Margin Calls Tighten Squeeze on Frantic Investors
For the past few years, Santa Monica stock market newsletter editor Al Frank had advised his clients to buy stocks with borrowed money, a process Wall Streeters call buying on margin. And in the five-year bull market starting in August, 1982--during which the Dow Jones industrial average more than tripled--that strategy made Frank and his clients a mint.
But beginning last Monday, when the market crashed, Frank and many of his clients received margin calls--requests that they sell stock or deposit more cash with their brokers to replenish the declining value of the stock used as collateral to back the loans. Frank, editor and publisher of the Prudent Speculator, will cancel remodeling his Santa Monica house and will sell some of his stocks to meet those margin calls.
“We’re hunkering down, we will probably eat out less, be less generous with our Christmas gifts,” said a distraught Frank, who claims he lost $700,000 of his $2-million portfolio in the market debacle.
Since last Monday’s crash, margin calls like Frank’s have ballooned and--by forcing investors to sell additional stock--have been a major contributor in driving down stocks even further. Market watchers say margin calls were a significant factor behind Monday’s 156.83-point decline in the Dow average, its second-largest single day point drop ever following last Monday’s record 508-point free fall.
Margin calls have been “up substantially,” said Hugo W. Quackenbush, senior vice president of marketing for Charles Schwab & Co., the nation’s largest discount brokerage.
“They’re heavier than normal, but not alarming,” said Betsy Flagler, spokeswoman for Merrill Lynch, the nation’s largest brokerage.
Increasing margin calls could force many affluent investors to sell homes, cars or other assets to pay off stock debt, experts predict. Or, as in Frank’s case, they could reduce consumer spending, which in turn could depress economic growth and possibly lead to a recession in the next year or so.
Also, margin calls are threatening the holdings of some major speculators and corporate raiders who use margin to acquire stakes in publicly held companies. For example, British-born financier Alan E. Clore may lose the control he recently won in Oakland-based KaiserTech, holding company for Kaiser Aluminum & Chemical, due to margin calls.
In addition, margin calls are causing increased strain among the nation’s brokers and their clients. Some investors complain that they were not properly notified of margin calls or that brokerages sold their stock without first consulting with them.
Many investors, facing margin calls for the first time, have been unprepared for the resulting trauma, some brokers say. In the bull market of the last five years, “people have rarely seen any stock they’ve bought take a drop for very long” and so have never had margin calls, said Jim Angelone, a broker in the Los Angeles office of Kidder, Peabody & Co.
In some cases, the investor trauma can even lead to tragic results. On Monday, a distraught Miami investor--reportedly facing a margin call--shot and killed the branch manager of his brokerage office and critically injured his broker. The investor then killed himself.
The surge of margin calls is an unpleasant, though expected, result of the boom in margin borrowing since the bull market began in 1982. Margin debt at the end of September had ballooned to a record $44.17 billion, double the $22.47 billion at the end of 1984 and quadruple the $10.95 billion five years ago, according to the New York Stock Exchange. More than 2.8 million investors have margin accounts, with the average account size growing to more than $4,880, up from $1,415 in mid-1984, when the NYSE first started tracking them.
Such growth has been easily understandable. In the 1982-87 bull market, buying on margin was wildly profitable.
Federal regulation allows investors to borrow up to 50% of the value of stock purchased. Such borrowing leverage allows an investor an opportunity to earn a profit with a smaller initial investment.
For example, suppose an investor bought $10,000 worth of stock by borrowing $5,000--typically from his broker--and putting up $5,000 of his own cash. If the value of the stock doubled to $20,000, the investor would have made a $10,000 profit on his $5,000 investment, minus borrowing costs. But if the investor had bought the stock entirely with cash, his $10,000 profit would have been against a $10,000 investment.
But margin is a double-edged sword: while profit potential is greater on the upside, losses can also be greater. If that $10,000 in stock plummeted to $5,000, the investor would lose his entire investment, whereas if he had not borrowed, he only would have lost half of his investment.
Because of that loss potential, many investment advisers discourage margin borrowing. “Margin is too risky for the average investor, and potentially too costly,” said John Markese, director of research for the American Assn. of Individual Investors.
Accordingly, institutional investors such as pension funds are forbidden by law to use margin. Although only as few as one in 10 individual stock investors is said to use margin, those that do tend to be well-heeled individual investors or traders who trade and speculate often.
But when prices go down sharply, they inevitably face margin calls. Those calls are usually triggered when the investors’ equity in his stock--its market value minus the amount of the loan--drops to 25% or 30% of the total value.
If that happens, the investor must either add more securities or other collateral, put up more cash, or sell the stock. Generally, brokerages inform clients of margin calls by mail and allow 48 hours for a decision.
Brokerages say many investors have chosen to sell rather than stick it out, wanting to cut their losses or lacking enough money to meet the margin call. That often is a financial disaster for the investors.
Being forced to sell due to a margin call means that “you get taken out of the market at the worst possible time” when stock prices are low, said A. Marshall Acuff, portfolio strategist for the brokerage of Smith Barney, Harris Upham. “That’s just the opposite of what you should be doing as an investor.”
Others, however, have chosen to stick it out and meet the margin calls with more cash.
But in some cases, due to the record volume that is overwhelming brokerages with paper work, not all those margin calls have been handled with utmost smoothness.
Angry at Broker
Frank Bellinghiere, a Westlake Village lawyer who says he plays the market “regularly” and has faced margin calls before, says that he may sue one of his brokerages over an alleged mixup of a margin call.
The brokerage, Bellinghiere said, asked him to pay $4,200 within 48 hours last week or it would sell some of his stocks. He claims that the brokerage received his check on time, but the brokerage nonetheless went ahead and sold his stocks. What’s more, Bellinghiere claimed, it sold nearly his entire portfolio, far more than the amount needed to cover the margin call.
“The fact that the market fell doesn’t bother me at all,” Bellinghiere said. “But the fact that they sold out my stocks bothers me a lot.”