E-Brokerages Face Backlash After ‘Margin’ Debacle
NEW YORK
Walking into the margin loan department of an online brokerage earlier this year, Bill Singer jokingly asked a colleague: “What is this, a Clearasil convention?”
The staff was so young that to Singer, a New York securities lawyer and former regulator, most of them seemed barely out of high school.
Like their higher-profile and better-paid colleagues in the newest generation of stock strategists and money managers, many of these “back office” workers had never been through a sustained bear market or even a sharp sell-off.
They hadn’t been “stress tested,” as one industry analyst put it.
Now they have.
Singer and other Wall Street veterans say inexperience and lack of manpower in the margin-lending departments of e-brokers--along with marketing programs at some firms that pitched borrowing to virtually anyone--contributed to a flood of complaints from margin customers during the technology stock havoc of March and April.
Margin investors, who typically borrow against stocks they own to buy more stock, have howled to securities regulators, lawyers, Internet message boards and the news media about what they consider high-handed and unfair treatment at the hands of their broker-lenders.
Many say their stock was sold out at rock-bottom prices as the market plunged, despite their willingness to meet “margin calls,” or demands by the brokerages for additional cash to back up their loans.
To be sure, a number of the complaining investors clearly didn’t understand margin-lending laws, which give brokerages broad latitude to sell assets in a margin account without advance notice if the market turns ugly. Others said they simply couldn’t reach brokerage officials when they needed to.
For their part, the brokerages say their margin staffs followed procedures designed to protect not only the firms’ loans, but also their customers’ remaining capital in time of crisis. Some firms say they went out of their way to communicate with customers.
But the forced stock sales nonetheless have created a public relations fiasco for many e-brokerages, risking the alienation of some of their best customers.
Investor Says Broker Acted Before Deadline
Michael Geis of Santa Clarita, a 33-year-old product manager for Internet service provider EarthLink, is typical of many irate investors.
On Thursday, April 13, the day before the Nasdaq composite index plunged a record 355 points, Geis got a margin call from his brokerage, Datek Online, demanding that he deposit $2,554 into his account to replenish his shrinking collateral.
Geis, an EarthLink loyalist, held 1,615 shares of the company’s stock, which had soared above $62 a share in 1999 but on that day closed at $12.81 in Nasdaq trading. The Datek message gave Geis until the close of business the following Monday to deliver the funds.
When he checked his account before heading to the bank Monday, however, Geis discovered that all but 20 shares of his stock had been liquidated that morning to close out his $17,000 in margin loans.
“I about fainted,” he said.
The selling price was under $11--within pennies of the 52-week low that EarthLink touched in early trading that Monday. Since then, EarthLink has rebounded to as high as $22.
Geis claims he was never notified that the deadline had changed and that his stock was about to be sold. The Web site provided no means of checking his margin status as the market shifted, and it was difficult to reach anyone in authority by telephone, he said.
The worker he finally contacted--”like a low-level drone in Sector 7G,” in Geis’ description--simply recited the mantra that Datek was within its rights because “market conditions warranted” the sale.
“Three business days is standard, but [brokerages are] not really even required to issue margin calls,” said Datek spokesman Mike Dunn. “If your account falls below minimum margin requirements, we can close you out.”
Some may find it hard to summon much sympathy for Geis and his fellow sufferers. Margin customers are, after all, required to sign contracts acknowledging that the brokerage has the right to sell their stock to protect itself against loan losses.
Moreover, analysts say, online brokerage customers ought to know that the flip side of the heavily advertised cut-rate trades often is no-frills service.
However, brokerages that play hardball with margin customers risk not only lost accounts and a public relations nightmare, experts say, but perhaps tightened regulation of the lucrative margin-lending business--or even class-action lawsuits.
The latter may be a long shot, because brokerage customers sign contracts agreeing to settle disputes in arbitration rather than in court. But analyst James M. Marks of CS First Boston expects a surge in new arbitration cases, especially against online brokerages, which do a larger proportional share of margin lending than full-service firms.
“If somebody’s been sold out and lost their account, it’s a no-cost option to use arbitration to try to regain what you lost in the market,” Marks said.
Margin borrowing by individual investors skyrocketed from October through March, in step with the explosion in technology stocks. Margin loans outstanding from New York Stock Exchange-member brokerages jumped from $179 billion to a record $278.5 billion in that period.
Measured as a percentage of the total value of all U.S. stocks, the March margin figure was 1.54%--eclipsing the previous high of 1.37% set in September 1987, according to research firm Trimtabs.com.
For many online brokers, that ratio has been far higher, ranging from 5% to 10% of customer assets.
The use of margin is popular because it can dramatically multiply an investor’s profit--as long as the market is rising.
Say you buy $1,000 of stock, with $500 of your own money and $500 on margin. If the stock’s value doubles, to $2,000, you’ve nearly tripled your $500 investment after paying back the $500 loan plus interest (often an attractive rate compared with other consumer loan rates).
The flip side: If the stock’s value falls, your losses are magnified as well.
By the end of April, with technology stocks in a deep bear market, margin loans outstanding plunged nearly 10% from March’s peak, to $251.7 billion, as investors scrambled to exit losing bets.
But as Geis’ complaint illustrates, not all of the margin reduction was voluntary.
TD Waterhouse Is Panned for Sell-Off
TD Waterhouse Group, the No. 2 Internet brokerage after Charles Schwab, conducted one of the most aggressive purges of margin loans, abruptly selling out thousands of customers at the open of the market Monday, April 17--the same morning Datek moved on Geis.
Waterhouse declines to say how many forced liquidations it executed that day, but spokeswoman Melissa Gitter said it was “nowhere near” the 25,000 figure that was widely repeated on Internet message boards.
Boards at the Yahoo, Motley Fool and Silicon Investor sites, among others, seethed with complaints about Waterhouse in the wake of the Monday sell-off.
“TDW really doesn’t give a damn about the carnage they caused by deciding to liquidate so many accounts without warning,” an investor wrote on a Motley Fool board. He said his stock was sold at the opening Monday even though a Waterhouse official had assured him on the phone Friday that he had all day Monday to settle his margin call.
“I think TD Waterhouse has a major problem and completely lost control,” echoed a poster on Yahoo. “We must be able to get through to them on the telephone if they can’t inform us on their Web site of our margin position.”
Gitter maintained that Waterhouse’s actions that weekend were “orderly and thoughtful.”
The training and experience levels of the Waterhouse margin staff have no bearing on how the purge was handled, Gitter said, since the firm’s risk-management committee, led by president and chief operating officer Frank Petrilli, was at work all that weekend and made the decision to “act decisively” against accounts with less than 10% equity.
Under regulations set by the Federal Reserve, a brokerage may lend no more than 50% of the value of stocks in an investor’s portfolio. After that, the investor’s equity--the total account value minus the amount borrowed--must stay above a “maintenance” level set by the NYSE and Nasdaq.
The minimum level is 25%, but at the time of the April 17 purge, Waterhouse and several other online brokerages required 30% equity. Waterhouse has since reacted by pushing its maintenance requirement to 35% and nearly doubling, to about 800, the number of volatile stocks on which it places individual margin restrictions.
Rival brokerages also have tightened their margin-lending criteria.
Waterhouse took other measures to help customers that weekend, Gitter said. The firm had already planned to keep its 170 U.S. branch offices open Saturday because of the April 17 federal tax-filing deadline, but after Friday’s plunge, the offices were kept open Sunday as well.
And from the close of the market Friday, investors were notified by a “pop-up screen” on the Waterhouse Web site that all margin calls were due immediately. Normally, investors have 72 hours to answer a call.
If Waterhouse’s aggressive action upset certain customers, it impressed some of those who follow the company’s stock, such as CS First Boston’s Marks.
“It’s a very tricky line the online brokers walk,” Marks said.
Margin customers are even more profitable than rapid-fire traders, so no brokerage wants to alienate them, he explained. On the other hand, mismanaging margin risk is the quickest way to go out of business.
Marks last week gave Waterhouse stock a “strong buy” rating, in part because the firm came through the 34% Nasdaq market crash from March 10 through April 14 with “fairly negligible margin losses.”
Increase in Arbitration Cases Could Follow
Waterhouse took a $14-million charge for margin losses during the quarter ended April 30--by far its largest such charge ever, Marks said. Yet, with revenue up 28% from the previous quarter to $489 million and profit up 34% to $76.6 million, the charge doesn’t look so bad, he said.
Because its fiscal quarter runs from February through April, Waterhouse was first to report results that include the worst of the tech-stock downturn. Similar losses may show up at other brokerages in the weeks and months ahead.
Whatever the firms’ losses, their margin customers in total lost far more. And the backlash from forced sellouts of customers is only beginning to be felt, some say.
“An investor doesn’t get blown out of his margin position Tuesday and call my office Wednesday. It takes a while,” said Mark Maddox, an Indianapolis-based lawyer who often represents investors in arbitration cases.
Nevertheless, Maddox has received more than 30 calls from angry investors and believes that margin problems may produce “the most explosive increase in securities cases since the old limited-partnership cases” of the 1970s and 1980s. In those cases, investors who thought they were buying foolproof tax shelters instead got hit with disqualifications and penalties from the Internal Revenue Service.
At the heart of many potential margin cases, Maddox said, will be the issue of suitability--whether brokerages should have screened out or dealt more carefully with investors who were too unsophisticated or inexperienced to be appropriate candidates for margin accounts.
A worrisome precedent for the industry may have been set in January when a National Assn. of Securities Dealers arbitration panel awarded $40,500 (including interest and legal fees) to an Indianapolis investor named Lael Desmond. Desmond, a biology graduate student at Indiana University, lost thousands of dollars investing on margin with Ameritrade during the 30% Nasdaq slide in late-summer 1998 brought on by the Russian financial crisis.
Maddox argued that Ameritrade should have realized from Desmond’s scant investing history that he was not a good candidate for a margin account and in any event should not have been investing on margin in such volatile stocks as America Online, Excite and Yahoo.
Ameritrade denied at the time that the case had any broad implications for the industry or even that it turned on the question of suitability.
Beyond arbitration cases, some regulators feel that the industry--in the wake of the record margin credit extended last winter, and the subsequent market plunge--needs to do a better job of educating investors about margin risks.
“We have ratcheted this issue up, and it’s No. 1 on our hit parade,” said Elisse Walter, chief operating officer of NASD Regulation, the self-policing arm of the Nasdaq market. “We have intensified education efforts so people understand what they’re getting into [with margin],” she said.
“Margin has gotten to the point where it’s subject to serious abuse,” contends G. William McDonald, enforcement director of the California Department of Corporations, the state’s securities regulator.
“We’ve got to really take a look at margin rules,” he added, and suggested that regulators perhaps impose different levels of borrowing restrictions on customers based on their investment experience.
The industry, however, believes it is already doing a good job, and that further regulation is unnecessary. Brokerage officials point out that many firms have long had more stringent margin rules than regulators demand.
“We feel that we police ourselves. We’ve always been more restrictive than required,” said Datek’s Dunn.
After all, he added, “It’s our money that’s at risk.”
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Times staff writer Thomas S. Mulligan can be reached at thomas.mulligan@latimes.com.
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Borrowing Binge
Margin debt outstanding--loans taken out by brokerage customers, usually to buy more stock--rocketed from October to March, fueled in part by investors’ hunger for high-flying technology stocks. Margin debt reported by New York Stock Exchange member firms at the end of each month, in billions of dollars:
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April: $251.7 billion
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Source: Bloomberg News
