Margin Calls Hurt

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As a longtime Fool writer, I traipse down memory lane occasionally, recalling highs and lows experienced by The Motley Fool and its community members. One high point, for example, is our eMeringue.com joke. As a sobering low point, I recall one of our discussion boards' most recommended posts ever.

Written by Globalstreamer, it detailed how he got carried away using margin and lost more than $60,000. I recently read that the Carlyle Capital fund, tied to private equity giant The Carlyle Group, has received several margin calls recently.

In a nutshell, using margin is investing with money you've borrowed, typically from your broker. If your investments go up, earning more than the interest rate you're paying, you'll make more money than you could have without margin's leverage. If they go south, you'll lose money, plus you'll still owe interest on your loan.

When margin investments lose value significantly, lenders issue margin calls, requiring infusions of more capital. This can lead to a wave of badly timed selling to raise the cash needed to repay the loan.

The Carlyle Fund had invested in, among other things, several residential mortgage-backed securities from Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Its counterparties, many of which have issued margin calls, have included Bear Stearns (NYSE: BSC), Deutsche Bank (NYSE: DB), Credit Suisse (NYSE: CS), and UBS (NYSE: UBS).

Lesson to learn
As painful as it was for investors, this Carlyle story is a welcome one to me. It illustrates how risky it is to invest on margin. Imagine margining your account to the max, for example, and then seeing the market take a big nosedive and stay depressed for a year or three. You'll likely receive a margin call, and have to sell some valued holdings at depressed prices to meet the call. (Otherwise, your brokerage may sell your holdings for you.)

Meanwhile, you'll be paying interest for a long time, at significant rates. At Scottrade, for example, borrowing $10,000 to $20,000 recently cost 8.75%. At Fidelity, the rate was 8.825%, and at Schwab (Nasdaq: SCHW), 8.95%. On a $15,000 loan, that's more than $1,000 per year.