Senator Charles E. Schumer
House Banking Committee
Subcommittee on Domestic and International Monetary Policy
March 21, 2000
Thank you Chairman Bachus for holding this hearing today. I want to thank you for your leadership on this important issue that affects the fundamental underpinnings of our economy.
Id also like to thank the economists who have come forward for this hearing. Disagreeing with Chairman Greenspan is always a risk in the economics profession. Its like betting against the house. So I thank Mr. Schiller, Mr. Galbraith and Mr. McCulley for presenting testimony today.
I think one of the most important economic decisions facing Chairman Greenspan today.
Because it is all but certain that today the Fed will raise interest rates.
Despite the fact that the American economy is the strongest in the world. Despite the increases in productivity that are fueling the unabated rise in GDP. Despite the fact that inflation is in check.
And more than anyone else, I thank Chairman Greenspan for presiding over this remarkable period of prosperity. To paraphrase Adam Smith, this rising tide has lifted all boats in America.
But despite all this apparent economic strength, the Chairman is raising interest rates today. Why?
Most economists believe it is out of concern with the tremendous rise in the stock market -- the wealth effect-- which is partly powered by a hidden undercurrent with the power to wash away economic gains: excessive margin borrowing.
Take a look at this chart. Today margin debt is a greater share of total market capitalization than at any point in since the Great Depression brought about by the 1929 crash. The closest is the crash of 1987. That spike would be precisely October 19,1987. Black Monday.
This rise in margin debt shows no sign of slowing. In fact, its increasing. In January and February of 2000 alone, margin debt has climbed 15%. In the last six months, margin debt has climbed $83 billion, 45% while stock market prices have risen 10%.
These numbers are an indication that margin borrowing itself may be fueling the markets rise. And that means speculation. Many investors are leveraging their investments to the maximum, betting that the market will continue to go up. And for almost ten years theyve been right. Its hard to argue against experience.
American investors comfort with our equities markets has been buoyed by the robustness of the economy.
A whole generation of investors are new to the market since the technological revolution ushered in an era of democratization of the markets. These investors have only known the rising bull market.
And as a result, today we are a culture of confidence. Confidence in the markets. In the economy. In technology
So why worry?
Because if history serves as our guide, confidence no matter how rooted in rationality, cannot continue unchecked.
The leveraging of the market, particularly by retail investors, means that a large drop in the market could set off a chain reaction of sell offs by investors trying to meet margin calls. This is obviously most precarious for certain tech stocks with no earnings and market capitalization regarded by many analysts as excessive.
We should also be concerned because since the last market crash of 1987, a much greater proportion of American families -- 50%-- have equity investments, meaning the effects of a serious decline in stock prices would be much more pervasive.
The Federal Reserves reaction to the tremendous rise in the market and margin debt has been to raise interest rates, as they will today.
But if we are concerned about the wealth effect or speculation in the markets, perhaps we should direct our monetary policy on the markets and margin debt?
That is a question that both I and Chairman Bachus have posed to Chairman Greenspan on a number of occasions before our respective Banking Committees. And I have to admit the answer left me somewhat unsatisfied.
First, it is argued that rasing margin requirements is not fair to smaller investors, and second, and more fundamentally, that there is no evidence that raising margin affects stock prices.
With regard to smaller investors, I would say first that there is no unalienable right to buy on margin particularly if margin debt is shown to have a negative impact on the markets.
In fact, there is evidence to suggest that most investors are not aware of the risks of buying on margin, further jeopardizing the overall integrity of the market. For example, the NASD, and this is probably true of the NYSE and the SEC, is flooded with calls by retail investors uninformed or ill-informed about margin.
And you can bet that if the market takes a dip, theyre not the only ones that will be hearing about it. A constituent of mine called yesterday to complain that the biotech sell off last week wiped out her savings. She never considered the risks associated with equities. And now shes paying the price.
Some may say increasing margin requirements is paternalistic, but if it means that we avoid a market crash that hurts all investors, in my mind the benefits outweigh the costs.
With regard to the correlation of margin requirements to stock prices. I would say that a full-scale investigation into the effects of margin on the markets hasnt been conducted by the Fed since it stopped using margin requirements as a tool of monetary policy in 1974. As Chairman Greenspan has noted, we are in a new economy.
Im pleased that the Fed is working with the SEC to analyze the nature and pervasiveness of margin borrowing and am hopeful that we will gain greater insight into what is driving this increase in margin debt. For example, are hedge funds and day trading firms most responsible for the rise? How many retail investors are using margin accounts? How are they backing up their accounts?
I think we should analyze margin debt fully before making any decisions. But if the results demonstrate that margin requirements do affect investors appetites for stocks, I hope that the Fed and the SEC will not shy away from making difficult, if unpopular, decisions that may hurt us in the short run but protect us from a crash in the long run.
What might those alternatives look like? There are many possibilities, each with costs and benefits.
1. Increase the initial margin requirement under Reg T. This would obviously have an immediate effect on margin borrowing.
2. Increase the maintenance margin requirements for broker dealers through the NYSE and the NASD. According to an in-house survey, margin requirements vary by broker dealer, which supports the theory that a smaller number of firms are probably responsible for much of the increase in margin debt. Many firms of their own accord have responded to the increase in margin debt and volatility of the markets by increasing maintenance margin and declaring some stocks ineligible. But in all likelihood there are less responsible firms that have failed to do so. Raising the floor of maintenance margin may reduce margin debt.
3. Increase maintenance margin for certain volatile securities. Recently Datek very responsibly raised margin requirements on 85 volatile tech stocks. This would allow a tailored approach to speculation in certain types of stocks.
4. Strengthen the standards for marginable securities. For example, excluding certain stocks with characteristics, like exceptional volatility and/or no earnings. This would essentially reduce the proportion of marginable securities by taking away broker dealers discretion on certain stocks.
It is my hope that the Fed and the SEC through their investigation will examine each of these possible actions. Because whether were concerned about the wealth effect or margin debt, a problem borne of the stock market may be best resolved by treating the stock market.
I thank Chairman Bachus for letting me testify today and look forward to the Committees questions.