Economy May Face Margin Call
By Mitchell S. Ostwald
An often unlooked area of the stock market is the level of margin debt (the amount of money borrowed by individual investors to purchase stocks). While many have been focused on the rise in interest rates as a means to cool the growth of the economy, recently both the industry and observers have begun to wonder if the level of margin debt could create a serious downturn in the market place.
Recently, Federal Reserve Chairman, Alan Greenspan, expressed concern about the level of margin debt stating during testimony in January before the Senate that the central bank is studying the matter.
The statistics are staggering. The amount of margin debt in 1990 was $35 billion. As of December 31, 1999, Americans had borrowed $228.5 billion to buy stocks. This was up from $141 billion dollars a year earlier. No study has been performed to determine if there is a link between the margin buying power utilized by investors in 1999 and the huge increase in both the Nasdaq and NYSE.
Investors borrow money to buy stock in the hopes that the stock will increase. The stock is purchased on margin and is used as collateral against the value of the loan. If the stock goes up, everyone is happy because the investor can use the profits to pay back the borrowed money, plus the interest charged by the lender. But if the stock price falls, this could result in a margin call - where the broker either requires the borrower to put up more cash or the stock position is liquidated to satisfy the margin loan requirement. Historians of the 1929 crash cite excess margin (it was well beyond the currently allowed percentage limits) as one of the major contributing factors to the stock market crash.
Greenspan, however, has been reluctant to exercise the Federal Reserve Board's authority to tighten limits on such borrowing, saying that studies have suggested that a rising level of stock prices is unrelated to the margin requirements. Yet the NYSE and NASD are seeking changes to increase the minimum amounts a trader must keep in its account. The SEC is also discussing the issue with the Fed, the NYSE and the NASD to "get their prospectus on what is the actual margin situation. "
Whether these changes are needed or are fair to the small investor (who wants to trade on margin with a minimal account), the issue the individual investor needs to be reminded of is that their investment portfolio should always be in line with their risk tolerance. If the investor is utilizing margin, this must be factored in when determining one's level of acceptable risk.
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