Template:AI Margin lending

Margin lending is the practice of lending money to hedge fund punters who use it to buy securities, meaning they can buy more securities than they could buy with just their own cash. The investor’s securities serve as collateral for the loan.

The broker usually limits the amount of money the hedge fund can borrow based on the value of the securities pledged as collateral. The investor has to maintain a certain level of equity, known as the “margin requirement”, to cover the potential losses. If the value of the securities falls below the margin requirement, the hedgie may have to deposit additional cash or securities, or sell some securities to repay part of the loan, to maintain the margin requirement.

Margin lending can be a useful tool for hedge funds trying to goose their returns to make it look like they are beating the market. This works as long as the stocks go up faster than interest accrues on their loans: in the last twenty years that has been most of the time, and as a result there are a lot of run-of-the-mill individuals who have managed to persuade themselves, and gullible money managers, that they have some special talent.

This talent has a habit of mysteriously and suddenly vanishing when market conditions invert. Because the investor is levered they can quickly find they have lost their own shirt, and their prime broker’s, should rates suddenly rise or stock prices unexpectedly reverse. Messrs Plotkin and Hwang are nifty recent examples.