculators. Second, it was determin-
ed that reasonable amounts of both Speculation and credit are healthy
in assuring continuous and active markets, therefore neither should
be entirely prevented. Third, the conclusion was reached that,
because of the dramatic fluctuation in security credit in the late
1920's, "excessive” credit use agd_"excessive" Speculation by margin
traders must have magnified the unrealistic rise and meteoric fall
in stock prices. None of these studies identified the relative in-
fluence of Speculative as opposed to investment decisions on the
demand for margin credit. Nor did any of them successfully validate
the assumption that margin trading destabilizes the security markets
by accentuating buying pressure in upswings and selling pressure in
downswings.

Nearly all of the studies which have appeared within the past
ten years have had as their central theme the effect of changes in
Inargin requirements on security credit flows and/or stock prices.
Atlthough general models of the demand for margin credit have been

developed and tested in these studies, the reliability of test

rsasults has been impaired through the use of distorted security

28
credit data.1 For example, the customer net debit balance series
collected by the New York Stock Exchange is seriously distorted by
including temporary debt which exists in cash accounts and because
it is reduced by the proceeds of short sales. Loans made by banks
for the purpose of purchasing and carrying securities are also in-
accurate measures of regulated margin credit. Bank loans to brokers
and dealers include funds to support the brokers' investment positions
and underwriting activities. Furthermore, such loans are not the only
source of funds for brokers and dealers. Bank loans to others includes
a substantial amount of loans made on over-the-counter securities,
which are not covered by margin regulations. Data is unavailable on
some bank loans which are not regulated because either the purpose of
a loan for which stock collateral is taken is not the purchase and
carrying of securities or the collateral taken for a loan to purchase
securities is not stock. Many of these loans, however, are con-
ceptually equivalent to security loans, and their magnitude cannot
be measured. Finally, there is no data to indicate the amount of
stock market credit which is provided by lenders other than brokers
or banks. Most importantly, there is no way to judge the extent of
substitution of regulated for unregulated credit when margin require-
ments are changed, so that the true influence of regulatory changes
is unknown. Because all of the models in recent studies have been
tested with some combination of these data, the conclusions reached

regarding the effectiveness of margin requirement changes are

 

1Because of the technicality of some of these distortions, a
complete discussion is reserved for Appendix A.

29
questionable. And the validity of coefficients generated by these
models, in assessing the relative importance of other factors on
changes in margin credit, is equally questionable.

The only recent attempt to isolate the behavior of margin
traders was made by Moore.1 Testing a model of the demand for
security credit in which margin requirements, stock prices, and
changes in stock prices were the independent variables, he found a
negative coefficient for the price change variable and concluded
that margin traders were a rational, stabilizing influence on the
stock market. Aside from the fact that the data representing the
dependent variable in his tests were distorted,2 the model ignores
the influence of economic growth on the demand for securities and
security credit. In another test, Moore develOped evidence that
the variation in stock prices was not significantly higher in the
fifteen year period preceding margin regulation than in the fifteen
year period following World war II, and thus concluded that stock
price stability had not been increased after margin regulations were
instituted. Whatever the results of such a test, it would be
difficult to ascribe them to a single cause, in light of other
structural changes between these two periods. Both monetary and
fiscal policy became more active instruments in the latter period.
Furthermore, in the immediate postwar years, the economy set upon a
new path of economic growth, the uncertainty of which might reasonably

have been reflected in wider stock price variations.

 

1Moore, "Stock Market Margin Requirements," pp. 163-66.

2Moore used loans to brokers and dealers and loans to others
made by banks.

30

On eight of the fourteen occasions when margin requirements have
been changed since 1945, the Federal Reserve Board has at least partly
based its decision on the level of "Speculative activity" and the be-
havior of prices in the market.1 For example, in commenting on the
increase in margin requirements from 50 per cent to 75 per cent in 1951,
the Federal Reserve noted:

. . . there had been some increase [in stock market

credit] during the preceding several months, together

with increases in the volume of trading and in prices

of securities. The expanding business and economic

situation appeared to be encouraging stock market

activity and Speculation. . .2
Explaining the second increase in margin requirements during 1955,
first from 50 per cent to 60 per cent and ultimately to 70 per cent,

the Board indicated in its annual report that the second action was

taken

in the light of these evidences of continued Speculative
pressures in the stock markets and was designed as an
additional step to prevent excessive use of credit from
adding to such pressures.3

It is clear from these statements that flexible margin requirements

have not been used by the Board solely for its convenience in

 

1Cohen, "Federal Reserve Margin Requirements and the Stock
Market," p. 32.

20.8., Board of Governors of the Federal Reserve System,
Annual Report, 1951, p. 81.

3U.S., Board of Governors of the Federal Reserve System,
,égnual Report, 1955, p. 84.

 

CO

1'9

in

de.

SE

1111'

C0:

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tra

$611

31
controlling, through demand, the building up of excessive margin credit
relative to the resources of the banking System. The flexible margin
instrument has been used instead in reSponse to the assumed Speculative,
destabilizing behavior of margin traders. The need to test these

assumptions remains.

flypothesis and Plan of Study

The need for research is established through evidence that the
selective stock market credit instrument has been applied based upon
untested assumptions about the behavior and impact of margin traders.
Consequently, this study tests the hypothesis that margin trading of
securities predominantly reflects strategies which are Speculatively
oriented toward short term stock price movements rather than invest-
ment oriented toward long term price appreciation through growth in
earnings and dividends. Furthermore, margin traders are hypothesized
to exert a destabilizing influence on stock price movements.

In Chapter II, a model of the supply of and demand for margin
credit is develOped, with the goal of identifying the extent to which
changes in outstanding margin credit are influenced by stock price
changes per se, as opposed to changes in credit availability and the
value of securities reflected in economic growth variables. If margin
traders are Speculators, margin credit changes will be much more
sensitive to short term fluctuations in the price of stocks than to
changes in the discounted value of their future earnings and/or
dividends. If the Speculative activity of margin traders is de-
stabilizing, then changes in prices should bear a direct relation-

ship to the change in margin credit not explained by changes in either

val
pri
to

not

111

Jun
ity
on

Jun
it};
cre.

be 1

one

32

value or credit availability, indicating that margin traders buy in
price upswings and sell in price declines. Analysis of the model seeks
to identify the absolute destabilizing influence of margin traders and
not a destabilizing influence of margin traders relative to the stab-
ilizing or destabilizing activity of those who invest or trade with cash.

The model is tested with monthly data on margin debt reported
by large multi-regional brokerage firms, from January, 1965 through
June, 1968. The time period is limited on one hand by the availabil-
ity of new and more accurate data on margin debt beginning in 1965 and
on the other hand by a change in margin requirements which occurred in
June, 1968. Limitations on both the time period and sources of secur-
ity credit were accepted in order to minimize distortions caused by
credit arising from transactions other than in listed securities covered
by Regulations T and U.1

In Chapter III, the hypothesis is tested further using data
on actual purchase and sale transactions which occurred in a sample
of 418 individual margin accounts. The accounts represent a random
sample of all margin accounts maintained by one of the large multi-
regional brokerage firms on February 28, 1966, and the time period
covered is from that date through June 17, 1966. If margin traders are
Speculators, they may be expected to concentrate their activity in
stocks subject to higher price variability than would investors; these

stocks provide the opportunity of greater short-term gain. As Speculators

 

1Essentially, the regulations effective during this time period
<:over margin transactions in all securities listed on a national
semurities exchange. The distortions present in other data series,
ass well as the problem introduced by including time periods with
‘marying margin requirements, are discussed in detail in Appendix A.

OI

ac
se
di
ac

th

80

1110'l

SE:

for

33
margin traders would also be expected to exhibit their short-term
orientation in a higher turnover of shares than investors. Finally,
since Speculators seek short-term price performance rather than
investment quality or value, margin traders would be expected to be
more active than investors in issues of companies which are less
seasoned or unstable in their patterns of growth in earnings and
dividends. Each of these presumptions is tested by comparing char-
acteristics of trading in sampled accounts with those of trading on
the New York Stock Exchange as a whole.

If the activity of margin traders is destabilizing in an
absolute sense, the timing of purchases and sales of stocks in margin
accounts should Show a high positive correlation with market price
movements. A simple model of the daily purchase and sale activity in
sampled accounts is used in testing this proposition, with market
price movements as the independent variable. A similar test is made
for the most frequently traded stocks, where the independent variable
is a price average of these stocks. Other groupings of trades tested
include those made by large accounts and those made in stocks with
high price variability and stocks or companies with either undemonstrated
or fluctuating growth patterns.

In Chapter IV a summary of the results of the study is pre-
sented. Evidence developed in the study regarding the behavior of
'margin traders is discussed in terms of its implications for policy in

setting margin requirements.

CHAPTER II

A MODEL OF AGGREGATE MARGIN CREDIT CHANGE

The hypothesis that margin trading is Speculative and destabili-
zing to stock prices is tested through an aggregate model of margin
credit change. The test seeks to identify the extent of speculative
behavior by determining the importance of Stock price changes in ex-
plaining margin credit changes. The timing of margin credit changes,
relative to stock price changes, is analyzed as a test for destabilizing
margin account activity.

After a discussion of the factors underlying the supply of and
demand for margin credit, these factors are adapted to available
data and incorporated into a reduced form regression equation. The
model is tested with monthly data using generalized least squares
techniques, and results are presented for both initial and revised
formulations. Finally, the empirical performance of the model, and its

support of the hypothesis, are discussed.

Factors Affecting the Demand for Margin Credit
The decision-making process of the margin trader may be sub-
divided into three broad and not necessarily mutually exclusive categories.
First, the margin trader establishes his quantity demand for securities
on the basis of his resources and the supply function of listed stocks.

Second, the margin trader modifies his quantity demand to conform with

34

the .

hi

are
0the

Qua;

0f

35

his desire to accept additional debt. Third, he selects among individual
securities, as does any purchaser of equities, on the basis of portfolio
judgments and the relation of the market price of a stock to the
investor's evaluation of the discounted value of future dividends and
capital gains from that stock. The resulting demand for margin credit
is:

C = f (S, Ee, 1e, R, P, B)

d Cd

the arguments of which are discussed below.

The Supply of Listed Stocks: S

The supply of listed stocks is fixed in the short run, and held
by a group consisting of investors and traders. At any point in time
there will also be a group consisting of investors and traders who wish
to purchase part of the fixed supply. Market prices for all securities
are determined by the interaction of one group's demand to buy and the
other group's demand to hold these securities, and the sum of the
quantities demanded by these two groups is the fixed supply. The lower
are prices of securities, the greater will be the demand by security
holders to reserve their holdings from the market,1 and the group wishing
to purchase part of the fixed supply faces an upsloping supply function.
However, Since the demand for margin credit is a function of the securities
held on margin as well as of securities purchased on margin, the relevant
supply is the fixed supply, and increases in the fixed supply will

increase the demand for margin credit.

 

1It Should be noted that this classical analysis may not
strictly apply if falling stock prices, combined with expectations
of further decline, precipitate an increase in supply from those
security holders who wish to minimize losses.

36

Expected Future Growth in Earnings: Ee

Following Miller and Modigliani, in a market in equilibrium with
rational investors acting under perfect certainty, the "price of each
share must be such that the rate of return (dividends plus capital gains
per dollar invested) on every share will be the same throughout the
market over any given interval of time."1 were this not the case,
shares with a lower rate of return would be traded for those with a
higher rate of return until equality was achieved. The price of shares
in the current period, and the determination of capital gain to be
achieved in the next interval of time, are derived by discounting the
future stream of earnings and/ or dividends at a rate of return which
reflects the risk associated with each stock. The higher is the growth
in earnings for all stocks, the greater is the future rate of return,
and the demand for stocks increases relative to the demand for other
financial assets, for example, savings accounts. Furthermore, since
both rational behavior and perfect certainty are ideals not actually
achieved in the trading and valuation of securities, evidence of greater
growth than had been anticipated would also lead to increased demand
for stocks until prices reflected the discounting of the greater expected
future flow of earnings and dividends. In both cases, the demand for
margin debt is increased because of the increase in demand for stocks,
and a direct relationship between expected growth and the demand for

margin credit is anticipated.

 

l

Merton H. Miller and Franco Modigliani, "Dividend Policy,
Growth, and the Valuation of Shares," Journal of Business, XXXIV
(October, 1961), 413.

 

Expected

margin <
judgmen'
the eco:
very 1i
increas
invests
PIOSpec
insofax
Conseqw

in EXp

Th

(0
(1
O

37

Expected Rate of Inflation: 1e

 

Expectations about inflation can influence the demand for
margin credit in several ways. First, the rate of inflation affects
judgments regarding growth in corporate earnings. Nominal growth in
the economy, and thus in corporate earnings, investment return, and
very likely stock prices are increased as inflationary expectation
increases. Second, the relative appeal of equity over fixed dollar
investment is greater, increasing the demand for Stocks. Third, the
prospect of inflation provides an advantage to users of margin debt
insofar as their assets are supported by fixed-dollar liabilities.
Consequently, a direct relationship is expected in the impact of a change

in expectations regarding inflation on the demand for margin credit.

The Cost of Borrowing; R

The willingness of the margin trader to hold debt depends
on the interest cost associated with margin borrowing. In aggregate
terms, higher interest costs will reduce the quantity demanded of margin
credit. It is worth noting here that the investor may not view the
interest cost separately in making the decision to increase or decrease
margin borrowing. Preperly, interest cost should be offset against the
incremental return from the additional Shares purchased with borrowed
funds. For example, on a purchase of 100 shares of stock at $100 per
share, the total investment is $10,000. At 70 per cent margin require-
ments, $3,000 of this amount, or 30 shares, would be the incremental
investment resulting from.margin borrowing. In justifying the investment

made, interest cost over the time horizon should be offset against the

38

incremental flow of dividends and capital gains. The risk of assumption
of this debt as well as the portfolio risk of the added investment would
determine the apprOpriate rate of discount.

For the purposes of this model, however, it is not inapprOpriate
to view interest cost as a discrete cost; the stream of anticipated
returns is not ignored but is implicit in the expectations variables.
Furthermore, it is not the investment decision per se but rather the
decision to incur debt which is of concern here, and, whether directly

or indirectly, the interest cost is relevant in the latter case.

Extent and Direction of Change in Market Prices: P

Let us define investors as those who do not attempt to profit
from Short-term movements in market prices. Their investment decisions,
and thus their demand for stocks and for margin credit, are measured
by expectations regarding future growth in earnings and dividends. Thus,
while the quantity of stocks and credit demanded by investors may

increase if stock prices decrease from influences other than reduction in

 

expected future return, such an increase represents movement along, not
a shift in, demand functions.

Let us define Speculators as those who d9 attempt to gain from
short-term price swings. The speculator's demand function for stocks and
credit is influenced by stock prices and by anticipated changes in stock
prices, whether or not these changes reflect changes in Stock values.

Thus the influence of stock price changes in determining changes in margin
credit is also a measure of the influence of speculative trading on

changes in margin credit.

39

The economically useful role of speculators is demonstrated
by the actions of Short sellers in the stock market. By selling
short as market prices increase, the Short seller is anticipating
a decline in prices which will be profitable to him, but at the same
time he is Stabilizing the market because his selling dampens the
increase in prices. Similarly, when stock prices do begin to decline,
the Short seller stabilizes through his buying to cover short positions.
New York Stock Exchange rules, which prohibit short sales in continuous
price declines, help to prevent the short seller from becoming a
destabilizing influence, as he would be if he waited for confirmation
of a price decline and added selling pressure through short sales in
an already declining market.

There is no provision, however, to control similar destabilizing
activity on the part of speculators who trade "long" in securities.
Long speculators may amplify market price movements by adding buying
pressure during market upswings and selling pressure once a declining
market is confirmed. If margin traders are Speculative and destabilizing
to stock prices as is hypothesized in this Study, then their speculative
orientation will be demonstrated by the relatively strong influence of
2513; changes, as Opposed to 1312; changes, on changes in margin credit
outstanding. And destabilizing speculative activity by margin traders
will be suggested by a direct relationship between price changes and
margin credit changes. Such a direct relationship is not conclusive
evidence of destabilization, however, since a stabilizing influence
could be provided by margin purchases in rising markets and sales in

falling markets which add pressure to return stock prices to their

40
mean or central value level. On the other hand, a truly destabilizing
price sensitivity will be confirmed by evidence that margin traders

respond directly to prices throughout price swings.

Existing BorrowingyPower in Margin Accounts: B

 

For each customer margin account, the broker sets up and
maintains a special miscellaneous account [SMA]. This type of
account is authorized in Regulation T, which specifies that it may
be used, among other things, for the purpose of receiving from or
delivering to a margin customer any cash or securities. In the Simplest
of terms, this account is very Similar to a checking account maintained
by the customer with his broker. The account is debited for the amount
of margin required to support purchases made by the customer, and it
is credited with the maximum amount allowed by Regulation T whenever
a sale is made.' Cash deposits by the customer are credited to the
account, and withdrawals by him are debited to it. Dividends received
by the broker on stock held in the account are credited to the SMA.

For all of these transactions, adjustments are also made to the debit
balance in the margin account; however, the SMA and the debit balance
are entirely separate account entities.

Whenever a transaction occurs which requires an entry to a
margin account, the account is "marked to the market." This process
involves calculating the maximum loan value of securities in the account
and comparing it with the adjusted debit balance in the account, which
is the sum of the debit balance and the SMA. If the maximum loan value
is greater than the adjusted debit balance, the SMA is credited with the

difference. The net effect of marking to the market is to establish a

41

line of credit for the customer equal to his maximum borrowing power.
The amount which is not currently being borrowed by the customer is
set aside in the special miscellaneous account. This "excess loan
value" becomes customer equity, and it can be used by the customer in
future periods as margin deposits to purchase additional securities,
just as though it were a cash deposit.1 The maximum market value of
securities which can be purchased with the balance in an SMA is 1/m
times the SMA, where m is the current margin requirement.

What is most significant about these SMA balances is that they
represent purchasing power for which the customer need deposit no
additional cash or securities as collateral. Since no interest is
earned on funds maintained in an SMA, it can be assumed that these
funds represent the least amount by which margin customers anticipate

. . 3 . . .
utilizing their equity in the near future. That 1S, increases in

 

1The SMA is not reduced in the event that marking to the market

indicates that the adjusted debit balance is greater than the maximum
loan value of securities in the account. As a result, equity generated
by marking to the market remains in the account until it is used or
until the account is closed. In addition, there are few restrictions
on additional borrowing which results from the "spending" of balances
in special miscellaneous accounts; as long as a customer's market value
exceeds 130 per cent of his debit balance (the maintenance requirement
imposed by the New York Stock Exchange), he may utilize SMA balances,
and increase his borrowing.

2For example, if the customer's SMA had a balance of $7,000,
and the margin requirement were 70 per cent, a total of $10,000 in
securities could be purchased; the remaining $3,000 would be borrowed
from the broker.

3There are two exceptions to this reasoning. First, cash which
is allowed to remain in the SMA (in the form of deposits or proceeds
from sales), will reduce the interest charge in an account with a debit
balance, so there is an Opportunity cost of removing some of the funds
making up SMA balances. Second there is evidence that SMA balances
tend to accumulate in inactive accounts suggesting that part of SMA
balances, even though available, are not actively used.

42
SMA balances are readily available for, and presumably committed to,
future increases in demand for margined securities. A one month
lag is assumed in the effect of changes in SMA balances on demand for

margin credit.

Factors Affecting the Supply of Margin Credit

Since the major portion of funds lent by brokers to their
customers is, in turn, borrowed from other sources, an important
determinant of the supply of margin credit is the availability of
borrowed money to brokers. Brokers also commit funds to their own
investment position and to new issue underwriting activities, so the
supply of margin credit is affected by the return on these alternative
investments. The resulting supply function for margin credit is:

GS = fCS (A, R, M)

where R is the margin credit lending rate, equivalent to the cost of
borrowing in the demand function; the supply of margin credit is
directly related to the rate of interest charged borrowing customers.
The rate of return on alternate investment, A, represents the profit-
ability of competing uses for funds obtained by brokers; the higher
the rate of return from the firms' own investment positions and from
their underwriting activities, the less margin credit will be supplied.
M reflects monetary policy and represents availability of borrowed
funds to brokers. The less stringent is monetary control, the greater

is the supply of funds for margin credit to brokers.

tested,

The ac:

[£5

Stock

PUblis
Board
Mali

3 ampl

,U [xi
1 I!

(L7 If,

(I)
(I) If)

43

Regression Test of the Model

 

The reduced form of aggregate demand for margin credit was

tested, using generalized least squares, with the following equation:

‘MRt= alDLRt + aZIPRt + a3CPRt + a4NYRt +-aSSMARt__1 +
+ a6FRDt + a7TYDt_1 + 38CDt + a9DDt +
+ alOEDt + u
The actual variables used are described below.
MR Margin credit extended to customers by large multi-regional

brokerage firms which are member firms of the New York
Stock Exchange. The data are obtained from the margin account panel
published jointly by the New York Stock Exchange and the Federal Reserve
Board.1 The actual data used are disaggregated components of the
published series, however, because the technique used to expand the
sample to universe estimates introduces distortion.

For this new margin credit series, data on balances in customer
margin accounts are collected from 38 firms. In constructing the sample,
representation was sought from three strata. Stratum I accounts for
approximately one-third of all margin credit and includes the five firms
which reported the largest Customer Net Debit Balances [CNDB] prior to
the formation of the sample. All five of these firms provide information,
so that Stratum I is covered exhaustively. Stratum II consists of those
twenty-six next largest firms maintaining approximately a second third

of total margin credit. Five of these firms supply data, accounting in

 

1U.S., Board of Governors of the Federal Reserve System, Federal

Reserve Bulletin, Monthly issues, p. A-34; New York Stock Exchange,
Research Report, Monthly issues.

44

total for about one-third of the total margin credit in Stratum 11.
Twenty-eight of the remaining 316 NYSE member firms supply sample data
for Stratum III, accounting for roughly 7.5 per cent of CNDB reported
by the stratum.1

Universe estimates of total margin credit are obtained for Strata
II and III by blowing up margin debt reported by sample firms with the
inverse of these firms' percentage contribution to total CNDB. Recall
that changes in CNDB cannot be taken as a reliable indicator of changes
in margin debt because of the distortion caused by short sales and cash
account debt. Thus, although the new margin credit series is EQEE
reliable than historically available series in isolating margin credit
change between periods, it is still influenced, through blowup factors
used, by factors unrelated to margin transactions. To eliminate this
influence, the margin credit series was disaggregated, and the model is
tested with the combined raw sample data in Strata I and II. The model
is thus potentially valid only in explaining changes in margin debt
originating in large multi-regional (nearly all with more than 50
branches) brokerage firms. Since about half of estimated margin credit
is extended by such firms, and since the individual account data used in
testing also reflects the characteristics of these large firms, the
treatment seems justified. The data used represent approximately 40 per
cent of total margin credit extended by New York Stock Exchange member
firms to their customers. The data consist of account balances for all

transactions executed by the last business day of each month.

 

1A complete discussion of the new margin credit series is con-
tained in Ulrey, "Margin Account Credit."

45

2L3 The dollar value of all shares listed on the New York

Stock Exchange,1 divided by the NYSE index of stock
prices. This variable serves as a proxy for the total supply of
securities which influences the demand for margin credit; it is superior
to both dollar value and number of shares listed, because both of these
alternative series are influenced by other changes than in the supply
of listed stocks.

In addition to reflecting changes in the supply of securities
which occur through new flotation of securities and listing or delisting
of securities, the unadjusted dollar value series is influenced by
changes in the price of shares in the previously existing supply. Since
price changes are included as a separate variable in the model, bias
through intercorrelation could result. In fact, the Simple correlation
between rates of change in dollar value of listed securities and stock
prices is rather high (r = .71). The alternative of using total shares
listed is not an attractive one. By eliminating dollar values
altogether, bias is introduced, because low priced Shares are given
weight equal to higher priced shares and because stock splits occur.
Since the NYSE index is adjusted for stock splits and reflects general
stock price movements as well, the adjusted Share index which results
from dividing the dollar value of listed securities by the NYSE Index
is a relatively better measure of increases in the supply of listed

stocks.

 

1New York Stock Exchange, Monthlnyeport, Monthly issues.

 

46

ERR The seasonally adjusted Total Index of Industrial

Production as of the end of each month.1 This variable
serves as a proxy for real growth in corporate earnings; the latter
variable is unavailable on a monthly basis. The use of the current
value of the rate of output is, in addition, based on two assumptions
about investor behavior. First, the investor is assumed to be correct
in his formation of expectations, in that his projection of earnings
growth and the actual growth in earnings, as indicated by output, are
the same. Second, the investor is assumed to form his judgment of
expected future earnings and dividends by projecting the current,
short-run performance. The former assumption is unavoidable; investors'
actual expectations are not visible. The latter assumption is
supportable on two grounds. First, discounted future returns are
most affected by near-term earnings performance. Second, if margin
accounts are used for earnings-growth-oriented investment purposes
rather than speculative price-oriented purposes, then the risk of the
debt assumed will orient the margin "investor," moreso than the cash
investor, toward near-term earnings growth. That is, investment
activity in margin accounts, because it is partially supported by
debt, is assumed not to be directed toward capital gains in the "long

pull" or based on long-term growth trends. Instead, margin account

 

1U. 5., Board of Governors of the Federal Reserve System,

Federal Reserve Bulletin, Monthly issues, p. A-52.

 

invest
result

ance .

fl

form I

contii

p3

47
investment activity seeks to profit from near-term capital gains which

result from current, and perhaps temporary, growth in earnings perform-

ance .

CPR The Consumer Price Index, chosen to reflect expectations
. . . 2 . .
regarding inflation. Again, investors are assumed to
form their expectations naively, by supposing that inflation will

continue at its current rate. Data used are as of the end of each month.

NYE The average price of Shares listed on the New York Stock
Exchange. The New York Stock Exchange Index was chosen

as a proxy for price movements of all securities listed on national
securities exchanges.3 Because other exchanges, particularly the
American Stock Exchange, are more heavily influenced by less seasoned
and more volatile issues, the New York Stock Exchange Index is not
totally representative. However, the fact that trading on the NYSE
accounts for such a substantial prOportion total share trading reduces
the potential bias. The data used are a monthly average of daily

closing prices.

 

1The validity of this current period orientation for expecta-
tions regarding earnings growth and inflation was tested by intro-
ducing distributed lags for these variables into the model. The
results Of these tests confirm the greater Significance of current
performance. See Infra, p. 55m, and Appendix C.

2U.S., Board of Governors of the Federal Reserve System, Federal
Reserve Bulletin, Monthly issues, p. A-60.

 

3New York Stock Exchange, Historical Data on NYSE Common Stock
Index (New York: Research Department, New York Stock Exchange, 1966),
pp. 15-25; and New York Stock Exchange, NYSE Common Stock Closipg
Indexes, Monthly releases.

 

 

48

SMAR Special Miscellaneous Account balances reported by a

sample of member firms of the New York Stock Exchange.
These data are also contained in the margin account panel from which
margin credit data are obtained. The actual data used for this
variable are the end of month SMA balances reported by sample firms
in Strata I and II of the margin account panel, as is the case with the
margin credit variable.1 The series is lagged one period, following
the assumption that changes in the purchasing power of SMA balances
will be reflected in the demand for margin credit in the following

period.

FRD Net reserves reported by member banks of the Federal
Reserve System.2 This variable serves as a proxy for

monetary policy in the model. The data are averages of daily figures

for the month. If positive, they are net free reserves; if negative,

they are net borrowed reserves.

TED The current yield on U.S. Treasury bills computed as an
average of daily closing bid prices.3 A one period lag

was introduced in this variable to achieve greater consistency in the

relationship of interest rates to monetary and growth variables in the

model.

Ceteris paribus, one would expect to find a negative relationship

 

between the rate of change in margin credit extended and the change in

 

1Supra, p. 43.

20.8., Board of Governors of the Federal Reserve System, Federal

Reserve Bulletin, Monthly issues, p. A-6

3U.S., Board of Governors of the Federal Reserve System, Federal
Reserve Bulletin, Monthly issues, p. A-29.

49
interest rates. In fact, initial tests of the consistency of the
variables indicated positive simple correlation (r = .21) between
these two variables. Furthermore, the correlation Of the current
interest rate variable with other variables does not consistently
reflect fundamental economic relationships.

The building up of demand pressures in the economy should be
evident first through increased industrial output, second through
increased interest rates reflecting rising investment demand, third
through increased prices if growth in investment and output are
insufficient to meet rising demand, and fourth through reductions in
net bank reserves reflecting monetary attempts to counteract infla-

tionary pressures. Although the correlation of interest rate changes

with industrial production growth is Significantly positive (r = .31),
as it is with consumer price changes (r = .32), changes in net reserves
are not negatively correlated with interest rates (r = .03), as would

be expected.

The introduction of a one period lag in interest rate changes
overcomes these difficulties. Correlation with changes in net reserves
becomes negative (r = -.10), the correlation with growth in industrial
production increases (r = .45), and the correlation with price changes
iS only slightly affected (r = .23). In addition, the anticipated
negative relationship between interest rate changes and margin credit
changes exists (r = -.07).

Interpreted in light of the model of aggregate margin credit
change, such a lagged interest rate formulation is not unreasonable.
Since the interest rate on margin balances has in recent years borne

a fixed relationship to the prime bank loan rate, the changing

50
attractiveness of alternative investment of funds available to brokers
is not necessarily reflected in the supply price. Instead, a more
informal process must occur if brokers wish to divert funds from margin
credit into underwriting activities, for example, as would be the case
in periods of high investment demand. Such a process might take the
form of reducing efforts to either obtain new margin account business
or stimulate activity in existing margin accounts. In either case,
there would be some time lag before these efforts took effect. The use
of more direct means to reduce margin credit by refusing it to customers
would, in normal markets, be extremely costly to brokerage firms if it
led, as is certainly likely, to the transfer of margin customers to

more COOperative competitors.

CD A dummy variable to account for the effect of amendments

to Regulation T in March, 1968. The main effect of these
amendments was to prohibit the inclusion of any bonds in margin accounts
and to provide for special accounts and special margin requirements for

convertible bonds. CD assumes a value of "1" in March, 1968, when

bonds were removed from margin accounts.

92 Dummy variables introduced to account for the addition of
and sample firms in Stratum II of the margin account panel.
ED One of these firms was added in July, 1965, and the other

in November, 1965. Because of the influence of these
additions on the rate of change in margin debt for those months, the
dummy variables are assigned the value of "1" for the months when

each addition was made.

The residual.

lc

51
Specification of the Regression Test
The model was tested with data covering 41 monthly periods from
January, 1965 through May, 1968. With the exception of treasury yields
all variables were transformed to rate of change, of the form:
(Vt - V 1)

t-
x 100

 

Vt-l

Treasury yields, since they already express a rate, were transformed
to ordinary first differences.

Because the likelihood of error through autocorrelated residuals
exists even in transformed time series data, generalized least squares
techniques were used.1 The technique assumes a residual term of the
form

ut = put_1 + et
where et represents the true estimation error. An estimate of p is

made, and the regression equation is re-estimated:

k

= + -+2 — \+
yt Pyt_1 80(1 p) j=1 a.(xjt pxjt_1, et

A new estimate of p is made, and the iterative process continues until
two successive p's are substantially equal, or until (l-p) becomes zero.
With all variables initially in first difference form, the effect of
autoregressive transformation is to at least partially transform the

variables into second differences. In the extreme case where p equals

 

1The method used follows J. Johnston, Econometric Methods
(New York: ‘McGraw-Hill, Inc., 1963), pp. 193-94.

 

52
one, the regression equation would be based on variables in fully second
difference form.

The constant term is suppressed in tests of the model. The
variables are in difference form, and there is no basis on which to
assume a constant minimum rate of growth in margin credit, as the
value of a constant would reflect.

Coefficients of the variables in the model are expected to

exhibit the following signs:

a1 > 0 The rate of increase in the supply of listed stocks
is directly related to the rate of change in margin
credit.

a2 > 0 Reflecting expectations of growth in corporate

earnings, the change in industrial production is
directly related to the change in margin credit.

a > 0 Increases (decreases) in the price level increase
(decrease) the demand for stocks and the demand for
margin credit; a direct relationship is expected.

a > 0 Margin traders are hypothesized to be destabilizing.
Therefore, they add buying pressure, increasing their
borrowing, when prices are rising; and they add sell-
ing pressure, decreasing their borrowing when prices
fall. A direct relationship is expected.

a > 0 Increases in the purchasing (and borrowing) power of
margin traders in the previous period will increase
their demand for margin credit in the current period.

a > 0 The greater (less) the rate of change in net reserves,
the greater (less) the availability of funds to brokers,
encouraging (discouraging) growth in customer borrowing.

a < 0 If the return on alternative investment increases,
brokers have an incentive to divert funds from margin
credit, and, conversely, to divert funds to margin
credit if alternative rates of return decline; an
inverse relationship is expected.

a < 0 The removal of bonds, and the debt associated with them,
from margin accounts in March, 1968 reduced the rate
of change in margin credit for that month.

53
a > 0 The addition of a firm to the sample in July, 1965
increased the rate of change in margin credit for
that month.

a > 0 The addition of a firm to the sample in November,

1965 increased the rate of change in margin credit
for that month.
Performance of the Model

Results of the regression test of the model are summarized in
Table 1.1 All of the coefficients have the expected Sign, although
several of the coefficients are not reliably different from zero. In
particular, although the coefficient of DLRt, the proxy variable for the
supply of listed stocks, is positive, its t-value (.028), indicates
that the coefficient is statistically different from zero with a
probability of less than one-tenth. The lack of significance of this
variable may be an indication that the supply of stocks to which margin
credit demand responds is not total supply of listed Stocks but rather
that which "confronts" the market at any point in time. That is, the
relevant supply of stocks is that which is available for trading, ex-
cluding shares which are held as relatively permanent investments.

The dummy variable CDt’ introduced to account for the removal
of bonds from margin accounts in.March, 1968, is also insignificant.
Lack of significance could indicate that the amount of bond trading in
margin accounts was very small. It is more likely, however, that the
removal of bonds from accounts was accomplished gradually over the

several months preceding the effective date of the regulation, Since

 

l .

A table of Simple correlation coefficients between the variables
in the model after autoregressive transformation is presented in Appendix
B.

54

TABLE 1

DEMAND FOR.MARGIN CREDIT AT BROKERS

 

 

 

 

Probability
Level of
Variable Coefficient t-value Significance
DLRt a1 = .001817 .027924 --
IPRt a2 = .875967 2.603517 .02
CPRt a3 = 4.507426 3.724649 .001
NYRt a4 = .440615 6.246636 .001
SMARt_1 a5 = .128452 1.782107 .1
FRDt a6 = .002242 1.035755 .4
TYDt_1 a7 = -3.124370 -2.580508 .02
CDt a8 = .389401 .322425 .8
DDt a9 = 2.186216 2.027535 .1
EDt a10= 5.630749 5.325229 .001
, 2
Adjusted R 0.646
Durbin-Watson Statistic 2.29
Degrees of Freedom 29
N 41

p 0.729

 

55

the prOposed regulation was released on October 20, 1967, and required
loans made subsequent to that date to conform with the regulation when
it became effective.1

The model was rerun without DLRt and CDt as variables. Although

SMAR the customer borrowing power variable, FRDt, the net reserves

t-l’
variable, and DDt’ one of the dummy variables representing the addition
of firms to the sample, were only marginally significant in the test

described in Table 1, they remained in the model. The results of a

regression test of the abridged model are presented in Table 2.2

 

1U.S., Board of Governors of the Federal Reserve System, Press

Release, October 20, 1967, p.3.

2The two tests described here were not the only regression tests
of the model. Earlier tests were conducted to determine the most
successful formulations of variables to represent the model. For example,
the NYSE Composite Average was chosen over the Standard and Poor 500
Stock Average, and monthly averages of daily closing prices provided
better results than month-end closing prices. In addition, the season-
ally adjusted production index provided superior results to the non-
seasonally adjusted index, and SMA balances were found to be a stronger
indicator of margin customer buying power than were free credit balances
reported by New York Stock Exchange member firms. The money supply was
tested as an indicator of monetary policy but rejected in favor of net
reserves of commercial banks; even if money supply is a relevant indicator,
limitations on degrees of freedom in the model preclude testing it with
the lagged response which its prOponents have found to exist. For the
sake of clarity, these alternative tests are not described in detail.

The results of one additional class of tests are presented in
Appendix C and deserve some comment here. The model presented in Table 2
assumes that those using margin accounts for purposes of investment
rather than Speculative activity will form their expectations about
future earnings and inflation by reference to current changes in these
variables. The basis for this assumption is the belief that because of
the risk of debt assumed by these investors, they will be primarily
interested in near-term growth and therefore will not form their ex-
pectations based on longer term performance. This assumption is sup-
ported by the results of tests in which both IPR , the earnings proxy,
and CPR , the inflation variable, were tested wiEh Six month, two month,
and one month distributed lags. In these tests, weights assigned by the
Almon polynomial interpolation technique were statistically insignif-
icant in all lagged periods and of the wrong Sign in most lagged periods.
Only the current period was significant in each of the three cases. The

56

TABLE 2

DEMAND FOR MARGIN CREDIT AT BROKERS -- REVISED MODEL

 

 

 

 

 

Probability
Level of
Variable Coefficient t-value Significance
IPRt a2 = .882201 2.775183 .01
CPRt a3 = 4.518621 3.879911 .001
NYRt a4 = .437745 6.615105 .001
SMAR“1 a5 = .132450 1.949455 .1
FRDt a6 = .001930 1.026129 .4
TYDt__1 a7 = -3.206770 -2.888572 .01
DDt a9 = 2.173197 2.083583 .05
EDt 810- 5.642888 5.524553 .001
2
Adjusted R 0.667
Durbin-Watson Statistic 2.29
Degrees of Freedom 31
N 41

P 0.724

 

57

The revised model also conforms to expectations regarding the
signs of coefficients. In addition, all variables with the exception
of net bank reserves (FRDt) and customer borrowing power (SMARt_1) are
significantly different from zero at better than the .05 probability
level. Two-thirds of the variation in the dependent variable is ex-
plained by the model.

FRDt, while it is still only marginally reliable, is now signif~
icant at the .4 probability level. The poor performance of this
variable in the model is not inconsistent with broker borrowing behavior.
Because of the nature of financing arrangements between brokerage firms
and banks, the supply of bank credit to support customer margin trading
is very nearly perfectly elastic in the relevant range at the existing
prime loan rate. Brokerage firms obtain "day" or "street" loans from
banks under flexible loan agreements on the basis Of cash needs and the
availability of pledgable security collateral. And financing is done as
a result of a day's security transactions, not in anticipation of them.
Thus the loan arrangement of brokers with banks is considerably more
flexible than the typical commercial loan which specifies a binding line
of credit. Because of this flexibility, brokers' loans are less likely
to be affected by changes in monetary policy and general credit avail-

ability.

 

introduction of these lagged variables reduced the significance of some
other variables in the model, but it did not alter the expected signs.
For a description of the Almon technique, see Shirley Almon, "The
Distributed Lag Between Capital ApprOpriations and Expenditures,"
Eponometrica, 33 (January, 1965), 178-196.

58

The Durbianatson statistic of 2.29 in the revised test of the
model indicates that the hypothesis that residuals are independent of
one another cannot be rejected.1 However, in achieving this result,
the variables in the model were subjected to autoregressive trans-
formations. An approximation of the transformation needed to eliminate
autocorrelation among the variables was made by using input data in
first difference (rate of change) form. There is, however, nothing
inherent in the first difference transformation which assures inde-
pendence of the residuals. In fact, the value of p in Table 2 (.724)
indicates that correlation was not removed from the residuals until
the variables had been substantially transformed into second differences.
The final form of the variable input to the model described in Table 2
is:

(vt - vt_1) x 100 (v

T = - 0.724 x
t Vt-l Vt-2

t-l - Vt-Z) x 100

 

 

where T represents a transformed variable and V its levels at time t.
The only exceptions to this general form are that TYD, the interest
rate variable, and FRD, the net reserves variable, are in simple
differences rather than of rates of change, and that both TYD and SMAR,
the customer buying power variable, are lagged one additional period.
The coefficients of the model must be interpreted in light of
these transformations. Table 3 illustrates the relationship between

the rate of change in stock prices, the transformed stock price

 

1For a description of this statistic,£i_:‘. H. Theil, Economic
Fprecasts and Policy, (Amsterdam: North-Holland Publishing Company,
1961), pp. 222-23. A value of the Durbianatson statistic in the
neighborhood of 2 is evidence of the absence of either positive or
negative serial correlation.

GROWTH ON MARGIN CREDIT GROWTH

59

TABLE 3

ILLUSTRATION OF THE IMPACT OF STOCK PRICE

 

 

Time

t-l

Monthly
Rate of

Stock Price

Change
(per cent)

Transformed
Stock Price
Variable

a
(per cent)

 

 

1.55

-.17

3.21

1.48

Impact on
Margin
Credit
Growth

(Per cent)

.68

-.07

1.41

.65

 

aThe final transformation equals:

(rate of change)t - 0.724 x (rate of change)“1

bThe transformed stock price variable multiplied by

a

4

( = .438 ), the coefficient of NYRt in Table 2.

60

variable, and the impact of this variable on the growth in margin credit.
For example, if the rate Of change in stock prices increased from 2 per
cent in one month to 3 per cent in the following month, the trans-
formed stock price variable would be 1.55 per cent, and the increase
in rate of growth in stock prices would predict a .68 per cent increase
in the rate of growth of margin credit. An interesting property of this
transformation is that the direction of impact of a variable is a
function not only of the direction of change in the rate of growth in
that variable, but also of the relative magnitude of change. The second
example in Table 3 illustrates the point; in the first difference trans-
formation, a decrease in the rate of growth in stock prices from 3 per
cent to 2 per cent would have a positive, but lesser, impact on margin
credit. In the final transformation, however, a decrease in the rate
of growth of this magnitude (33 per cent) results in a negative impact
on margin credit (-.07 per cent). On the other hand, a decrease in the
rate of growth of the same amount but of a smaller relative magnitude,
from 9 per cent to 8 per cent, leads to a continued positive impact
(+.65 per cent). A formulation of this sort is appropriate to the model;
large percentage decreases in the amount of net reserves held by banks
could, for example, easily reduce the supply of credit to brokers and
thus to margin traders, even if the rate of growth were still positive.
Similarly, a leveling off in the rate of growth in output or price levels
reduces expectations regarding future returns and could induce selling
of securities and reductions in margin credit demand; it is not
necessary for output or price levels to actually decrease in order for
expectations to be revised downward.

A large decline in the rate of growth in stock prices, such as

would occur just prior to a fall in stock prices, would predict a negative

61

impact on the transformed margin credit variable. This negative impact
would contradict the hypothesized direct relationship between margin
credit and stock price changes if margin credit decreased absolutely
while stock prices were still rising. However, bggh margin credit and
stock prices may continue to rise, but at a sufficiently reduced rate
to cause bggh transformed variables to become negative. Under these
circumstances, the stock price variable should predict a negative impact
if it is directly related to the margin credit variable, which would
itself be negative. In fact, evidence is presented in the following
section which indicates that decreases in the level of margin credit do

follow, rather than lead, stock price declines.

Empirical Support of Hypothesized Margin Trading_Behavior

 

The model summarized in Table 2, as well as the timing of margin
credit movements, provide evidence that trading done on margin is
destabilizing. Having removed from the dependent variable the influence
of investors on margin credit through expected real growth and inflation
variables, the demand for credit represented in accumulated borrowing
power in margin accounts, and the supply of margin credit determined by
net reserve and interest rate variables, a highly significant positive
relationship nevertheless exists between margin credit and Stock prices.
Recall that demand for margin credit by investors is not a function of
changes in the prices of stocks, but of changes in the discounted value
of their future returns. Since the influence of these value changes is
accounted for in the model by earnings and inflation expectations
variables, the Significance of price changes in explaining margin credit
change is strong evidence that credit is used at least in part to support

Speculative trading. Furthermore, the positive Sign of the price variable

62
in the model indicates that margin traders add buying pressure during
price upswings, and selling pressure during price downswings.

Whether this direct relationship between margin trading and
stock prices is destabilizing or not depends on the timing of margin
trading activity. It is assumed that the stock price fluctuations
from which margin traders seek to profit are short-term price move-
ments around the mean or central value of these stocks. Margin traders
would be a stabilizing influence if they purchased stocks when prices
were rising but below this central value, and sold stocks when prices
were falling but above this central value. Margin trading would then
impose pressure to return the prices of stocks to their mean value
levels. The withdrawal of activity when this value was reached would
decrease the likelihood that prices of stocks would be forced away
from this central value.

A stabilizing influence of this sort would be suggested if it
were observed that purchases by margin traders were concentrated in
the early stages of market upswings and were curtailed before the
peaks of upswings were reached. Similarly, a stabilizing influence
in downturns would be suggested if selling by margin traders occurred
in the early stages of price declines and subsided when prices were
above the trough.1 On the other hand, if margin traders followed the
market by buying throughout price upswings and selling throughout price
downswings, they would not perform a stabilizing function.

Margin credit movements and stock price movements are plotted

in Figure 1. Comparison of the movement in margin credit with stock

1There are other cases in which margin trading would be destab-
ilizing, but this case is the only one which is also consistent with
the positive price coefficient resulting from tests of the model.

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MARGIN CREDIT AND STOCK RICE MOVEMENTS

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64
prices suggests that margin traders do not stabilize the market by
concentrating their activity at the beginning of price advances and
declines. Instead, margin traders appear to exaggerate fluctuations
by following the market throughout cyclical swings. Moreover, margin
traders continued to add buying pressure for two months after a peak
in prices in April, 1966, and they continued to liquidate holdings for
three months after tle low in prices was reached in the following
December. Such activity, had it not been counteracted by other market
aetivity, would have led to a higher peak and a lower trough in prices
and further increased the amplitude of the cyclical price swing.
Therefore, contrary to the normal role of Speculators (Short sellers,
for example) in dampening price swings, speculative margin trading
descabilizes the market by adding buying pressure beyond price
uIDSI’nrings and selling pressure beyond price downswings. And since
this speculative, price-oriented influence occurs independently of
ch'T'lt'lges in the discounted earnings potential of securities or changes
in the supply of credit, it cannot be justified as an aid to good
reSource allocation.

Although the existence of Speculative activity is indicated by
the significance of the stock price coefficient in the model, the
prevalence of this activity in margin trading behavior is not so in-
dicated. To identify the extent to which margin credit is used to
suppert Speculative, price-oriented trading of stocks, the impact on
mar:gin credit of the stock price change variable was analyzed in re-

lation to that of other variables in the model.

65.

The Average Impact of Stock Prices

Over a series of time intervals, the variables in the model will
exert influences of differing magnitude and direction on changes in
margin credit. In order to examine the relative importance of these
variables in explaining margin credit change, they were analyzed in
terms of their average impact on margin credit, irrespective of the
direction of impact. The results of this analysis are summarized
in Table 4. In this table, the impact of the variables is derived by
weighting the variable coefficients by the absolute value of each
variable, averaged over all time periods studied. For example, TYDt_1,
representing changes in rate of return on alternate broker investment
oPPOrtunities, has an average absolute value of .131 per cent per month
over the time period of the study, partially representing both the
Change in Treasury yields and the change in that change. Multiplying

by the coefficient of TYDt_ , the impact of this average monthly change

1
on margin credit growth is .420 per cent. And Treasury yield changes
thus contributed 12.8 per cent of the average total impact on margin
credit of all variables in the model. The combined effect of TYDt_1
and FRDt’ the change in net bank reserves, represents the supply of
funds for margin credit by brokers, and these supply factors account
for 18.4 per cent of the total impact on margin credit change by the
model . The remaining 81.6 per cent of the total impact is provided by
factors affecting the demand for margin credit.

Analysis of variable impact provides considerable support for
the hYpothesis that margin traders are at least in part motivated by

Speculative goals. Thirty-four per cent of the average total impact

on Ina'li‘gin credit of all variables is accounted for by changes in the

66

TABLE 4

IMPACT OF COEFFICIENTS IN REVISED MODEL

 

 

 

 

 

 

 

 

 

Average Average
Absolute Absolute Percentage
Absolute Change in Impact of Total
Variable Value of Variable of Variable Absolute
Coefficient (per cent) (per cent) Impact
ZI'LP'Rt a2 = .882201 .656961 .579572 17.7
(IPRt 3 = 4.518621 .147463 .666331 20.3
TEFYRt 4 = .437745 2.532241 1.108476 33.9
SHEARt_1 5 = .132450 2.394685 .317176 9.7
mt 6 = .001930 94.663210a .182700 5.6
ZTYDt_1 7 = 3.206770 .131074 .420323 12.8
Total Absolute Impact 3.274578 100.0

 

8Change

in millions of dollars.

67

price of stocks, an impact greater than any of the other variables.
However, the impact of variables associated with investment goals
is also substantial; therefore it cannot be concluded that margin
trading is exclusively speculative.

The two variables which reflect the importance of investment
goals in the demand for margin credit are IPRt, the proxy for expectations
regarding future corporate earnings, and CPRt, the expectations variable
regarding inflation. The combined impact of these variables on margin
credit is 38 per cent of the total impact of all variables in the model,
or about the same relative impact as the speculative, price change

variable. Margin customer borrowing power (SMAR ), the only remaining

t-l
variable in the demand function for margin credit, accounts for 9.7
per cent of the total impact. Since there is no basis on which to assume
that this borrowing power is used more by speculators than investors, the
strongest conclusion that can be drawn from the analysis of average

imPaCt of variables is that margin credit growth appears to be about

equally affected by speculative and investment activity.

S~':°‘:I<\Price Impact durirpg "Critical Periods" of Stock Market Activity
The provision in the Securities Exchange Act of 1934 for flexible
margin requirements implies, however, that there was concern over changes
in the influence of speculative activity, not over the existence of it.
Similarly, when the Federal Reserve Board based the need for increases
in margin requirements on speculative activity, the expressed concern
was OVer the growing influence of speculation with margin credit during
- periods of rapid stock price movement. If the concern over the specu-

la °
tIVe use of margin credit is greatest in periods of intense market

68

activity, the importance of speculative behavior by margin traders
may be better judged by identifying cases of extreme impact than
through average impact . In fact, the total impact on margin credit
accounted for by price changes alone varied considerably over the time
period studied.

Monthly predictions by the model indicate that the impact
accounted for by stock price changes, plotted in Figure 2, varies
between nearly zero per cent and 66 per cent of total impact. In
twelve of the thirty-nine periods plotted, more than 40 per cent of the
tOtal impact of all variables is the result of the Stock price variable,
and in each of these cases there is an accompanying Sharp stock price
movement. It is clear from the performance of the model, therefore,
that in periods when margin credit has either risen or fallen substantially,
such movement has been primarily in response to stock price movements
and not to changes in future expectations nor to changes in the supply
of Credit. One of the most dramatic examples of the speculative
influence of stock prices on changes in margin credit occured in April
and May, 1966. During April, Stock prices advanced 2.7 per cent after
a drop in March of 4.1 per cent, and margin credit expanded 4.3 per
cent - In the following month, Stock prices drOpped 5.5 per cent and
margin credit contracted by 3 per cent. During each of these months,
Over 55 per cent of the change in margin credit predicted by the model
was accounted for by stock price changes. By way of contrast, the
average monthly rate of change in margin credit outstanding over the
en: ire period of the study was 1.7 per cent, and the average monthly
rate of change in the New York Stock Exchange Index was 2.4 per cent.

The model thus suggests that precisely in those critical periods of

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1965

FIGURE 2

VARIATION IN IMPACT OF STOCK PRICES ON MARGIN CREDIT CHANGE IN THE AGGREEATE MODEL

7O

sharp stock price fluctuation when destabilizing Speculative activity
can be most disruptive, the actions of margin traders are influenced

to the greatest extent by speculative, price-oriented strategies.

Summary of SupportingEvidence from Aggrggate Model

In summary, tests of an aggregate model of changes in margin credit
support the hypothesis that margin trading is influenced by speculators
and that their speculative activity is a destabilizing influence on the
stock market. Stock price changes accounted for 34 per cent of the
average total impact of all variables in the model over the three year
time period studied. In periods of sharp stock price fluctuation, the
Price variable was even more influential in explaining changes in margin
Cred it; in twelve such periods, the impact of stock prices on the model
aCCOunted for over 40 per cent of the total impact of all variables.

The positive coefficient of the stock price variable is significant at
the -001 probability level, and analysis of margin credit changes in
relation to stock prices indicates that margin buying and selling persists
throughout, respectively price advances and declines. Thus margin traders
do not lend stability to the market either by selling in periods of
increasing stock prices and buying as prices decline or by adding
buYing or selling pressure to return stock prices to their mean or central
Val ue.

The evidence developed thus far suggests that in periods of
interlse market activity and rapid stock price change, margin trading is
predominately motivated by price-oriented, speculative strategies, and
that this speculative activity does not serve an economically useful

if .
unct:Lon because it contributes to, rather than counteracts, price

71
fluctuations. Fluctuations in margin credit are only a proxy for
stock trading, however, and can also be greatly influenced by the
pattern of customer deposits and withdrawals of cash from margin
accounts. Consequently, in the following chapter, confirmation
of the evidence is sought through an analysis of actual stock trans-
actions in a sample of individual margin accounts during one recent

"critical period" of rapid Stock price fluctuation, March-June, 1966.

CHAPTER III

SECURITY TRADING BEHAVIOR IN A SAMPLE

OF MARGIN ACCOUNTS

As a further test of the hypothesis that margin traders are
speculative and destabilizing in their market behavior, the actual

purchase and sale transactions in a sample of 418 individual margin

accounts were analyzed. Individual accounts were studied to identify

the speculative appeal of the specific securities traded in these
accounts, the frequency of trading, and the timing of security purchases
and sales in relation to movements in stock prices.

Following a description of the sample, aggregate trading
activity in the sample is compared with trading on the major stock

exchanges in terms of the price variability, investment quality, and

rate of turnover of shares. Margin traders are assumed to exhibit

their Speculative orientation by selecting higher-risk stocks with
greater short-run profit potential, and by turning their investment
over at a more rapid rate than is the case with all market trading.
The response of sample account trading as a function of stock
Iarices is tested through a regression model in which all other vari-

ables affecting the demand for and supply of margined Stocks are

<2<>nsidered as part of the residual. Through this model, the

Significance of Speculative behavior is assessed by determining the

ability of stock price movements to explain both daily and average

Variations in total Share trading of sample accounts.

72

73

A positive relationship between stock price changes and sample
account trading will indicate that sample accounts do not stabilize
stock prices by buying during price downswings and selling during price
upswings. Speculative sample account trading could also be stabilizing,
however, if purchases in rising markets were made at prices below the
mean or central value of stocks and sales were made in falling markets
at prices above this mean value. If such were the case, margin traders
would profit from Short-term cyclical price movements around the mean
values of stocks and would at the same time impose pressure to return
stock prices to their mean values. Support for the hypothesis that
margin trading is destabilizing will be provided by the combination of
a positive stock price coefficient in the model of sample account
trading Egg evidence from the timing of sample account trading that net
purchase or sale activity does not subside when stock prices approach,

respectively, peaks or troughs of cyclical swings.
Description of the Sample

The individual account data used are from a random sample of
the accounts maintained by one large, multi-regional brokerage firm on
February 28, 1966. In designing the sample, consideration was given to
the tradeoff between degree of statistical error and cost of obtaining
(data, and also to the diversity of margin account activity. Obtaining
clata for each month for a Single account involved the searching and

nnicrofilming of bound copies of both a monthly Statement and an histor-
ixzal record for the account, manual conversion to numeric coding of all
alphabetic information for each transaction to attain computer compati-

IDility, keypunching of each transaction, and a computerized recreation

74
of day-by-day account balances from summary month-end information.
Because the total cost of this data-gathering process was quite high in
terms of both direct expense and man-hours expended, it was necessary
to minimize both the size and the time period of the sample. A four
month time period, from March 1, 1966 through June 17, l966,was chosen
because it includes two periods of substantial stock price decline
(March and May), a period of price recovery (April), and a period of
relative stability in prices (June). Thus an exposure to margin trad-
ing activity in a variety of market conditions was made possible.
Finally, observation of the population of accounts maintained by the
firm indicated that much of the margin trading activity originated in a
small number of active accounts. Sample size was reduced, without
losing substantial trading data, by stratifying the population of
accounts into active accounts and inactive accounts, and a separate
random sample was taken from each subpopulation. Sample Size was
determined by the decision to accept a sampling error of as great as
50 per cent in a 10 per cent sample cell, at the .95 probability level.
Thus a sample Statistic which indicated that, for example, 10 per cent
of margin accounts had credit balances would mean that the probability
is .95 that between 5 per cent and 15 per cent of the universe of margin
éaccounts had credit balances. Especially since expansion of sample
laalances to universe totals was not contemplated, this level of sampling
error was considered acceptable.
The sample consisted of 500 accounts. TWO hundred of these
‘Veire "active" accounts chosen at random from a population of 875

accounts in which either $1,000 in commissions were generated and/or

75

more than 10 transactions occurred during the month of February, 1966.1
A sample of 150 accounts from this subpopulation would have been
sufficient to meet the acceptable level of sampling error; sample size
was increased, however, in order to allow for the likelihood that some
accounts would have to be dropped because of incomplete data. The
remaining 300 accounts were chosen at random from the subpopulation of
"inactive" accounts, which are by definition all those accounts main-
tained by the firm on March 1, 1966 which did not meet the criteria for
active accounts. A sample from this population consisting of 200
accounts would have been sufficient to meet the criterion for sampling
error; the inactive sample was also expanded, however, to allow for the
eventuality of incomplete information in some accounts.

The final sample on which the analysis of this chapter is based
consists of data from 418 margin accounts, of which 154 are active
accounts and 264 are inactive accounts. The active sample represents
17.6 per cent of the total active subpopulation, and the inactive
sample represents less than one per cent of all remaining accounts.

Of the accounts dropped from the sample, 36 were incomplete because of
missing or unreadable records, and 46 had unreconcilable accounting
inconsistencies. There was no evidence that missing records were a

matter of design rather than carelessness, or that accounting errors

were not equally probable for all transactions, so the deletion of

 

1The selection of these standards was based on the availability
of a monthly list of active accounts meeting these standards which is
produced by the brokerage firm.

2The exact sample proportion cannot be revealed without dis-
closing the number of accounts maintained by the firm, a figure which
is confidential.

76

sample accounts is unlikely to have destroyed the randomness of the

sample.

Differences Between Active and Inactive Samples

Although the analysis of trading in sample accounts deals with
active and inactive account samples combined, some differences between
active and inactive sample accounts should be noted. While active
accounts number only 37 per cent of the total sample, they account for
77 per cent of the average daily debit balance, 71 per cent of the
average market value, and 78 per cent of the average daily change in
market value in the sample resulting from purchase and sale transac-
tions. As is indicated in Table 5, the difference in average size
between active and inactive accounts is substantial. The average debit
balance in active accounts is over $73,000, more than six times the
average for inactive accounts. Similarly, the average market value of
securities in active margin accounts of $233,903 is more than four
times the average market value in inactive accounts. There is much
less difference in purchasing power between active and inactive
accounts, however, as measured by the Special miscellaneous account
balance. The SMA balance in active accounts, $11,555, is only 50 per
cent higher than that in inactive accounts. This smaller difference
might be attributed to more aggressive purchase and sale activity in
the active sample. Rather than allowing their purchasing power to
build up, active accounts appear to utilize purchasing power as it is

generated by increases in the market value of stocks held in these accounts.

 

1A proportionately greater number of active accounts than
inactive accounts were dropped, but this is a result of the fact that
the number of transactions in active accounts was greater, not that the
type of trading in these accounts is unique.

77

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78
Representativeness of the Sample

The purpose of studying individual account data is to isolate
the market activity of margin traders. It is not proposed to expand
debit balances or any other totals to approximate universe figures,
because the sample it too small to be reliable for such purposes. In
order to be able to conclude that the behavior of margin traders in the
sample is indicative of the behavior of margin traders generally, the
sample should, however, be representative. Even though the sample is
drawn at random from the population of accounts maintained by the firm
which cooperated with this study, there is reason to suspect that bias
is nevertheless present because this one firm is not necessarily repre-
sentative of all firms which carry margin accounts for their customers.
Concern over bias is only partly mitigated by the fact that the sample
data is provided by one of the largest national brokerage firms.

In Table 6, the geographical distribution of accounts in the
sample is compared with that of total share ownership. This comparison
suggests that the Midwest and Northeast are somewhat under-represented
in the sample, and that the South is over-represented. The greater
representation of foreign accounts in the sample than in the distribu-
tion of total Shareownership may be misleading, since the sample
includes accounts of foreign nationals and the distribution of total
Shareownership does not. There is no available benchmark which provides
a geographic distribution of all margin accounts, and the distribution
of total Shareownership may not be entirely comparable. For example,
it is likely that margin accounts are even more heavily concentrated in
New York City, where a greater proportion of shareowners than elsewhere

are traders, rather than investors. Consequently, margin accounts in

79

TABLE 6

GEOGRAPHIC DISTRIBUTION OF SAMPLE ACCOUNTS
AND TOTAL SHAREOWNERSHIP

 

 

Number of Number of a
Sample Per cent of Shareowners Per cent of
Geographic Area Accounts Sample Accounts _(thousand§)_ Shareowners

 

 

 

 

Northeast 117 27.99 6,629 33.03
South 136 32.54 4,326 21.55
Midwest 68 16.27 5,214 25.98
West 76 18.18 3,746 18.66
Foreign 3 5.02 157 .78

4:8 100.00 20,072 100.00

 

a
Source: New York Stock Exchange, 1965 Census of Shareownership
(New York: New York Stock Exchange, 1966).

80
the Northeast may be more poorly represented than is indicated in
Table 6.

Sample totals and universe estimates of margin credit, market
value of securities in margin accounts, and special miscellaneous
account balances are compared in Table 7, as of the end of each of the
four months studied. The relationship between the sample and estimated
universe totals is quite stable for both debit balances in margin
accounts and the market value of securities contained in margin
accounts; sample accounts reflect the same direction and approximate
magnitude of change in margin credit and market value as do the universe
totals. Furthermore, the average sample proportions for debt (.186 per
cent) and market value (.198 per cent) are very close, indicating that
the "quality" of margin credit in the sample, measured by the loan to
collateral ratio, is very close to that of the estimated universe. The
direction of the difference of sample proportions indicates that sample
accounts tend to borrow somewhat more heavily relative to market value
than the average customer in the universe.

There is less stability in the relationship of sample SMA
balances to universe SMA balances; in April the change in SMA for the
sample is in the Opposite direction from the change in the universe
total. The sample percentage remains fairly stable, however, so this
divergent movement is not a strong indication of divergent trading
behavior. The average sample proportion for SMA balances is substan-
tially lower than that of either debit balances or market value, and
this difference does suggest some dissimilarity in the trading behavior
in the sample and the average trading behavior in the universe. Com-

bined with the fact that the percentage of debt to market value is

81

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n mam<H

82
slightly higher in sample accounts, this lower average SMA balance is
evidence either that sample customers withdraw idle funds from their
accounts to a greater extent than "average" customers, or that sample
customers make more active use, through additional borrowing, of excess
loan values generated by increases in the market value of Stocks held
in their accounts. In either case, sample customers are evidently
slightly more aggressive than the broad average of customers whose
activity is implied by estimated universe totals. The heavy influence
of active customers in the sample is very probably the cause of this
greater aggressiveness.

In summary, there is evidence that the sample of customer
accounts contains some geographical bias, and some bias toward greater
assumption of debt. Since the relationship between the sample and the
universe of debt, market value and SMA balances is quite stable over
time, however, the relative importance of these biases is small, and
the behavior of the sample appears largely representative of aggregate

margin trading.

Characteristics of the Account Sample

It was suggested at the end of the last chapter that changes in
margin credit are at best a proxy for the trading activity in margin
accounts, because of the effect of other transactions on customers'
margin account debits. Evidence supporting this assertion is provided
by the percentage distribution of the absolute impact of various trans-
actions on changes in sample account debit balances, presented in
Table 8. Only 20 per cent of the total absolute impact of all trans-

actions on the average daily change in margin credit in the sample

83
TABLE 8

ABSOLUTE IMPACT OF VARIOUS TRANSACTIONS ON
SAMPLE ACCOUNT MARGIN DEBT CHANGE

 

 

Per cent of Total
Transaction Absolute Impacta

 

Purchases and Sales in the Market:

Long, listed Stocks and bonds 20.04
Long, unlisted stocks and bonds 3.53
Short 4.03
Government and Municipal Bonds 1.80
Subscriptions to New Stock and U.S. Treasury Bills 19.67
Redemption of Bonds and Stocks 11.50
Receipt of Securities from Customers 9.37
Delivery of Securities to Customers 7.43
Deposits, Withdrawals and Transfers of Cash 10.66
Dividends and Bond Interest 6.75
Interest Charged on Debit Balance 3.52
Cancelled Transactions 1.26
Other .45
TOTAL 100.01

 

aTotal absolute impact is the absolute sum of average daily
percentage changes in sample debt caused by the transactions listed
above.

84
resulted from long purchases and sales of listed stocks and bonds. An
equal percentage of the impact on change in margin credit was the result
of subscriptions to new issues of Stock, which also represent purchases,
but which are not regular market transactions. The net effect of
deposits and withdrawals of cash by customers was nearly 11 per cent of
the impact on the average change in margin credit.

Similarly, changes in the market value of securities in margin
accounts can arise from a number of transactions, the average impact of
which is summarized in Table 9. While long purchases and sales of
listed stock provided the greatest percentage of total impact (20.6 per
cent) on the average change in market value over the period studied, an
almost equal impact was provided by changes in the market value of
stocks already held in margin accounts. And transfers of securities
into and out of margin accounts (the sum of receipts, deliveries, and
transfers) accounted for a total of 33.14 per cent. Such transfers do
not necessarily represent purchase and sale activity, since most are
the result of movements of securities already held by customers to and
from cash accounts, bank loan accounts, or even safety deposit boxes.

If, over a series of time periods, the impact on margin credit
changes of transactions other than purchases and sales of stock were
quite Stable, the amount of change in margin credit would be misstated,
but actual market activity would not be obscured. There is, however,

reason to believe that the effect of non-market transactions varies

 

1Short transactions had a very small impact on sample account
margin credit changes (4.03 per cent of total) and market value changes
(2.89 per cent of total). Because of this slight impact, short selling
was ignored entirely in the analysis.

85

TABLE 9

ABSOLUTE IMPACT OF VARIOUS TRANSACTIONS ON
SAMPLE MARKET VALUE CHANGES

 

 

Per cent of Total
Transaction Absolute Impacta

 

Change in Market Value of Securities Heldb
in Accounts 21.79

Purchases and Sales in the Market:

Long, listed stocks and bonds 20.58
Short, listed stocks 2.89
Government and municipal bonds .77
Transfers of Securities to Other Accounts 13.37
Receipt of Securities from Customers 11.52
Delivery of Securities to Customers 8.25
Subscriptions to New Stock and U.S. Treasury Bills 12.43
Redemptions of Bonds and Stocks 6.59
Stock Splits and Stock Dividends .69
Other 1.12
TOTAL 100.00

 

aTotal absolute impact is the absolute sum.of average daily
percentage changes in market value caused by the transactions listed
above.

b . . . .
Unlisted Stocks and bonds are given no market value in margin
accounts in the sample.

86
considerably over time. For example, the proceeds of sales from margin
accounts may be left on deposit with brokers if market purchases are
planned, but withdrawn if market conditions make trading unattractive
in the near future. An increase in the rate of withdrawals, however,
would increase margin credit as well, and thus give the impression that
net market purchases were being made when in fact funds were being with-
drawn in greater amounts because such purchases were 22; made.
Similarly, in periods of Sharp stock price decline, margin account
equity may decline sufficiently to result in a call for additional
margin. In cases such as this, an increased rate of cash deposits
would reduce margin credit and give the false appearance of net selling
of shares in the market.

In any event, it is the actual market trading activity
originating in margin accounts which is potentially destabilizing;
therefore, the study of sample accounts is limited to actual purchases
and sales of securities by margin traders. Sample accounts provide
data on over 8,000 purchase and sale transactions on 78 trading days
from February 28, 1966 through June 17, 1966. These transactions
involved more than 1,650,000 shares of stock with an aggregate market
value of over $75 million. The major characteristics of security
trading in the sample of accounts are summarized in Table 10. On each
day studied, an average of 50 accounts made over 100 combined purchase
and sale transactions. These transactions involved over 21,000 shares
of Stock with an aggregate market value of more than $950,000. The
average margin transaction involved over 200 shares of stock at an

average price of approximately $45 per share.

87

TABLE 10

SUMMARY OF STATISTICS ON TRADING OF
SECURITIES IN SAMPLE ACCOUNTS

 

All Accounts, Average per Day:
Number of Accounts Executing Market Transactions

Number of Transactions Executed
Purchase
Sale

Number of Shares Traded
Total
Bought
Sold
Average per Transaction
Bought
Sold

Dollar Value of Shares Traded
Total
Bought
Sold
Average per Transaction
Bought
Sold

Price per Share Traded
Bought
Sold

All Daysy Averpge per Account:

Number of Transactions Executed
Bought
Sold

Number of Shares Traded
Bought
Sold

Dollar Value of Shares Traded
Bought
Sold

50

52.
.66

50

10,714.
.09

10,564

205
208

$468,875
$488,676

$8,997
$9,535

$43.
$45.

14
14

2,775

$121,580
$132,100

10

56

.64
.52

.44
.06

.93
.61

76
73

.20
.40

.50
2,860.

60

.31
.06

 

88

The average account in the sample executed 29 purchase or sale
transactions in the 78 day study period. These transactions involved
the trading of more than 5,600 shares of stock with an aggregate market
value exceeding $250,000. The distribution of account activity is
highly skewed, however; trading in 111 largest accounts in the sample,
classified as such if either the number or dollar value of shares
traded exceeded the total sample average, accounted for 85 per cent of
the total number of shares traded by all sampe accounts and 87 per cent
of the market value of these shares.

The stocks which are eligible for loan value in broker margin
accounts include all issues listed on national securities exchanges, of
which the 2,639 issues listed at the time of the study on the New York
Stock Exchange and the American Stock Exchange are the majority. As is
indicated in Table 11, however, only 858, or 32.5 per cent, of these
issues were traded by sample accounts. Issues listed on the New York
Stock Exchange represented 71 per cent of the total number of issues
traded and 81.1 per cent of the market value of stocks traded in the
sample. Furthermore, there was considerable concentration of trading
in a relatively few issues. Over 50 per cent of the dollar value of
securities traded in sample accounts is accounted for by purchases and
sales of the twenty-Six Stocks described in Table 12.

The possibility exists that the issues traded in these accounts
are more characteristic of the brokerage firm than of margin trading in
general. For example, it is reasonable that the research departments
of brokerage firms have "favorite" stocks, which are in turn recommended
to customers either in published literature or by registered representa-

tives. In fact, however, this same group of twenty-six Stocks accounted

89

TABLE 1 1

STOCKS ELIGIBLE FOR.MARGIN TRADED BY SAMPLE ACCOUNTS

 

New York American
Stock Stock

Exchange Exchange Total

Listed Stock Issues 1608 1031 2639

Stock Issues Traded by Sample 608 250 858

Percentage of Total Listed Issues
Traded by Sample 37.8 24.2 32.5

Percentage of Total Stocks
Traded by Sample 71.0 29.0 100.0

Percentage of Market Value of Stocks
Traded by Sample 81.1 18.9 100.0

 

90

TABLE 12

STOCK ISSUES MOST TRADED BY SAMPLE ACCOUNTS

 

 

--- Traded by Sample Accountsa-

 

 

 

 

Per cent Per cent
Number Dollar of Dollar of Total
of Value of Value Trading by

Common Stock of Shares Shares Traded Marketb
Fairchild Camera 18,165 $3,174,162.00 4.21 1.77
S. C. M. 14,106 2,976,961.00 3.95 1.93
National Video (ASE) 33,230 2,975,122.00 3.95 1.79
Admiral 24,410 2,684,595.00 3.56 .73
I B M 4,750 2,538,368.00 3.37 .87
Syntex (ASE) 24,730 2,529,974.00 3.36 2.01
Collins Radio 30,177 2,137,057.00 2.84 .78
Trans World Airlines 22,440 1,868,463.00 2.48 1.08
Magnavox 22,065 1,866,830.00 2.48 .87
Boeing 9,503 1,425,334.00 1.89 .96
Commercial Solvents 21,200 1,338,604.00 1.78 .53
Eastern Airlines 14,400 1,300,155.00 1.73 1.69
Pan Am Airways 17,450 1,119,812.00 1.49 1.19
Motorola 5,210 1,045,146.25 1.39 .99
KLM Royal Dutch 8,850 . 986,925.00 1.31 .55
Solitron Devices (ASE) 6,665 876,983.75 1.16 .75
Texas Gulf Sulphur 7,706 865,121.87 1.15 1.55
Burroughs 12,725 809,237.50 1.07 .69
General Dynamics 13,760 787,468.75 1.04 .32
Raytheon 16,330 784,758.75 1.04 .48
R C A 12,955 697,965.62 .93 .92
Gulf and Western Industries 6,458 662,702.50 .88 .19
U.S. Smelting and Refining 9,375 630,178.12 .84 .49
Occidental Petroleum 13,024 618,482.00 .82 .32
Northwest Airlines 3,515 564,016.87 .75 .28
Roan Selection Trust 42,235 548,595.37 .73 .16
TOTAL 442,034 $37,803,648.00 50.20 23.89

 

8Purchases and sales combined.

bDollar value of all shares of each stock traded on the exchange,
as a percentage of the dollar value of trading of all 2,639 issues on
the combined New York and American stock exchanges. Trading figures are
for May, 1966, and average price is the simple average of low and high
prices for the first half of 1966. Source: Standard & Poor, Stock
Guide . —

91
for a substantial amount of total stock market activity during May,
1966, one of the four months studied. The total share volume of this
group of stocks, weighted by the average of high and low prices between
January and June, 1966, was 23.89 per cent of total average dollar share
volume in all stocks listed on the New York and American Stock
Exchanges. Only ten stocks contributed more than one per cent of total
average dollar volume on these exchanges during May, 1966. Eight of
these stocks are among the twenty-Six most active sample account Stocks,
and the remaining two (General Motors and Xerox) are respectively 45th
and 38th in the ranking of stocks from sample accounts by dollar
volume of trading. Thus, while it is not possible to assert that there
are no "favorable" stocks in the sample, it is nevertheless clear that
the majority of sample account trading is in stocks which are generally

the most popular in the market as a whole.

Evidence of Speculative Destabilizing Behavior
in Sample Account Trading_of Stocks
In order to test the hypothesis that margin trading is
Speculative and destabilizing to stock market price fluctuations, two
analytical approaches are utilized. First, the trading of Stocks in
the sample is compared with the trading of stocks in the market as a
whole, in order to identify differing investment quality, price avail-

ability, and turnover of securities traded on margin. Second, the

 

1One of the most common arguments for the value of readily
available credit for security trading is that credit provides liquidity
which if absent would endanger the breadth of the market in some stocks.
The general popularity of stocks most traded by sample accounts indi-
cates that this liquidity is largely concentrated in trading of stocks
for which the market is already quite liquid.

92
importance of stock price changes in explaining margin trading activity
is tested through an analysis of daily aggregate purchase and sale

activity in sample accounts.

Speculative Selection and Tradingyof Securities

The goal of speculative trading is to gain from short-term price
movements in securities. In pursuing this goal, the speculator is
unlikely to choose securities whose growth patterns are traditionally
predictable and stable; the price fluctuations in such securities will
be small, reflecting fairly uniform appraisals by investors of the dis-
counted value of future returns through dividends and capital gains.
With prOper timing, the speculator can achieve greater gain, in a
shorter time period, by selecting securities of companies whose earn-
ings are less stable or less predictable; lesser certainty about future
returns leads to a greater range of expectations on the part of traders
and investors, and to greater price fluctuations as either predictions
or expectations change. If margin trading is Speculative, then there
should be confirming evidence that the Stocks traded in margin accounts
are more highly price variable issues of companies with earnings growth
which is either unestablished or less Stable than Stocks traded by the
market as a whole. Furthermore, the short-term orientation of the
speculator should be evident in a higher turnover of shares in margin
accounts than in the market.

In order to compare price variability of sample account trading
to market trading, each stock listed on the New York Stock Exchange or
the American Stock Exchange was first assigned a percentage price vari-

ation equal to the difference between its high and low prices in the

93
period January through June, 1966, divided by the average of its high
and low prices in this period. Each stock was then weighted by its
sales for the month of May, 1966 and its high-low average price for the
first six months of 1966, and an average price variation of stocks
traded on the exchanges during May of 39 per cent was derived.1
Similarly, the price variations of stocks traded in sample accounts
were weighted by the dollar value of shares bought and sold in these
accounts over the four month period studied in deriving an average
price variation for sample accounts of 47.5 per cent. The weighted
average price variability of stocks traded in sampled margin accounts
was eight percentage points (over 20 per cent) higher than that of all
Stocks traded on the New York and American Stock Exchanges.

To test the assumption that margin traders, as Speculators,
prefer Stocks with less stable earnings and dividends, similar averages
weighted by dollar value of trading on exchanges and in sample accounts
were calculated, utilizing the Standard & Poor Rankings for stocks.
This ranking is objectively determined for Stocks on the basis of the

stability and growth in both earnings and dividends in past years. The

 

1The month of May, 1966 was selected for trading volume data
because trading volume was greater in that month than in any of the
other months studied.

2The price variations for the "market" and for stocks in sample
accounts are both surprisingly high. One factor influencing their
magnitude was the general trend of market prices during the period
studied, the NYSE index reached a high of 51.06 (February 9, 1966) and
subsequently shrank 11.75 per cent to a low of 45.06 (May 17, 1966).
Second, the variation for each stock is calculated as a percentage of
the average of the year's high and low closing prices from January
through June, 1966, not the decline from the high. Consequently, the
absolute price variance is high, but it is nevertheless a good relative
measure of price performance among Stocks and groups of stocks.

94
highest rankings are assigned to those stocks with the greatest
stability in earnings and dividends, combined with sustained rates of
growth. Stocks offering the greatest potential gain to Speculators
through price fluctuations are those with either a high but unstable
rate of growth, or unseasoned stocks which have not yet developed a
pattern of growth. The former group of stocks would be rated lower on
the ranking scale of seven to one, and the latter group would not be
ranked by Standard & Poor and therefore assigned a ranking of zero.
Based on this scale of zero (lowest ranking) to seven (highest ranking),
the dollar weighted average of all Stocks traded on the exchanges was
3.35, and the dollar weighted average of Stocks traded in sample margin
accounts was 2.72. The average stability/growth ranking of stocks
traded in sample accounts was nearly 20 per cent lower than that of all
listed stocks traded.

Comparison of turnover of shares in sample accounts with
turnover of shares listed on the New York Stock Exchange provides
striking evidence of the short term orientation of margin account
trading. The average dollar value of shares traded on the Exchange, as
a percentage of the total dollar value of shares listed, was 1.83 per
cent per month (21.96 per cent per year) in the period of March through
June, 1966. Over the same period, the dollar value of shares traded
monthly in sample accounts averaged 27 per cent of the market value of

securities held in these accounts, an annual turnover of 324 per cent.

 

1For a description of these rankings, see Standard & Poor,
Stock Guide, MOnthly issues. The rankings used were those contained in
the March, 1966 issue. Letter rankings were converted to numbers, from
7 (A+ for common stocks and AAA for preferred stocks) to 0 (not ranked).

95

The 26 stocks most actively traded by sample accounts,
described in Table 12, reflect a somewhat greater price variability and
a somewhat lesser investment quality ranking than the average stock
traded in the sample. The average price variability of these active
stocks was 54 per cent, as compared with 47.5 per cent for all stocks
traded by the sample. The average investment quality ranking for active
stocks was 2.63, and for all Stocks traded by the sample it was 2.72.
While this group of active stocks is more speculative when judged by
these measures than the group of all Stocks traded in listed markets, it
does not include many of the highly speculative margin traders. For
example, only three issues listed on the volatile American Stock
Exchange are included in the most active list, and there is no repre-
sentation of newly listed issues of companies with high but unproven
potential. The Speculative orientation of the accounts sampled may be
a conservative one because of the absence of these types of stocks from
the actively traded list. But however conservative is the selection of
stocks, the turnover comparison between sample accounts and the market
indicates that trading activity in sample accounts is nonetheless con-
ducted at a vigorous pace. Comparative measures of speculative activity
thus suggest that sample margin traders seek to profit from frequent
trading on short-term price fluctuations in volatile stocks which are
also well known and actively traded.

The results of the three comparative tests of speculation,
summarized in Table 13, indicate that margin traders apply Speculative
strategies in their selection of securities and particularly in their
frequency of trading. Furthermore, the concentration of margin trading
in stocks of greater price variability increases the likelihood that

margin traders will sell stocks in the event of market price declines.

96
TABLE 13

SECURITY SELECTION AND TURNOVER: A COMPARISON
BETWEEN SAMPLE AND MARKET TRADING

 

Trading
by Sample Trading
March-June in Marketa
1966 May, 1966
Average Price Variationb 47.50 per cent 39.00 per cent
Average Growth/Stability Rankingc 2.72 3.35
Average Monthly Dollard
Turnover of Shares 27.00 per cent 1.83 per cent

 

8Based on total trading in all Stocks on the New York Stock
Exchange. Source: Standard & Poor's, Stock Guide, June, 1966.

 

bAverage of the ratio to average price of the range between the
high and low price of each stock in the period January-June, 1966. The
average is weighted by dollar value of trading in each stock.

CAverage ranking of stability and growth in dividends and
earnings of each stock, weighted by the dollar value of trading in each
stock. Source of rankings: Standard & Poor's, Stock Guide, March,
1966. The scale of rankings assigned by Standard & Poor ranges from
zero (not ranked) to seven (A+).

dDollar value of shares traded as a percentage of average market
value of securities held in sample accounts for the "sample" column, and
as a percentage of the dollar value of shares listed on the New York
Stock Exchange for the "market" column.

97
If margin traders intentionally select highly price-variable stocks,
they may be expected to be as sensitive to the potential loss in price
declines as to the potential gain in price advances, and to react to a
price decline by selling to minimize this loss. In the following
section, the timing of security trades in sample accounts is examined
in an attempt to determine the extent to which the decision to buy or

sell margined securities is influenced by price changes.

Response of Sample Account Trading to Market Prices

In Chapter II, it was determined that changes in Stock prices
were the most important single variable in explaining changes in the
amount of margin credit outstanding. The amount of margin credit,
however, is also influenced by transactions other than regular market
purchases and sales of securities; as is indicated in Table 8, only
20 per cent of the total impact of all transactions on margin credit in
sample accounts results from market transactions. Thus it is conceiv-
able that observed fluctuations in margin credit during periods of
rapid stock price movement are largely the result of customer deposits
and withdrawals of either cash or securities, rather than of market
activity. And deposits or withdrawals of this sort need not be desta-
bilizing nor Speculative in a market trading sense.

For example, consider an account with $100,000 in market value
and $30,000 in debt, with a special miscellaneous account balance of
zero. If the market value of securities in the account increases to
$120,000 because of rapidly advancing security prices, the SMA will be
credited with excess loan value of $6,000 at margin requirements of
70 per cent. The customer may, if he chooses, withdraw this amount in

cash, whereupon his debit balance will increase to $36,000, exactly

98

equal to the borrowing capability in the account at 70 per cent margin
requirements. The customer has in part realized his profit from
increasing market values by borrowing from his broker the amount of
this increased value which Regulation T permits. And if the return on
alternate investment opportunities exceeds the interest cost of margin
credit, such withdrawals are profitable to the investor. In the event
of a market decline, the account in this example will become restricted;
if the decline were severe enough, the account might fall sufficiently
in market value to require the addition of margin by the customer. In
such a case, the deposit of cash by the customer would reduce his debit
balance with the broker. Both the withdrawal of cash and subsequent
deposit in this example would affect aggregate margin credit in such a
way as to suggest that credit had been used to support destabilizing
market purchase and sale activity. In fact, the activity in this
account would be destabilizing gply if the customer were unable to
supply additional margin when called for by the broker to support
declining collateral values, for in that event, securities would be
sold from the account by the broker in order to reduce the debt balance.

The hypothesized role of Stock prices in causing destabilizing
transactions is tested in a simple model of the daily dollar amount of
net purchase or sale of shares (AS) in sample accounts:

AS = a0 + alAP + u

where AP are changes in the market price of stocks. Whatever other
influences determine share purchases will be reflected in the error
term and the constant. Non-market transactions, which can influence
margin debt change, are eliminated entirely. The model is designed to

test the significance of price changes, both through the value of the

99
coefficient a1 and through the proportion of variation in share
purchases explained by this simple formulation. The greater the
magnitude of the coefficient, the greater is the apparent sensitivity
of sample trading to changes in market prices. And the greater the
proportion of total variance in trading explained by prices, the
greater is the relative importance of prices, as opposed to other
influences, in determining share trading patterns.

Although the small size of the sample does not permit great
flexibility in testing the sensitivity of various account and Stock
subclassifications, several formulations of the dependent variable were
developed. These are:

1. Trading in all stocks by all accounts,

2. Trading in the 26 most active stocks by all accounts,

3. Trading in all stocks by large accounts,

4. Trading in high price variance stocks by all accounts,

5. Trading in stocks ranked low in earnings-growth
stability by all accounts.

Although the twenty-six most active stocks accounted for only 26.4 per
cent of total Shares traded by the sample, over 50 per cent of the
dollar value of trades was concentrated in this group. The effect of
these few issues on changes in sample account margin credit was thus
substantial, and a separate test of the timing of trades in these
securities is warranted. Large accounts are tested separately on the
assumption that their activity may be destabilizing and price-oriented,
but could be dampened by activity in the remaining accounts. A total
of 665 stocks were traded by the 111 largest accounts in the sample,
which accounted in total for 85 per cent of all shares traded and

87 per cent of the dollar value of these shares. Trading in groups of

100
Stocks with high price variation and Stocks with unstable earnings were
tested separately because of the likelihood that the greater risk asso-
ciated with them would attract the interest of the most Speculatively
oriented sample accounts. Purchases and sales in 281 stocks with
greater than average price variation accounted for 55.5 per cent of all
shares traded and 59.8 per cent of the dollar value of trades. Stocks
of lower than average ranking in growth and Stability of earnings
numbered 525, and involved 77.2 per cent of shares and 65.2 per cent of
dollar value traded by all sample accounts.

The results of regression tests of the daily model of net Share
purchases are presented in Table 14. In these tests, stock price
changes are represented by the average of relative price changes in the
twenty-six stocks most actively traded in sample accounts. This formu-
lation of price changes was considered preferable to changes in a
broader price index, such as the NYSE Index, because it is more closely
related to the actual trading which was done in sample accounts and
consequently represents the price changes to which sample margin traders
are hypothesized to be most sensitive. The dependent variable is the

dollar value of shares bought less shares sold in all transactions and

 

1Subclassifications of trading in volatile Stocks, such as
stocks listed on the American exchange or newly listed and unseasoned
issues, would have been useful in further testing the model for price-
sensitive trading. Subclassifications of these sorts were not possible
because the volume of sample trading within these groups is too small
to be statistically meaningful. For example, only 29 per cent of the
issues traded by the sample were listed on the American Stock Exchange,
and trading in these issues represents only 19 per cent of the total
dollar value of sample trading.

101

TABLE 14

REGRESSION TESTS OF THE MODEL OF AGGREGATE
DAILY SHARE PURCHASES IN SAMPLE ACCOUNTSa

 

 

 

 

AS = a0 + alAP + u
Stock t-value Adjus- Durbin-
b Price of c ted Watson
Dependent Variable Coefficient Coefficient R2 Statistic
(1) All Stocks 34148.01 4.221 0.181 2.111
(2) 26 Active Stocks 17296.37 2.447 0.062 2.148
(3) Trades in Large
Accounts 31744.17 4.238 0.182 2.121
(4) Stocks Ranked Low
in Growth/Stability
of Earnings 20612.46 3.515 0.130 2.092
(5) High Price Variance
Stocks 21387.93 3.129 0.104 2.074

 

8The constant term, so, was insignificant in all tests and is
not presented in the table.

bNumber of observations: 77; Degrees of freedom: 75.
cThe coefficients in all tests are significantly different from

zero at better than the .02 level, the critical value for which is 2.39
with sixty degrees of freedom.

102
in four subclassifications.1 The stock price coefficient is significant
at better than the .02 probability level in all of the tests, and the
Durbin-Watson statistic of nearly two in each of the tests indicates
that serial correlation is absent from the residual term.

In evaluating the results of this model in terms of hypoth-
esized margin trading behavior, four questions must be answered. First,
is sample trading behavior destabilizing? Second, is the sensitivity
of the model to price changes substantial? Third, what is the impor-
tance of price changes in the model relative to other influences on
market trading decisions? Finally, do the tests of the model indicate
that speculative, destabilizing market activity is attributable to the
activity in selected types of accounts or stocks? Positive answers to
the first two questions would lend support to the hypothesis that
margin trading is Speculative and destabilizing. The last two questions
seek to identify the significance and source of Speculative activity.

The Sign of the stock price coefficient in all tests of the
model indicates that margin trading activity in the sample is destabil-
izing. In test (1), where the dependent variable is the dollar amount
of net daily purchase or sale activity in all accounts, an increase of
one per cent in the average price of the twenty-six most actively

traded stocks, is related to purchases of $34,148.01 in market value of

 

1Dollar values of transactions are used because price differ-
ences among issues prevent share units from being comparable. The
unavoidable appearance of some form of stock prices on both sides of
the model equation is unlikely to lead to spurious results, however,
since the prices applied to the dependent variable are those of the
actual stocks bought and sold by sample accounts and not the average
price of a uniform group of shares, which forms the independent vari-
able.

103
stocks by sample accounts.1 A decline of one per cent in the 26-Stock
price average, leads to sales of stock in the corresponding amount. In
each of the other tests of the model, the stock price coefficient is
also significantly greater than zero.

The significantly positive Sign of the Stock price variable in
all of these cases indicates that margin traders in the sample are net
purchasers of stock when Stock prices are rising and net sellers of
stock when prices are falling. Such trading activity will be destabil-
izing only if, in addition, transactions are not timed in a way which
adds pressure on prices to return to or remain at their mean value.
That is, sample margin trading will be destabilizing if it amplifies
rather than dampens the fluctuations of stock prices about their mean
value.

The timing of sample account trading can be compared with
movements in stock prices by referring to Figure 3. The lower panel in
this figure is the cumulative net dollar amount of shares purchased and
sold in sample accounts. The upper panel in Figure 3 is an index of
average prices of the 26 stocks most actively traded in sample accounts.
The figure covers the entire period sampled, from February 28, 1966 to
June 17, 1966. This time period can be divided into seven periods of

differing stock price behavior, as follows:

 

1Percentage increases in the average price of these twenty-six
stocks are measured relative to the price on February 28, 1966, the
first day of the sample study, and not to the previous day's change.

104
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CIMULATIVE DAILY PURCHASES AND SALES IN SAMPLE ACCOUNTS AND STOCK PRICE MOVHIENTS

105

Period From To Prices
I Feb. 28 March 15 declining
II March 15 April 14 rising
111 April 14 April 29 stable
IV April 29 May 17 declining
V May 17 May 27 rising
VI May 27 June 7 declining
VII June 7 June 17 rising

During each of the three periods of declining prices, sample
accounts were substantial net sellers and, with some day-to-day
fluctuation, continued their selling throughout the period of stock
price decline. Furthermore, in the two latter periods of rising stock
prices (periods V and VII) sampled margin accounts were substantial net
buyers of stock throughout. In all of these cases, sample accounts
destabilized stock prices by following the market and thereby amplify-
ing the fluctuation of stock prices around their mean value.

In period 11, during which prices rose in four weeks from 89
per cent to 117 per cent of their February 28th level, patterns of both
buying and selling activity are evident in sample accounts. In order
to have stabilized prices during this upswing, sample accounts would
have had to behave in either of two ways. First, they could have been
net sellers of stock, thereby dampening the price rise. Second, they
could have bought stocks at the beginning of the upswing, adding
pressure to return prices from the previous trough to their mean value
level, and then either sold stocks or remained inactive as prices
approached peak levels, adding pressure on prices not to rise above
their mean value levels. In fact, sample account trading during period
II followed neither of these patterns. Over the period of the price
rise, sample accounts were not net sellers of stock, but net purchasers

in the amount of about $500,000. And the timing of alternate buying and

106
selling patterns which occurred during this period was the reverse of
that required to stabilize prices at their mean levels; selling occurred
near the beginning of the upswing and buying pressure was added as
prices rose toward their peak. If the mean value of stocks is presumed
to be the average price around which prices fluctuate, sample account
trading during this period of rising prices was destabilizing, because
it added pressure initially to prevent prices from rising to this
average level, and, once the average level was reached, sample account
trading added pressure on prices to rise above the average level. Con-
sequently, in each of these five periods of distinct stock price trend,
margin traders in the sample exerted a destabilizing influence on stock
prices.

In order to judge the sensitivity of the model to stock price
changes, the average impact of stock prices on share trading was
calculated; the results are presented in Table 15. On the average over
the 77 day time period covered by the model, the 26-stock price average
either increased or decreased 2.07 per cent, and the resulting average
daily net purchase or sale of all Stocks in the sample was $70,681.92.
This average absolute dollar value of daily market transactions is 50.8
per cent of the absolute average dollar value each day of stocks
actually traded by the accounts in the sample. In other words, the
average impact of stock price changes in the model represents over half
of the average daily trading activity in sample accounts. Daily varia-
tions in the impact of other variables, conceptually represented by the
error term in the model, are ignored in this average relationship, so
it is not proper to conclude that stock price changes explain over half

of sample margin trading activity. The impact of the stock price

107
TABLE 15

IMPACT OF STOCK PRICE CHANGES ON DAILY
SHARE PURCHASES IN SAMPLE ACCOUNTS

 

 

 

 

Average Per cent
Absolute of Price
Impact Impact to
Stock of Price Average
Price Predicted Account
Dependent Variable Coefficient by Model8 Tradingb
(1) A11 Stocks 34148.01 $70681.92 50.8
(2) 26 Active Stocks 17296.37 35800.47 32.1
(3) Trades in Large
Accounts 31744.17 65705.95 49.5
(4) Stocks Ranked Low
in Growth/Stability
of Earnings 20612.46 42644.16 40.9
(5) High Price Variance
Stocks 21387.93 44268.31 33.7

 

aStock price coefficient multiplied by the average absolute
daily change in the 26-stock price average: 2.070.

bDaily average impact of stock prices as a percentage of the
average absolute daily dollar value of shares purchased or sold by the
portion of the sample defined by the dependent variable.

108
variable in the model relative to actual trading in the sample is
substantial, however, and indicates that market activity is highly
sensitive to price changes per se.

The value of the multiple correlation coefficient (R2) in tests
of the model gives some guidance as to the ability of stock price
changes to explain daily variations in sample purchase and sale activ-
ity. The test of the model including trades of all stocks in all
accounts, as indicated in Table 14, explains 18.1 per cent of the total
of squared deviations about the mean of sample account trading. The
remaining 81.9 per cent of variation is the combined result of "true"
estimation error and remaining factors influencing the demand for and
supply of margin credit which are not directly specified in the simple
daily model. It is not possible to determine what the "true" estimation
error would be if the model of aggregate margin credit developed in
Chapter II were applied to sample account security trading, because no
variables other than stock prices are available on a daily basis. Nor
is it possible to determine the precise contribution to the complete
model which stock prices would make. It is apparent from the Simple
model, however, that the contribution of stock prices to the explanation
of trading activity is not negligible, and that, consequently, specula-
tive behavior does significantly influence the trading of securities in
sample accounts.

Subclassifications of aggregate purchase and sale activity were
tested in an attempt to determine the source of speculative activity in
sample margin accounts. In each of the alternate tests of the dependent
variable described in Table 14, the stock price coefficient is signifi-

cantly positive. However the R2 of these tests does not indicate that

109

stock prices explain a greater proportion of the variation than in the
test of the dependent variable including all trades in all accounts.
In fact, with the exception of large account activity (R2 = .182), the
model explains lggg of the total variation in the alternate dependent
variables. The failure of the R2 to indicate an expected higher per-
centage of explained variation in these tests may be a result of the
inclusion of fewer sample trades and fewer accounts in the subclassified
dependent variables. For example, in the test of the dependent variable
including only trades in the twenty-six most active Stocks, the R2 drops
to 6.2 per cent, even though this is the subclassification most closely
related to the stock price index used as the independent variable.
Despite this close relationship, the poor performance is understandable,
for while this variable includes over 50 per cent of the dollar value of
stocks traded, it excludes nearly 75 per cent of the shares traded by
sample accounts. '

Similarly, the average percentage impact of stock prices on the
alternate dependent variables (equations (2) through (5) in Table 15)
does not indicate that active stocks, low stability-of-growth stocks,
highprice variance stocks, or stocks traded in large accounts are more
sensitive to stock price changes than the total sample. Failure of this
test to confirm the expectation of a higher sensitivity of these groups
may also be attributable to the statistical effects of sample diminution.

Analysis of the simple model of sample account stock purchase
activity provides evidence that purchases and sales of securities are
sensitive to the impact of speculative, price-oriented strategies, and
that these Strategies are destabilizing to stock price movements. Stock

price changes also explain a significant portion of the total variation

110

in net share purchases in the model. No conclusive evidence is provided
by this model that Speculative activity is more influential in the trad-
ing of either more popular or more risky stocks or of large accounts.

The model through which the sensitivity of sample account trading
to stock prices was tested is extremely naive. By including only stock
price changes as a distinct explanatory variable, the possibility exists
that the stock price coefficient is biased. Bias will be absent only if
stock price changes are totally uncorrelated with the many other influ-
ences affecting the demand and supply of margin credit, and the likeli-
hood of this lack of correlation is very small. On the other hand, the
statistical Significance and the positive Sign of the stock price variable
in the aggregate monthly model tested in Chapter II suggest that compar-
able results in the daily model are unlikely to be altered drastically
by the addition of other variables to the model. Consequently, although
the impact of stock price movement on margin trading may be greater or
less than that identified from the model, it is reasonable to conclude
that a statistically significant positive impact of Stock price changes

on margin trading does exist.

Summary of Evidence of Speculative Destabilizing
Behavior in Sample Accounts

By comparing the trading in sample margin accounts with all
trading on the major stock exchanges, it was determined that sample
accounts display security selection and trading characteristics which
are more Speculatively oriented than those of the market as a whole.
0n the basis of the price variation of shares traded, sample margin
accounts traded stocks with an average variation of 47.5 per cent,

twenty per cent greater than the 39 per cent average variation of all

 

111
shares traded on exchanges. When securities were ranked according to
the rate and Stability of earnings growth, sample accounts traded
stocks ranked twenty per cent lower than the market. Both of these
tests indicate a preference of margin traders in the sample for riskier
stocks with greater potential for short-term gain. The short-term
orientation of sample margin accounts was even further substantiated
through calculation of dollar turnovers; the average monthly turnover
of dollar value in sample accounts was 27 per cent, while the turnover
of the dollar value of all listed shares in the market was only 1.83
per cent, on the average, over the time period Studied.

Confirmation of the speculative orientation of sample margin
traders is provided by tests of a simple model in which daily Stock
purchases are a function of changes in market prices. The stock price
variable was significant in all tests, exerting an impact on Share
purchases equal to over half the average absolute daily market activity
in the sample, and explaining a significant portion of the total varia-
tion in daily trading. The positive sign of the price variable in the
model of daily purchase and sale activity suggests that sample accounts
are net purchasers of stock in price upswings and net sellers in down-
swings. Analysis of the timing of daily transactions provides evidence
that this purchase and sale activity is destabilizing because it does
not serve to dampen Stock price fluctuations around their mean value
level. In all except one of five periods of distinct stock price trend
identified in the sample period, purchases and sales in sample accounts
continued throughout price advances and declines. In one period of
price rise, when sustained intervals of both buying and selling

occurred, the timing of these intervals added pressure on prices to

112
move away from their mean value level, not toward it. The combined
evidence of these analyses supports the hypothesis that margin trading
is destabilizing to stock prices. Thus contrary to the normal role of
the speculator in dampening price swings, margin traders in the sample
amplified them through the timing of their trading activity.

The sample of accounts studied in this chapter represent less
than two-tenths of one per cent of the average margin credit and market
value estimated for all margin accounts between March, 1966 and June,
1966. However, because the sample is on the whole quite stable over
time in its relationship to aggregate margin account statistics, there
is substantial justification for concluding that the sample is repre-
sentative of margin accounts in general, and that the behavior of
margin traders identified through the sample reflects characteristics

common to margin trading.

CHAPTER IV
SUMMARY AND IMPLICATIONS OF STUDY

Margin requirements are the only existing selective control over
the demand for credit in the economy. Since the Federal Reserve Board
maintains regulatory authority over the supply of credit to finance
security transactions, through both general monetary controls and
specific controls over the stock-secured loan activities of bank and
non-bank lenders, margin requirements cannot be justified as a means to
prevent the excessive use of stock market credit relative to the resources
of the banking system. Instead, this selective control is rooted in the
concern that excessive use of credit is disruptive to the stock market
per se. On the one hand, higher required margins than were common prior
to the 1929 stock market crash are justifiable in order to reduce the
disruptive influence of wholesale liquidations of securities from.margin
accounts which occurs when declining market prices eliminate customers'
equity. On the other hand, changes in margin requirements are justifi-
able as a reSponse to rapid growth in outstanding margin credit if such
growth is evidence that bank credit is being used to finance Speculative
stock market activity which amplifies, rather than stabilizes, stock
price swings. The results of this study support the hypothesis that
margin trading evidences speculative, price-oriented strategies which
destabilize stock prices by adding buying pressure throughout market

upswings and selling pressure throughout market declines.

113

114

Two approaches were utilized in testing the hypothesis. First,
a model of the demand for margin credit was developed to explain changes
in the aggregate amount of credit extended to margin customers by
brokers. Second, the purchase and sale transactions in a sample of
individual margin accounts were analyzed in terms of the riskiness of
securities traded, the frequency of trading, and the reSponse of trad-

ing to stock price changes.

Evidence of Speculative Behavior in Mapgin Trading

Contrary to investors, whose demand for stocks is based on the
value of stocks reflected in discounted expected future returns,
Speculators base their demand on expected near-term price movements in
stocks. Consequently, the degree of Speculative influence on margin
trading can be measured by the extent to which activity in margin
accounts is explained by movements in stock prices.

An aggregate monthly model of the demand for margin credit was
tested with data on credit extended by large brokerage firms between
January, 1965 and May, 1968, in order to identify the relative influence
of stock prices on margin credit change. The stock price variable was
significant at the .001 probability level and was the most influential
variable in the model, accounting for 34 per cent of the average absolute
impact of all variables. An almost equal percentage of the average
impact of all variables was provided by expectations regarding future
earnings and inflation, that is, the value of securities. The remainder
of the impact was provided by changes in purchasing power in margin
accounts (10 per cent), interest rates (13 per cent), and credit

availability (6 per cent).

115

Calculated on a monthly rather than an average basis, the impact
of stock prices in the model varied considerably. In twelve of the
thirty-nine periods studied, stock price movements accounted for more
than 40 per cent of the impact of all variables, and each of these cases
occurred during or near a period of Sharp stock price movement. Margin
credit changes thus reflected a substantial Speculative sensitivity to
stock price changes, on the average, over the period studied. And in
periods of rapid price movement, the influence of speculative, price-
oriented behavior on margin credit was highly Significant.

Evidence of substantial Speculative margin trading activity is
confirmed through analysis of actual purchase and sale transactions in a
sample of individual margin accounts. The sample includes 418 accounts
selected at random from the accounts of one of the largest national
brokerage firms, and it covers one period of sharp stock price fluctua-
tions, from February 28, 1966 through June 17, 1966. A shmple model was
tested in which the net dollar value of stocks traded in the sample each
day was regressed on stock price changes, with all other influences on
the demand for stocks implied in an error term. It was found that on
the average over the 78 day period tested, 50.8 per cent of the dollar
value of market activity was accounted for by stock price changes. On a
daily basis, Stock prices alone explained 18.1 per cent of the total
variation in net stock purchase activity. Moreover, study of the sample
accounts provided evidence of a Speculative orientation through
characteristics of the Stocks traded and the frequency of trading.
Sample accounts traded only 858 different Stock issues, or 32.5 per cent
of the total number of issues listed on the New York Stock Exchange or

the American Stock Exchange. These stocks, weighted by the dollar

116

amount of trading, varied 47.5 per cent from their average price during
the first six months of 1966, compared with a variation of 39 per cent
for the weighted average of all trading in listed stocks. Similarly,
when stocks were ranked according to the stability and growth in their
earnings and dividends, stocks traded by the sample had an average rank-
ing of 2.72, on a scale of zero through seven, some twenty per cent
lower than the ranking of 3.35 for all trading in listed stocks. And
the rate of turnover of dollar value of Shares was 27 per cent per month
in sample accounts, but only 1.83 per cent in all listed stocks. Each
of these three comparisons is consistent with the finding that margin
trading is Speculatively oriented. Speculators would be expected to
concentrate their purchase and sale activity in issues likely to provide
the greatest short-term capital gain, including those Stocks which are
subject to the greatest price variability as well as those whose earnings
are subject to wide fluctuation and thus to considerable variability in
both expectations and market prices. And the short-term orientation of
the Speculator should be evident in a higher turnover of shares than

would be the case with long-term investors.

Evidence of Destabilizing Behavior in Margin Trading

If margin traders functioned in the normal economic role of the
speculator, there would be little cause for concern over the use of
credit to support Speculative margin activity. In such a case, margin
speculators would stabilize the stock market by reducing the amplitude
of stock price swings. To perform such a stabilizing function profitably,
margin traders could adOpt either of two patterns in their long trading

of stocks. First, they could buy stocks when prices are falling but

117

below their mean value level and sell them when prices rose above this

level. Second, they could buy stocks when prices are rising but below

their mean level and sell them when prices began to fall but were above
the mean.

In order for the first of these stabilizing patterns to be con-
firmed, stock price changes would necessarily have to bear an inverse
relationship to margin trading activity. Both of the models tested in
this study, however, indicate that stock price changes are directly
related to margin trading activity. In the test of both the aggregate
monthly model of margin credit change and the daily model of the dollar
value of sample account stock purchases, the coefficient of stock price
change was positive and significantly different from zero at better than
the .001 probability level. Thus both margin credit and market
purchases of stock increase with increasing stock prices and decrease
with declining stock prices.

Given that margin traders do respond directly to stock price
changes, they could still be a Stabilizing influence if they ceased
buying Stocks when prices exceeded their mean value level and ceased
selling stocks when prices fell below this level. In other words, margin
trading would be stabilizing if concentrated in the early stages of
either price advances or declines. It is evident, however, from a
graphical analysis of both monthly aggregate margin credit movements and
daily sample purchases and sales, that margin trading adds buying
pressure throughout price upswings and selling pressure throughout price
downswings. Consequently, the evidence developed in the study indicates
that margin trading is destabilizing because it amplifies fluctuations

of stock prices around their mean value levels.

118
Limitations of the Study

This study has not attempted to determine the effectiveness of
changes in margin requirements, insofar as the level of bank credit
supporting destabilizing speculative activity by margin traders is con-
cerned. Since an increase in margin requirements reduces the amount
which can be borrowed from banks and brokers to support any market
transaction, it is clear that the rate of growth in reported margin
credit will be reduced if margin requirements are raised. It is equally
clear that the higher are margin requirements, the greater is the
incentive for speculative traders particularly to seek credit from
lenders other than brokers or banks at lower margin requirements. Until
more experience is gained with the control of these other lenders under
Regulation G, reliable judgments of the effectiveness of margin require-
ment changes in Slowing the growth in Speculatively applied bank credit
are not possible.

Coverage of the study has been limited to analysis of margin
credit extended by large brokerage firms representing about 40 per cent
of the total credit extended by brokers. In addition to some brokerage
credit, the Study ignores margin credit extended by banks, which
accounts for approximately 25 per cent of the total of reported margin
credit outstanding. It is likely that considerably less Speculative
activity is conducted in loan accounts carried by banks because of the
inconvenience of executing frequent transactions with a bank as an
additional party to each transaction. Furthermore, the less frequent
revaluation by banks than by brokers of securities in loan accounts
reduces the ability of margin traders to borrow from banks on increasing

collateral values. The study has thus sought to identify Speculative

119

activity where it is most likely to occur. It does not presume to
attribute the same strength of speculative behavior to bank lending on
securities, but to determine whether margin credit is used for
destabilizing speculative activity, irreSpective of the source of such
credit.

Through tests of both aggregate credit statistics and activity
in sample margin accounts, a destabilizing effect of margin trading on
stock prices has been identified. These tests, however, have dealt with
trading on a monthly and daily basis, and it is not possible to determine
from them whether or not margin trading is destabilizing within smaller
time intervals. Although tests of the relative profitability of
security trades in sample accounts could provide some evidence of the
effects of margin trading in shorter time intervals, no tests of this

sort were attempted in the study.

Igplications of the Study for Margin Regulation

The test results of models,of both margin credit change and
margin transactions in sample accounts imply that rapid growth in the
amount of security credit outstanding is substantially the result of
destabilizing Speculative activity by margin traders. It can be inferred
from these results that a high rate of growth in margin credit outstand-
ing is evidence that credit is increasingly being used to support destabi-
lizing Speculative activity and that the use of credit for these purposes
can be discouraged by increasing margin requirements. Conversely,
stability or gradual growth in the level of margin credit is an indication
that value considerations are relatively more important to margin trading
<1ecisions (and price factors less so), and that high margin requirements

fire not needed to discourage an excessive speculative use of credit.

120

Regulatory authority granted the Federal Reserve by Congress
does not empower the Board of Governors to prevent Speculative activity.
Congress' mandate to the Federal Reserve was to control the availability
of margin credit to support speculative trading, based on the concern
that such trading is destabilizing to Stock prices. The system of
flexible margin requirements permits this control to be applied.
Furthermore, this study indicates that informational content about the
extent of Speculative activity by margin traders is provided by move-
ments in the amount of outstanding margin credit. The Federal Reserve
Board can thus determine the need for changes in margin requirements
through margin credit movements and need not presume to judge the
appropriate level of either stock prices or aggregate stock.market
activity. The Board need not place itself in the position of "arbiter"
of stock market conditions, for which it has at times been criticized in
the past, but can prOperly limit both its concern and its attention to

the amount of credit used to support stock market activity.

 

 

BI BL IOGRAPHY

BIBLIOGRAPHY

Books and Dissertations

Bernheim, Alfred L., and Others, eds. The Securitngarkets. (Findings
and Recommendations of a Special Staff of the Twentieth
Century Fund) New York: Twentieth Century Fund, Inc., 1935.

Bogen, Jules 1., and Krooss, Herman E. Securipy Credit. Englewood
Cliffs, N.J.: Prentice-Hall, Inc., 1960.

Bolster, Richard L. The Relationship of Monetary Policy to the Stock
Market: The Experience with Margin Requirements. The American
University, Ph.D. dissertation, 1966.

Haney, Lewis H.; Logan, Lyman S.; and Gavens, Henry S. Brokers' Loans.
New York: Harper & Brothers, 1932.

Harris, Robert E. Federal Margin Reqpirements: A Selective Instrument
of Monetary Policy. University of Pennsylvania, Ph.D. disserta-
tion, 1958.

 

Johnston, J. Econometric Methods. New York: McGraw-Hill, Inc., 1963.
Simpson, Kemper. The Margin Trader. New York: Harper & Brothers, 1938.

Theil, H. Economic Forecasts and Poligy. Amsterdam: North-Holland
Publishing Company, 1961.

 

Articles
Almon, Shirley. "The Distributed Lag Between Capital Appropriations
and Expenditures." Econometrica, 33 (January, 1965), 178-96.
Cohen, Jacob. "Federal Reserve Margin Requirements and the Stock

Market." Journal of Financial and_9uantitative Analysis, I
(September, 1966), 30-54.

121

 

122

Miller, Merton H., and Modigliani, Franco. "Dividend Policy, Growth,
and the Valuation of Shares." Journal of Business, XXXIV
(October, 1961), 411-33.

Moore, Thomas Gale. "Stock Market Margin Requirements." Journal of
Political Economy, LXXIV (April, 1966), 158-67.

 

Ulrey, Ann P. "Margin Account Credit." Federal Reserve Bulletin, LIV
(June, 1968), 470-81.

Government Documents and Publications

State of New York. Report of Governor Hpghes Committee on Speculation
in Securities and Commodities. 1909.

U.S. Board of Governors of the Federal Reserve System. Annual Report.
Washington, Annual issues.

 

 

U.S. Board of Governors of the Federal Reserve System. Federal Reserve
Bulletin, Monthly issues.

U.S. Board of Governors of the Federal Reserve System. Press Release,
October 20, 1967.

U.S. Board of Governors of the Federal Reserve System. Regulation Q;
Effective March 11, 1968. Washington, 1968.

 

U.S. Congress. Senate. Agricultural Inquiry. Hearings before the
Joint Commission of Agricultural Inquiry, under 8. Concurrent
Res. 4, 4 Vols. 67th Cong., lst Sess., 1921.

U.S. Congress. Senate. Committee on Banking and Currency. Bankingyand
Currency. 3 Pts. S. Rept. 133, 63rd Cong., lst Sess., 1913.

 

U.S. Congress. Senate. Committee on Banking and Currency. Stock Exchange
Practices. Hearingp before the Committee on Banking and Currency,
Senate, on S. Res. 84, 3 Pts. 72nd Cong., lst Sess., 1932.

U.S. Congress. Senate. Committee on Banking and Currency. Stock Market
Study. Hearings before the Committee on Banking and Currency,
Senate, 3 Pts. 84th Cong., lst Sess., 1955.

 

U.S. Congress. Senate. Committee on Finance. National Monetary Commission.
S. Doc. 243, 62nd Cong., 2nd Sess., 1912.

U.S. Securities and Exchange Commission. Securities Exchangp_Act of
1934 as Amended to August 20y_1964. washington: U.S. Government
Printing Office, 1965.

123
Other Publications
New York Stock Exchange. Historical Data on NYSE Common Stock Index.
New York: Research Department, New York Stock Exchange, 1966.

New York Stock Exchange. 1965 Census of Shareownership. New York:
New York Stock Exchange, 1966.

New York Stock Exchange. NYSE Common Stock Closing Indexes, Monthly
releases.

New York Stock Exchange. Monthly Report, Monthly issues.

New York Stock Exchange. Public Transaction Study; 1966. New York:
New York Stock Exchange, 1967.

New York Stock Exchange. Research Report, Monthly issues.

 

Standard & Poor. Stock Guide, Monthly issues.

General References Not Cited

"Bank Loans Secured by Stocks and Bonds." Federal Reserve Bulletin,
IL (July, 1963), 904-21.

Barnes, Leo. "'Pseudo Margin' and 'Pseudo Leverage' -- The Grand
Illusions of the Affluent Investor." Financial Analysts
Journal, XX (July-August, 1964), 89-95.

Cochran, William G. Sampling Techniques. 2d edn. New York: John Wiley
& Sons, 1963.

Deming, W. Edwards. Sapple Design in Business Research. New York:
John Wiley & Sons, 1960.

Farrell, M. J. "On the Structure of the Capital Market." Economic
Journal, LXXII (December, 1962), 830-44.

Funston, G. Keith. "Stock Market Margins Must Be Brought Up to Date."
Commercial and Financial Chronicle, 193 (February 16, 1961),
770 ff.

Hazlitt, Henry. ”Keynes on Speculation and the Stock Market." Commercial
and Financial Chronicle, 188 (September 4, 1958), 907.

Holbik, Karel. "Margin Requirements -- Their Role Assessed." The Banker,
CXIII (December, 1963), 833-38.

 

124

Johnson, Harry L. "Margin Requirements and Stock Market Credit."
University of Missouri, Business and Government Review, VI
(November-December, 1965), 5-10.

Lyons, John F. ”Unregulated Lenders Provide More Money for Stock
Speculation." Wall Street Journal, September 28, 1967,
pp. 1 f.

"Margin Requirements." Federal Reserve Bank of Minneapolis, Monthly
Review, October, 1963, pp. 2 ff.

Martin, William McChesney, Jr. "Industry's Responsibility in Stock
Market Credit Policing." Commercial and Financial Chronicle,
199 (January 16, 1964), 1513.

Martin, William McChesney, Jr. Statement before the Ways and Means
Committee of the House of Representatives, January 22, 1968.

Merjos, Anna. "Margins and the Market." Barron's, VLIII
(January 28, 1963), 5.

Spiegelglas, Stephen. "Margin Requirements and Stock Market Prices."
Financial Analysts Journal, XVI (November, 1960), 35-37.

Stigler, George J. "Public Regulation of the Securities Markets."
Journal of Business, XXXVII (April, 1964), 117-42.

U.S. Board of Governors of the Federal Reserve System. Regulation Tl
as Amended Effective Augpst 7, 1961. Washington, 1961.

U.S. Board of Governors of the Federal Reserve System. Regulation fly
as Amended Effective August 7, 1961. Washington, 1961.

U.S. Congress. House. Committee on Banking and Currency. Mongy Trust
Investigation. Investigation before a Subcommittee of the
Committee on Banking and Currency, House. 29 Pts. 62nd
Cong., 2nd Sess., 1912.

 

U.S. Congress. House. Committee on Banking and Currency. Report of the
Committee Appointed Pursuant to House Resolutions 429 and 504
to Investigate the Concentration of Mopgy and Credit. H. Rept.
1593, 62nd Cong., 3rd Sess., 1913. [The Pujo Report]

U.S. Congress. House. Committee on Interstate and Foreign Commerce.
Report of Special Study of Securities Markets of the Securities
and Exchange Commission. 5 Pts. H. Doc. 95, 88th Cong.,
lst Sess., 1963.

U.S. Congress. House. Committee on Interstate and Foreign Commerce.
Stock Exchange Regulation. Hearings before the Committee on
Interstate and Foreign Commerce, House, on H.R. 7852 and H.R.
8720. 73rd Cong., 2nd Sess., 1934.

 

125

U.S. Congress. Senate. Committee on Banking and Currency. Factors
Affecting the Stock.Market. S. Rept. 1280, 84th Cong., lst
Sess., 1955.

U.S. Securities and Exchange Commission. General Rules and Regplations
Under the Securities Exchange Act of 1934 AS In Effect April 1,
1967. Washington: U.S. Government Printing Office, 1967.

APPENDICES

126

APPENDIX A

THE INADEQUACY OF HISTORICAL MARGIN CREDIT DATA SERIES

Previous studies of margin credit have relied upon data series
which indicate the aggregate level of various components of margin
credit, and which are available over a considerable historical period.
These data series suffer from two significant deficiencies. First, they
are affected by influences other than those resulting from the market
activity of margin traders; these influences cannot be isolated or
removed from the data in any reliable fashion. Second, the data are
incomplete in that they take no account of financing of security

purchases not specifically governed by regulations.

Distortions in Historical Data

There are four historical series of data on the amount of credit
extended for Stock market activity, including two series on money
borrowed by brokers and dealers from banks, a series on bank loans to
individuals for the purpose of purchasing and carrying securities, and a
series indicating the amount owed by customers to brokerage firms. The
distortions in each of these series are discussed below:

Customer Net Debit Balances [CNDB]. This series has been

published since 1932 in the Federal Reserve Bulletin. It includes the

 

netted amount owed by all customers (cash, commodity, and margin) of all
brokerage firms which both hold membership in the New York Stock Exchange
and maintain.margin accounts for their customers. The most important
characteristic of these data, which makes them of questionable value in

measuring margin credit, is that they are designed to measure the total

 

127
amount of customer credit and not the credit extended solely to margin
customers. Consequently, the series is affected by temporary debit or
credit balances which occur in.g§§h accounts.

For a variety of reasons, some customers have not deposited the
payment for securities purchased within the four-day settlement period
after a transaction. Whenever a delay of this sort occurs, temporary
"cash account debt" is created and added to CNDB. One cause of cash
account debt which has grown to critical prOportions in the heavy trad-
ing volume of the past two years is the failure to deliver securities.

A "fail" occurs when a brokerage firm is unable to deliver securities

into or out of an account within the required settlement period. Some
customers, particularly banks administering trusts, will make payment

for securities only when they are physically delivered. If a fail occurs,
and payment is not made, cash account debt exists until delivery is
accomplished. The presence of cash account debt in CNDB overstates the
level of margin credit.

In addition to distortion through cash account debt, two common
types of transactions conducted through margin accounts obscure the
effect of actual margin trading activity on CNDB. The first of these is
the execution of a short sale by the broker, involving the sale of
borrowed shares of stock to be returned in the future through a market
purchase. Regulations require that the customer selling short deposit
the current margin on the selling price of the stock; the equity require-
ment for selling Short is the same as it would be for a regular "long"
purchase of the same shares of stock. No actual debt arises from a short
sale, however, since the broker retains the entire proceeds of the shares

sold. In fact, the debit balance in the account is reduced by the net

128

proceeds of sale of these borrowed securities, even though these proceeds
are fully offset by the future liability for payment which is certain to
arise when the short position is "covered." Therefore, the reduction in
credit extended to customers which results from such transactions is
apparent rather than real. At any point in time, Short sale proceeds
understate the actual amount of margin credit which is extended to
customers by brokers.

A second and similar distortion in the CNDB series occurs when a
customer subscribes to a new issue of stock. The customer is not charged
for the cost of a new issue until it becomes available. But the
currently required 25 per cent cash deposit by the customer is treated
as a reduction in the customer's debit balance and gives the appearance
of a reduction in margin credit. In reality, this deposit is committed
to the certain liability which arises when Shares are delivered and is
not therefore comparable to an actual reduction in margin credit such as
would occur when securities are sold from accounts. The end result of
including subscription deposits is an understatement in the amount of
margin credit outstanding.

Given the continuous and unpredictable variation in the extent
of short sale and subscription transactions, as well as in the size of
cash account debt, it is not clear that changes in CNDB accurately
reflect changes in the amount of margin credit outstanding. In
particular, there is no assurance that the relative importance of these
influences is stable over time, and thus little confidence can be placed
in the assumption that under- or over-statement in the series is

consistent.

129

Loans to Others Than Brokers by Banks. This series is developed
from data of large commercial banks reported weekly to the Federal
Reserve Board. Distortion is introduced into this series because banks,
unlike brokers, are permitted to extend credit on good faith loan values
of stocks traded over-the-counter. Such loans are not subject to margin
requirements but are nevertheless included in the bank loan data. As a
result, the series is not comparable to regulated credit on listed
securities, such as that extended by brokers to their customers. In
fact, during periods of margin requirement changes, the bank loan series
may considerably understate movements in regulated security credit,
since extensions of unregulated credit may react in an Opposite manner.

Loans to Brokers and Dealers. Two series are available which

 

measure the level of broker loans. One is the total of such loans for
large commercial banks reporting weekly, and the other is borrowing
reported from all sources by members of the New York Stock Exchange.

The main deficiency of broker/dealer borrowing as a measure of margin
debt is that an unknown volume of this borrowing at any point in time is
used to finance dealer inventories of securities, new issue underwriting
activities, cash account debt, and transactions between brokerage firms.
Furthermore, bank loans are by no means the only source of funds for
brokers. Free credit balances in customer accounts are available to
them as are loans from U.S. offices of foreign banks. Again, the level
of actual margin credit is uncertain within this statistic, and the
change in loans to brokers and dealers cannot be assumed to be a reliable
indicator of the change in margin credit since other influences cannot

be isolated.

 

130

Incomplete Coverage of Historical Data

In addition to the distortions present in historical data series,
these series fail to include information on non-regulated security loans
by banks and on all loans made to individuals by other than brokers or
banks.

The bank series on loans to others than brokers and dealers
includes only those loans which are subject to margin requirements under
the Federal Reserve Board's Regulation U. As a result, the series
includes only those loans which are pgpp for the purpose of purchasing
and carrying a security 32g collateralized by a stock or bond listed on
a national securities exchange. There are two groups of loans which are
not included in the series, but which are conceptually equivalent to
regulated security loans. One group is loans which include listed Stocks
as collateral but are used for purposes other than the purchase or
carrying of securities. Such loans can be used by individuals or
companies who purchase listed stocks with funds needed for other purposes
and subsequently pledge these stocks for a loan to provide these needed
funds. For example, a company might buy stock with working capital and
then borrow on the good faith loan value of that stock to obtain the
working capital it needed to begin with. Another category of bank loans
which is equivalent to regulated security loans is that of loans to buy
stock which are collateralized other than by listed securities. These
loans provide credit for activity in the stock market irrespective of
the fact that the collateral for the loan may be a house, a car, or in
some cases, only a Signature.

In addition to borrowing from banks and brokers, individuals

have access to non-regulated loans made by factors, finance companies,

 

131

and private parties. Until recently, margin requirements did not apply
to these lenders, and no data has been available on the volume of such
lending. The failure of existing series to take this source of funds

into account understates the amount of margin credit outstanding.

Uncertain Effects of Margin Requirement Changes

The problem introduced by the absence of information on these
sources of margin credit is most acute when historical margin credit
series are used to investigate the effect of changes in margin require-
ments. Changes in margin requirements are almost certain to lead to
substitution between regulated sources of credit, on which data are
available, and unregulated sources of credit, on which data are not
available. Thus it cannot be determined to what extent the change in
reported margin credit in response to a change in margin requirements is
dampened or exaggerated by a transfer of credit between regulated and

unregulated sources.

132

APPENDIX B

SIMPLE CORRELATIONS BETWEEN TRANSFORMED VARIABLES

IN THE AGGREGATE MARGIN CREDIT MODELa

 

 

 

MR DLR IPR CPR NYR
DLR -.13ooos
IPR -.026728 .257088 _,1,
SPR .219647 .004838 .173650 é ‘
NYR .519946 .293457 -.414l78 .099259 5 _:
SMAR .085739 .066068 .115139 .242342 .187900 I
FRD .217760 .176537 -.173491 .170060 .172184
TYD .231582 .147988 .354096 .065401 .128332
CD .041902 .113031 .130954 .106653 .215457
DD .292742 .102830 .145431 .065469 .063828
ED .390270 .100331 -.128586 .111003 .030782
SMAR FRD TYD CD DD
FRD .370470
TYD .015922 .057757
CD .028793 .425679 -.129l63
DD .071300 .009206 -.089142 -.001315
ED -.025603 -.O49928 .031897 -.001315 -.001315

 

aThe variables are in their finally transformed state: current
period change less .724 times the previous period change.

 

133

APPENDIX C

TEST RESULTS OF AGGREGATE MARGIN CREDIT MODEL FOR DISTRIBUTED LAG

FORMULATIONS OF EARNINGS AND INFLATION EXPECTATION VARIABLES

 

 

 

 

 

 

 

 

 

 

 

 

 

In§:p:n- 6 month lag 3 month lag 2 month lag
variable boefficient -va1ue Coefficient -value Coefficient -va1ue
IPRt 0.606055 1.689626 0.612239 1.689584 0.857811 2.547602
IPRt_1 0.131102 0.479016 -0.091989 0.300335 -0.l48500 0.450282
IPRt_2 -0.143260 0.590122 -0.296068 1.116873 0 0

IPRt_3 -0.255291 1.374878 0 0 0 0

IPRt_4 -0.243251 1.171417 0 0 0 0

IPRt_5 -0.145401 0.717922 0 0 0 0

CPR: 4.841454 3.743183 3.959851 3.010097 3.997771 3.496541
CPRt,1 0.377618 0.426550 0.038870 0.043878 -l.182718 0.941747
CPRt-2 -l.442547 1.639302 -1.280990 1.206736 0 0

CPRt_3 -l.504715 2.364212 0 0 0 0

CPRt_4 -0.694563 0.824827 0 0 0 0

CPRt_5 0.102233 0.113595 0 0 0 O

NYRt 0.405624 5.478068 0.426721 5.589794 0.430421 5.904860
SMARt_1 0.195144 2.413810 0.146775 1.858231 0.122609 1.717654
FRDt -0.000217 0.093925 0.000899 0.400012 0.002053 1.032804
TYD,,”1 -1.502160 1.170508 -2.045830 1.579614 -2.965230 2.554765
DDt 1.979341 1.482764 2.112600 1.683636 2.472224 2.141054
EDt 5.183267 4.142724 5.430544 4.422585 5.732807 5.116614
ggjusted .645 .617 .659

N 41 41 41
Degrees of 29 29 29
Freedom

,py .296 .477 .628

Degree

of Poly- 3rd 2nd 2nd

nomiala

 

 

 

 

8The distributed lag weights were assigned by the Almon
technique, in which a polynomial is fitted to the lagged observations.
The tail of the polynomial was constrained to zero in the most distant

period.

 

    
   

  

E IV

M'IIIIiIIIIiiEIIIIjIIIIIIIQIIiIs

331