Last week's harrowing stock market selloff
confirmed fears that the growing amount of debt held by investors
who borrow money to buy stock known as margin investing can
exacerbate a free falling market.
But since stocks bounced back as quickly as they fell, little
sentiment exists for new regulations that might prevent another
domino effect of selling should a similar stock plunge occur in the
Instead, market analysts hope the attention focused on margin
debt in the wake of the turbulence will alert investors to the
perils of buying stock on credit.
"The definition of speculation is when investors borrow money
to purchase overvalued stocks in the hope and prayer that those
same stocks will become more overvalued," said Hugh Johnson, chief
investment officer at First Albany Corp.
If a big drop occurs, as it did last week, margin debt can
"turn a rational decline into something disorderly," Johnson
Investors who had purchased volatile Internet and other risky
high-technology stocks on margin needed to sell stock last week to
cover so-called margin calls when the stock market began to
plummet, which put additional pressure a sliding market.
Margin debt has soared recently, jumping 50 percent in the last
six months, as investors have borrowed money to speculate on
volatile technology stocks.
On Feb. 29, total margin debt stood at $265.2 billion, up from
$176.4 billion at the end of August; and up from $151.5 billion a
year earlier. In February 1990, the figure stood at just $31.5
billion, according to Ned Davis Research, a Venice, Fla., market
Analysts have fretted for months that widespread borrowing would
perpetuate a market slide when margin investors sold stock to pay
off their loans during a decline. Those concerns were realized last
"When the stocks that had gone up the most started going down
the most, those are the ones that triggered the margin calls,"
said Sam Burns, a research analyst at Ned Davis.
Margin calls are issued by lenders, usually a stockbroker, who
want to ensure that the loans they make to investors are covered.
Here's how it works.
Investors borrow money to buy stock in the hope that the stock
will increase in value. The stock purchased on margin is used as
collateral against the value of the loan.
If the stock goes up, the investor can use the profits to pay
back the borrowed money plus interest charged by the lender.
But if the stock price falls, thus lowering the value of the
lender's collateral, the lender can make what's known as a margin
call, which requires the borrower to put up more cash to ensure
that the loan is repaid in full.
Margin calls are usually covered by selling the stock purchased
on margin, a dynamic that helped contribute to last week's sharp
if brief selloff.
Despite the scare, neither the New York Stock Exchange or the
Nasdaq Stock Market have immediate plans to make it harder for
investors to buy stock on credit. And officials at several major
brokerage firms said no further restrictions were planned to curb
The Federal Reserve Board, which regulates margin borrowing,
currently requires investors to have at least $2,000 in a trading
account to buy on margin. In addition, investors are limited to
purchasing $2 of stock for every $1 in their account.
Most major firms, acting independently last year, made it harder
to buy risky technology shares on margin by increasing the amount
of money investors needed to put up in advance.
Now, some are calling for an increase in so-called maintenance
accounts, or the amount of money an investor must keep in an
account to serve as collateral against stock bought on margin.
The NYSE and Nasdaq currently require that the portion of the
account held with the investor's own funds be no lower than 25
percent of the total value of the account. If it falls below that,
a margin call occurs.
For instance, an investor buys $10,000 in stock, with $5,000
cash and $5,000 borrowed.
A margin call could be expected if the value of the stock falls
below $6,666. The investor still owes $5,000, but his cash stake in
the overall portfolio has fallen below $1,666, or below 25 percent
of the total value of the account.
Mike Dunn, a spokesman for online firm Datek, said Datek has no
plans to increase maintenance account requirements.
Dunn said last week's selloff affected just a small percentage
of investors who have purchased stock on margin. "Investing in the
markets has certain risks to begin with," Dunn said. "When you
buy on margin, you add to that risk."