FOOL ON THE HILL
Mulling Over Margin

Back in 1999, margin debt -- the loans investors took against their portfolios to buy more stock -- was at an all time high. Many of the people who used margin were doing so to increase their exposure to aggressively priced stocks. Unfortunately, many of those stocks have collapsed, thus bringing on the dreaded margin call by brokers. Investors need to be careful not to go down this road again.

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By Bill Mann (TMF Otter)
March 8, 2002

[Editor's Note: This article was changed on March 12, 2002 to correct a calculation error.]

When's the last time you heard someone rail about the danger of margin? When I started at the Fool in 1999, margin was quite an issue, with usage rates at their highest points in history as a percentage of total stock market valuation. People use margin debt to juice their returns by virtue of using a little leverage. Or a lot. We don't have to talk much about portfolio leverage anymore, because the moral hazard of having too much of it seems, for the moment, to have dissipated along with a plunging stock market.

Which means, for me, that it is a PERFECT time to go back and look at the damage leverage caused to some investors, and to reinforce what I consider to be a healthy usage of margin, and what that would look like for an investor. Because as sure as we're sitting here, eventually, the market will begin to go up again, and eventually people will face the same set of questions again. Many people have done and will do irreparable harm to their financial future by taking on too much margin.

First, a lesson in nomenclature. "Margin" is an amount of money loaned to you by your broker that you can use to buy equities. In this article I may use the terms "margin" and "leverage" interchangeably. Margin is a type of leverage, a debt that someone takes on in the hopes of producing a larger return than if he simply used equity. Specifically, margin is  funds lent by a brokerage to an investor using his portfolio as collateral. The percentage of margin allowable is set by the Federal Reserve, and since 1974 it has been locked at 50% -- brokers may use more stringent restrictions if they wish. What this means is that if you have a portfolio with a market value of $100,000, you could then borrow another $100,000 from your broker, on which you will be charged interest. You could use those borrowed funds to buy additional securities, giving your portfolio total buying power of $200,000. If the stocks you own continue to rise (above the interest rate charged for the loan), your percentage return would be higher.

It's generally a pretty sweet deal for the brokers, since they have immediate access to your highly liquid portfolio if there is a problem. And for people who have close to the maximum in margin, there often is a problem. If your portfolio begins to drop in value, you could get a "margin call" from the broker, meaning that the value of your portfolio is no longer in compliance with the terms of your loan. If that same $100,000 portfolio principal drops 10%, then the amount of margin you could have by law is not $100,000, but $90,000. You thus have the choice of selling some of the margined securities or adding enough cash to meet margin requirements. If you choose to do neither, the brokerage will sell some securities for you. Since the price of your stocks at that moment is depressed, this is generally a pretty terrible time to sell. But if you don't want to deposit the cash, you've got no choice -- and the brokerage is not required to consult you on which stocks you would want to sell.

In 2000, Robert Shiller stated that the Fed ought to raise margin rates in order to cushion the blow to the stock market during a crash. His reasoning was that stock market speculation, or the "wealth effect," as the market was going up would cause greater destruction to more people when and if a crash occurred.

Well, a crash occurred, and anecdotally we have evidence that those who were the most willing to speculate and use the most margin were also tending toward the companies that had the most volatility. A 1999 study by Simon Kwan of the Federal Reserve Bank of San Francisco found that increased margin ratios followed rising stock prices by an average of one to two months. In other words, people were responding to stock rises by increasing their exposure to the market.

I'll let the ivory tower people banter about the universal effect of margin on the stock market. Let's instead focus on YOU. After all, if you lose your entire portfolio due to bad use of margin, does it really matter if the rest of the world uses it efficiently? Margin is really no different than a car loan, a mortgage, or even credit cards. None of these things in and of themselves are evil. The issue tends to come when something is misused, as all of these things can be. If you use leverage to buy a car that you would otherwise never be able to afford, that does not exactly put you in the Financial Genius Hall of Fame. Neither does using a home equity loan to increase your consumer spending, the dreaded "houses for blouses" strategy. And you know where we sit on big credit card balances.

Margin is the same. If you wish to use margin as a bridge loan in order to take on some stock equity for which you do not currently have cash, and it is, say, less than 20% of the value of your entire portfolio, that is fairly prudent. Remember, margin will have the effect not only of amplifying gains in your portfolio, but it will also make the losses bigger as well. Worse, your debt to the broker does increase and decrease with the level of the price of the stocks you bought with the margin. If you buy $20,000 worth of Bobala's Bobbing Birds (Ticker: CLUK) on margin at $20 per share and the price drops to $15 per share, your new margin level isn't $15 grand -- it's still $20 grand, and you're being charged interest on that loan. Even big boys have been nailed by this. Bernie Ebbers, the CEO of WorldCom (Nasdaq: WCOM) had enormous portions of his holdings in the company liquidated because his loan amount far exceeded the market value.

If your portfolio begins to drop in value and your margin level increases above 20%, sell some of the margined stock to pay it off. Yes, it is painful to sell at a loss if you believe that a company is undervalued, but companies can stay undervalued for a long, long time, and there is nothing that says one cannot become MORE undervalued in the interim, subjecting you to even worse losses, or even the dreaded margin call.

If that call ever does come, here's one hard and fast rule: sell. Don't add more money to satisfy the loan, just sell and get out of it. And when the market comes back, if you want to use a little margin, make sure that you are not wagering more than you could stomach losing, because in the blink of an eye, margin can do just that.

Finally, a rant
I was listening to Fed Chairman Allen Greenspan's Senate Banking Committee testimony yesterday. Senator Jim Bunning (R-KY) accused Mr. Greenspan of popping the stock bubble, particularly pointing to the collapse of the Nasdaq as a failure of U.S. monetary policies. What is this, Prozac logic? If there was in fact a bubble, how could anyone in a position of responsibility think that the healthiest thing was to keep it inflated? A bubble is a sign that there is over-exuberance. Perhaps the blame for its popping ought to be on the factors that, oh, I don't know, inflated the stupid thing in the first place? I'll call Greenspan out on some things, but when he was saying in 1995 that there was irrational exuberance surrounding the stock market, and it took another five years and 400% growth for the thing to blow up, I'd have to say that the guy let us know WELL IN ADVANCE what would happen if the stock market prices got too far ahead of themselves.

Senator Bunning, blame the investment banks that took garbage company IPOs public, for the enrichment of no one but themselves. Blame the managements who invested trillions of dollars into an infrastructure that has yet to yield anything but losses. Blame the $600 billion in debt taken on by telecommunications companies. Blame investors, individual and institutional, who really actually thought that they could invest in ANYTHING and that it would go up. Blame Congress, which blocked some pretty rational stock options accounting reforms. Greenspan, for any other mistakes that he has made, didn't bear top responsibility for fanning the flames that created the bubble, so it is pretty stupid to blame him for taking something that was so unhealthy and unsustainable back down.

Fool on! Bill Mann, TMFOtter on the Fool Discussion Boards

Bill's alma mater's basketball team, American University, plays this afternoon for the chance to make the NCAA Tournament for the first time. Bill owns none of the companies mentioned in this article. The Fool has a disclosure policy.