McTEER: Option for the Fed

By Bob McTeer | Wednesday, October 15, 2008

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COMMENTARY:

Among the actions the Federal Reserve is expected to announce imminently, it should include an immediate, but temporary, reduction in margin requirements for stock purchases.

The current requirement is that no more than 50 percent of value of stocks purchased and held should be with borrowed money. A 50 percent margin rate seems conservative and appropriate during normal times, but it's unnecessarily adding to the downward spiral of today's stock markets.

Margin requirements are pro-cyclical, in that a decline in the market increases the fraction of the holdings carried by debt and reduces the fraction owned outright by the investor. Often, a margin call requires investors to sell the stock to restore the required margin percentage, which adds more downward pressure to the already declining market. Alternatively, someone receiving a margin call may sell another asset to raise cash to meet the margin call. Either way, it puts further downward pressure on an already declining market.

Margin requirements are pro-cyclical, as are limiting the amount of bank capital held on the books during good times and raising insurance premiums during bad times. So is strict application of mark-to-market accounting rules on assets that temporally have no market. The Board of Governors could reduce margin requirements from 50 percent to 40 percent, 35 percent, or even 25 percent until the crisis passes and then gradually restore them partially or entirely. No permission from Congress or coordination with other regulators is necessary. Congress gave the Federal Reserve authority over margin requirements in the 1930s precisely for an occasion like we have today, or for an opposite problem of rapidly rising share prices.

Chairman Alan Greenspan rejected calls to raise margin requirements during the stock-market boom of the late 1990s. He said it would only hurt the small investor, while the larger, more sophisticated investors have alternative means of getting around higher requirements.

I never fully understood his argument at the time, but I thought he should at least try it. If it worked, fine; if it didn't work, at least he tried. Instead, the chairman gave an impression of being unconcerned about what was increasingly emerging as a bubble in certain sectors of the stock market.

If Chairman Ben Bernanke is throwing everything but the kitchen sink at the current problems, let that everything include a substantial temporary cut in margin requirements. What does he have to lose?

Bob McTeer is a distinguished fellow at the National Center for Policy Analysis. Prior to joining the NCPA, Mr. McTeer was chancellor of Texas A&M University System, had a 36-year career with the Federal Reserve System, including 14 years as president of the Federal Reserve Bank of Dallas and member of the Federal Open Market Committee (FOMC).

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