November 3, 2023 | The Federal Reserve Issues a Margin Call

The Federal Reserve kept rates unchanged this week, at the highest level since 2001. The chair, Jerome Powell, insisted that the Fed might have to hike more, if inflation does not behave in the next few months. The last rate hike in the U.S. occurred in July 2023, after a streak of 11 hikes that started in March 2022.

Have the rate hikes hurt borrowers yet?

Central bankers are fighting inflation as their number one priority. Since interest rates are so much higher today than they were in 2022 we would expect to see problems arise with consumers and businesses who owe too much money. Homeowners in the U.S. are in the enviable position of having locked-in low interest rates for 30 years but everyone else must accept higher rates sooner, perhaps very soon. And if their income doesn’t allow them to service the debts at the new rates, they must pay down the loan or sell something.

In the stock market, this process of forcing a borrower to reduce a loan is known as a margin call. For the investor trading on margin, the brokerage firm extends credit against the collateral of shares of a company. The rules for margin loans allow the broker to call the loan at any time without notice and the borrower — the stock trader — must deposit money to reduce the loan or sell something. Usually, the trader is unable to deposit more money so the decision is made to sell some shares. The trader can make that decision but if he is reluctant to sell the broker can sell enough shares to meet the margin call. There is no requirement to give the trader warning.

It seems like the current round of interest rate hikes are similar to a big margin call for the economy, and there are a lot of highly levered players who are scrambling to find a way to hold on to their speculative positions. But soon the lenders, usually banks, will force those borrowers to deposit more money to pay down their loan or to sell some assets to reduce the size of the loan. This could happen in the real estate sector, the stock market or private equity.

We saw something like this in March 2023 when several regional banks were in trouble due to higher rates affecting the value of their holdings.

The difference with the stock market is the degree of liquidity. Most shares in the stock market can be sold in a few minutes, if there’s a margin call. But real estate and private equity borrowers must arrange a sale that can take months or even years.

The banks often will exercise “forbearance”, which means giving the borrower time to get the loan back into good standing.

But since this round of interest rate hikes has lasted more than a year, the patience of lenders is running out. We will see soon who is facing a margin call that cannot be met.

Hilliard MacBeth

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Hilliard MacBeth November 3rd, 2023

Posted In: Hilliard's Weekend Notebook

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