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Margin Calls Have History in Market

Consumer VIEWS

October 29, 1987|DON G. CAMPBELL | Times Staff Writer

Question: After the drop of more than 100 points in the Dow average (Oct. 16), a lot of newspaper stories and television commentators talked about the influence of "margin calls" on the falling prices. I know that this has something to do with people who buy stocks on credit, but I haven't seen any explanation of why and how it works. Can you help?--B.W.

Answer: And little did either of us know how trifling that 108-point drop in the Dow Jones Industrial Average would seem just three days later in the face of an historic 508- point collapse.

Yes, you're right, margin has to do with buying stock through a broker with the broker putting up half the money for the purchase. Lending money for this purpose is a sizable source of revenue for brokerages, but until the collapse of the market in 1929 it was pretty well unregulated, and buying stock with as little as 10% of the price was quite common.

After that painful lesson, though, the Federal Reserve Board took over in 1934 and now tightly controls the margin-buying rules through its Regulation T. The margin, since then, has never been lower than 40% (from 1937 to '45); the 40% figure was put into effect for the purpose of stimulating participation in the market at a time when stocks were decidedly out of favor. And the margin has been as high as 100% (in other words, forget it) from January, 1946, to February, 1947, a period in which the Fed was seeking to cool off what it regarded as overstimulation. It's been at the 50% level since '74.

There's nothing particularly mysterious or dangerous about the practice under normal circumstances. You, the investor, buy 100 shares of a stock selling at $30 a share and put up half of that amount, or $1,500. The broker puts up a like amount and, for collateral, physically holds the stock.

The advantage to the investor is not simply that he has to put up less money, but in the leverage involved. In other words, if he had paid cash for the $30 stock ($3,000) and it subsequently doubled by the time he sold it at $60, he would have a 100% profit. But by buying it on margin and \o7 then\f7 selling it at $60, he doesn't have a 100% profit, but a 300% profit because, in collecting his $6,000 selling price, he has never at any time had more than $1,500 in cold cash at risk.

Unfortunately, leverage has a similar kick on the downside, and a 50% drop (if you had paid in cash) translates as a 100% loss for the margin buyer. The Fed's rule is that the customer must put up additional margin at any point where, if he sold the stock and paid off the broker what is owed him, the amount remaining would be less than 25% of the current value of the stock.

For instance, going back to our $30-a-share stock, what happens when the stock drops to, say, $20 a share? At this point, if he sold it, the customer would realize $2,000, but, unfortunately, he owes $1,500 of this to the broker. And the remaining $500 is exactly 25% of the current price ($2,000), and the minute it drops to 19, he's going to get a call from his broker to put up more margin. If he doesn't, the stock will be sold.

Another way of looking at this is to realize that a call for more margin will go out whenever the price drops below the level where--if you were coming in, fresh, as a margin buyer--the broker would put up half the cost.

In the example above, when the price dropped from $30 to $20, we had a situation where the brokerage could not lend more than $1,000 to a new margin buyer--but, because you came in earlier, in balmier times at the $30 price, you owe him $1,500, and that's 75% of the market price, not 50%. That means you're going to have to come up with an additional $500 to stay within the Fed's guidelines. And the average investor is inclined to view such a move as throwing good money after bad, leaving his broker with no recourse but to sell it out from under him.

Back in 1929, in the good old 10%-down days, if you bought 100 shares of stock selling for $150 on 10% margin ($1,500), the stock had only to drop to $147 a share before you were in trouble. (You would sell at $14,700, but you owe the broker $13,500.) Thus, $14,700 less the debt of $13,500 is $1,200, and 10% margin on a $147 stock is $1,470. So, after a mere three-point drop in the price of the stock, you already owed the broker $270. With many of the more popular stocks in 1929 dropping 10, 20 and 30 points in a matter of hours, the snowball effect on all of those 10% margin accounts being dumped was horrendous. While margin selling last week undoubtedly had a depressing effect on prices, it certainly wasn't the factor that it was in '29.

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