Borrowing money is a time-honored tradition, as average folks take out mortgages to buy homes or apply for loans to pay for college. But it can have a potentially devastating impact when you’re buying stocks with your broker’s money, also called a margin loan.
Buying on margin entails purchasing stocks or other securities with borrowed money, using the shares themselves as collateral. A broker sets up a margin account to lend customers cash, which they then use to buy securities.
In this decade-long bull market, margin debt has been on the rise. And until recently, more investors than ever were buying stocks on margin. For example, at the end of March, margin debt at New York Stock Exchange clearing firms alone jumped to $278.5 billion, a 55% increase from six months before and a 78% surge from a year ago, according to the Securities Industry Association, a trade group representing the brokerage industry.
While this total amount represents less than 2% of the United States’ overall stock market capitalization, the level of margin debt has been rising steadily for the past three years. It then surged at the end of 1999 to its current lofty level, along with the frenzy for hot technology stocks.
Naturally, when the tech-heavy Nasdaq composite index was doing well, the number of investors in hock to their brokers wasn’t a problem. But when tech shares and other highfliers dropped significantly, most notably this April, several investors suffered margin calls. That’s when a broker examines a customer’s holdings, and if they’re down, he or she asks that the margin loan be repaid. When investors can’t repay, the stocks are sold out from under them.
That’s apparently what happened on April 14, the day the Dow and the Nasdaq fell 617.78 and 355.49 points, respectively. Investors were either forced to sell their more liquid blue chips to meet margin calls, or their brokers sold holdings if customers couldn’t raise the capital to pay them back.
It wasn’t just the average investor jolted by the harsh reality of margin calls. Even some big institutional investors were caught flat-footed by the margin trap. The most well-known so far: online investing guru Baruch Israel Hertz, owner of Track Data Corp. (Nasdaq: TRAC) in New York and operator of the stock-trading system myTrack. Hertz reportedly owed $45 million to four unidentified brokerage firms that made margin calls on his accounts. Hertz pledged 25 million shares of his own company’s stock out of about 45 million shares he owns to cover his losses. Track Data recently closed at $1.88, close to its 52-week low.
So if you’re one of the lucky investors who doesn’t owe his or her broker money, don’t be tempted to take out a margin loan just because the market has rebounded slightly. All it takes is one day’s fall to trigger a margin call, as thousands of investors learned, to their regret, in the cruel month of April.