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Wednesday, February 3, 1999

An Investment Opinion
by Louis Corrigan

Margin Speedbumps

A week ago, the Fool's David Gardner received this e-mail from an unhappy online trader. "I am one of thousands of Waterhouse Securities customers trading on margin to take advantage of the bull market," he said. "Last week, I was informed that there was a $50,000 margin call against my account due this past Monday." He continued, "I believe there are many people like me that had margin calls in the tens to hundreds of thousands of dollars and were forced to sell their positions in fast-growing equities to cover their margin call." David's correspondent speculated that this spate of margin calls may have contributed to a market sell-off, particularly in the shares of many Internet-related companies, and that the ensuing recovery in Internet stocks commenced once these calls had been met.

This story is not unusual. In recent weeks, a number of leading online brokers -- including Charles Schwab (NYSE: SCH), E*Trade (Nasdaq: EGRP), Waterhouse, a unit of Toronto Dominion Bank (NYSE: TD), and Ameritrade (Nasdaq: AMTD) -- have changed their margin maintenance requirements, sometimes with little advanced notice. They've done so in order to protect themselves, and their customers, from the volatile trading -- and speculative bubbles -- in Internet-related securities.

Some online brokers, such as Schwab and Waterhouse, have also made additional moves, such as barring or restricting online trading of certain stocks. Schwab, for example, won't allow trades for some initial public offerings to be made through its website. And for certain fast-moving issues, it requires investors to enter a limit order setting a target price or to call a company representative to change a market order. Other firms such as Knight-Tribune (Nasdaq: NITE), Herzog Heine Geduld, and Schwab have removed certain Internet issues from their automatic execution systems.

The incredible volatility in stocks like (Nasdaq: BCST) and eBay (Nasdaq: EBAY), for example, has simply left market makers exposed to rushes of buy or sell orders that they can't or don't want to handle. Market-makers are supposed to provide liquidity in such one-sided markets, in part by creating more shares temporarily through naked shorting in order to satisfy investor demand. However, that demand has been so intense as to leave firms reluctant to fill that role since they can be quickly scalped for heady losses. Even major brokerage houses such as Bear Stearns have stopped making a market in particular Internet stocks because they don't want to be exposed to such volatility.

As David's correspondent suggested, though, some of these moves by brokerage houses may have contributed to the very volatility they were designed to counteract. In addition, the policy changes have no doubt annoyed some customers who find their online broker is no longer delivering the type of service they've come to expect. On balance, though, this is the free market in action. It may not be pretty, but the firms changing their rules have simply surveyed their risks and determined that it's in their interest to curtail their exposure to these Internet stocks. While the online brokers may alienate some customers, they may also save others from a lot of heartache if (or when) these stocks come crashing down.

Let's consider what's going on here. Investors who trade on margin are basically taking out a loan from their brokers and using the money to buy stock. The Federal Reserve determines what stocks are marginable, and thus which ones can be used as loan collateral. The Fed also determines the minimum equity for an initial margin loan. Though set at a very low 10% during the 1920s, the threshold in recent years has held steady at 50%. This means that to buy $10,000 worth of stock, you must start with at least $5,000 cash on deposit. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) both require margin investors to maintain account equity amounting to at least 25% of their initial positions. However, most brokerage firms have a higher minimum maintenance requirement, typically 30% to 35%. If your portfolio loses value and falls below this mark, your broker gives you a margin call telling you to put more money in your account or sell some of your stock.

As the largest discount broker and leading online broker, Schwab's recent moves exemplify the trend. In early December, Schwab boosted its minimum maintenance level from 35% to 50% for a group of Internet issues. Two weeks ago, it pushed the minimum equity threshold to 70% for a group of 23 stocks, including (Nasdaq: AMZN), Books-A-Million (Nasdaq: BAMM), CMG Information (Nasdaq: CMGI), eBay, OnSale (Nasdaq: ONSL), Yahoo! (Nasdaq: YHOO) and Schwab's own competitors, Ameritrade and E*Trade. There are now 52 other issues on the firm's 50% maintenance list, including (Nasdaq: BCST), @Home (Nasdaq: ATHM), Mindspring (Nasdaq: MSPG) and (Nasdaq: TGLO).

While E*Trade has boosted its margin maintenance requirements well above the normal 35% level to 40% to 60% on several dozen stocks, it's actually made over a dozen stocks totally unmarginable. The number two online broker now requires investors to put up 100% cash to buy or keep issues like K-tel (Nasdaq: KTEL), uBid (Nasdaq: UBID), and (Nasdaq: XMCM). Meanwhile, Waterhouse has its own slate of 100% margin maintenance stocks, and Fidelity reportedly has some 50 Internet stocks on a list requiring 80% equity.

These higher margin standards may crimp the style of some online investors who've used hefty margin borrowing to leverage their gains in Internet stocks. Still, the brokerage firms have a perfect right to raise their standards for making loans. After all, it's their money, and they want to make sure they get it back. (If you own stock in any of these brokerage firms, these latest moves likely seem pretty smart.) These firms are simply looking at the stock being offered as collateral for the loans and making their own judgments regarding what they think these shares are really worth. Like pawn brokers, brokerage firms don't have any obligation to loan money on what they consider poor quality goods, or stuff that glitters but just ain't gold.

Moreover, investors should prefer to see speculation in the marketplace addressed through stiffer margin requirements and other reasonable speedbumps to trading rather than through something as truly draconian and destabilizing as actual trading halts. Since December, a subcommittee of the NASD, which runs the Nasdaq market, had been considering the possibility of temporarily shutting down trading in especially volatile issues. In theory, such halts would give investors a chance to take a deep breath and think before they traded again. Yet, the lesson learned from the New York Stock Exchange's circuit breakers during the market's meltdown in 1997 is that volatility-related suspensions of trading only exacerbate existing problems. Anxious investors playing a game of musical chairs may act rashly to get a seat before the music stops. Luckily, the NASD committee voted down this proposal according to a story in today's Wall Street Journal.

The more basic, issue, though is that nobody should be using more than a little margin (say 10% of your equity) when investing. Margin loans can boost your overall returns if your stocks rise in value, but leverage naturally works both ways. Talk to the geniuses at Long-Term Capital Management. You can lose money a lot faster if you've taken out fat margin loans to pay for your stock portfolio and things go wrong. And sooner or later, things do go wrong.

Call Your Boss a Fool.

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