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Mania over margin calls
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May 27, 1999: 4:45 p.m. ET
Borrowing money to buy stocks is an attractive, but risky, affair
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NEW YORK (CNNfn) - With Internet stocks continuing their downward spiral, it's becoming increasingly clear that investors are cashing in to cover brokerages' margin calls.
The concept of buying on margin is simple: investors borrow money from brokerages to leverage the money they put up to buy stocks.
The attraction of buying on margin is also plain enough to understand. Investors can buy stocks without having to foot the entire bill themselves, with the hope that they'll get a better rate of return on their investment than the brokerage's fixed interest rate on the loan.
Also, any profits investors make are solely theirs - they don't have to share it with the lending brokerage - and they don't have to repay the loan until they sell the stock.
Things get more complicated, however, when stock prices tumble. When that happens, brokers may issue a margin call - requiring investors to put up additional money in their margin accounts - to protect themselves.
If a brokerage issues a margin call of 75 percent, for example, that means investors must put additional money into their margin accounts if their investments fall below 75 percent of the original value. If investors don't meet the call, they must sell the stock to pay back the loan.
Margin calls get settled at the end of a trading day -- but some brokers will give you up to three days to pay the tab.
As more investors sell shares as they try to meet their margin calls, stock prices fall further, creating a seemingly endless cycle akin to short sellers getting caught in a squeeze.
Margin calls, in part, facilitated the crash of 1929. Back then, however, investors could borrow up to 90 percent of a stock's value, compared with 50 percent today.
"Usually, when you have a stock market mania, it's driven largely by individual investors borrowing money to buy stocks at prices that are too high," said Hugh Johnson, chief investment officer at First Albany. "And usually, when a bubble becomes unwound, it's because of margin calls."
Johnson added that when investors take money out of one sector to meet their margin calls, it usually spills over into the general market as investors sell other stocks in their portfolios. Hence, the Dow Jones industrial average plummeted 235.23 points Thursday.
Warning signs
Last November, a number of brokerages - including Charles Schwab Corp. (SCH), Salomon Smith Barney and Donaldson, Lufkin & Jenrette (DLJ), imposed new margin-buying restrictions on certain securities.
"That was a signal that we were headed toward distress," Johnson said.
Nevertheless, Johnson said he "never got the impression that margin debt was part of the support for Internet stocks until the last two months."
The excessive valuations assigned to many Internet stocks and the hype surrounding the sector helped fuel the current scenario.
"These stocks are so extraordinarily overvalued, and a lot of debt was built up to buy them," Johnson said. "Everybody became a believer and had to be on board."
Over the last few days, Internet chat rooms have been buzzing with investors who received margin calls from their brokers, many using various four-letter words to communicate their frustration over the prospect of losing lots of money.
"I just got the dreaded call from my broker," one investor wrote. "My wife is going to leave me, I just know it. How could such a great situation turn so bad so fast. I'm ruined!"
Unfortunately, Johnson said, there isn't much investors can do to escape the double bind of losing money from falling stock prices and having to meet margin calls.
What typically happens under this scenario, however, is that investors tend to shy away from buying on margin for a while.
"Usually what happens is that it really reduces the appetite of investors to borrow money to buy stocks for years," Johnson said. "Not months - years."
-- by staff writer John Frederick Moore
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