Back in the spring of 2000, we heard a lot about the use of margin to buy stocks, just before the Dotcom Bubble burst. In fact in March 2000, the late Alan Abelson (writer and editor for Barron’s) wrote in his column, “Up & Down Wall Street,” about the dramatic and scary increase in the use of margin by investors during 1999 and 2000. Then in late spring the NASDAQ stock market experienced some dramatic declines and the talk about margin grew even louder. Eventually the Dotcom Bust was in part a result of the heavy use of margin.
What is margin and how does it work. Investors who want to buy stock but don’t want to pay the full price can leverage (use borrowed money plus the client’s own equity) their purchase by buying on margin. An investor sets up a margin account with a broker, signs a margin agreement (contract) and maintains a minimum balance in the account. The investor can now borrow up to 50 percent of the price of the stock and use his or her own funds for the rest, to buy stock.
Investors who buy on margin pay interest on the loan portion of their purchase, but don’t have to repay the loan itself until they sell the stock. Any profit or loss is theirs to keep. Conversely, any loss is solely their responsibility.
For example, if an investor wants to buy 200 shares of a stock selling for $40 a share, the total cost would be $8,000. Buying on margin, the investor would put up $4,000 and borrow the remaining $4,000 from their brokerage firm. If the stock price rises to $60 and the investor decides to sell, the proceeds amount to $12,000. The investor repays the broker the $4,000 he or she borrowed and puts the $8,000 in their pocket (minus interest and commission). That’s almost a 100 percent profit on the original $4,000 investment. Had the investor used his or her own money and laid out $8,000 for the initial purchase, a profit of 50 percent would have been made: a $4,000 return on an $8,000 investment.
However, if on the other hand instead the stock goes down by the same amount as above, the investor would lose substantially. Thus, while a leveraged portfolio can gain quickly, it can lose just as quickly. Worse yet, if stocks fall rapidly the possibility for large wholesale margin calls can add a technical factor to the market that creates a cascading effect to a general market decline.
Here is how a margin call works. If a stock an investor bought drops so much that selling it wouldn’t raise enough to repay the loan to the brokerage firm then to protect itself, the brokerage firm issues a margin call. This occurs when the value of the investment falls below 75 percent of its original value. That means the investor has to put up additional money in their margin account. If they don’t meet the call, or can’t afford to, they must sell the stock, pay back the brokerage firm in full and take the loss even if they think the stock will rise again.
For example, if the shares an investor bought for $8,000 declined to $5,600, the value would be less than 75 percent of the investment. To meet the margin requirement of $6,000 (75 percent of $8,000), they would have to add $400 to their account to bring it back within the acceptable limits.
Brokerage firms may set their own margin levels, but they can’t be less than the 75 percent required by the Federal Reserve.
During crashes, or dramatic price decreases in the market, investors who are heavily leveraged because they’ve bought on margin can’t meet their margin calls. The result is panic and forced selling to raise cash, which induces further declines in the market. That is exactly what happened when the Dotcom Bust was in full swing, back in the 2000-2001. In short, while the use of margin can add fuel to a bull (up) market, it adds fire to a bear (down) market.
Quote of the week: “Hope is a waking dream.” – Aristotle
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.