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As 'Margin' Borrowing Expands, so Do Worries

More individuals are buying stocks on credit. It can be a profitable strategy--but it also carries high risks. Here's a primer on how margin works.


Individual investors are borrowing more than ever before to buy stock on "margin"--so much so that regulators, and brokerages, are worried about the risks investors are taking.

Total margin debt has ballooned to a record $156.4 billion as of the end of March, up 11% from a year earlier. The total is up 100% from just three years earlier, according to the New York Stock Exchange.

As a percentage of the stock market's total value (as measured by the Wilshire 5,000 index), margin debt has risen from 1.22% in March 1996 to 1.33% last March.

Moreover, it's the type of stock being purchased on margin today that has some brokerages and regulators concerned.

Indeed, some online brokers have recently clamped down on their loans to investors who traffic in risky Internet stocks. Charles Schwab, DLJdirect and Discover Brokerage all have effectively forced customers to put up more of their own cash when they borrow from the firms to buy a wide range of Internet stocks.

The brokerages want to protect themselves from steep losses if their customers' Net stocks suddenly plunge, and the customers find themselves in a financial bind.

Regulators also are concerned about individuals' use of margin. They worry that investors may not understand the risks they're taking, especially during fast-moving markets in which stock prices can swing dramatically.

If you have recently begun to use margin--or if you're thinking about it--this primer has some answers to commonly asked questions about the use of credit to buy securities:


Question: What is a margin loan?

Answer: A margin loan is simply a secured loan from a brokerage firm--secured, usually, by the value of the borrower's investment portfolio.

For example, imagine that an investor wants to buy 100 shares of XYZ stock, which sells for $100 a share, for a total price of $10,000. But the investor has just $5,000 in cash. To buy the full 100 shares, the investor puts up $5,000 and borrows another $5,000 from a brokerage.

Under margin rules set by the Federal Reserve, investors can borrow as much as 50% of the value of a stock on the day it is purchased. In other words, the investor can buy $2 worth of stock for every $1 in cash currently held in the account.


Q: What's the benefit of using margin?

A: Buying a stock on margin can magnify the profit earned if the stock price goes up.

In the example above, the investor buys $10,000 worth of XYZ stock with $5,000 in cash and $5,000 borrowed. If the market value of that XYZ stock then rises from $100 to $150 a share, the investor's account rises accordingly, up 50% to $15,000.

But the investor actually has a 100% gain on the original $5,000 investment, less the cost of the margin loan.


Q: And what's the downside of using margin?

A: Just as gains on margin accounts are amplified, so are losses. If XYZ stock sags to $75, so the account above is worth $7,500, the stock decline is 25%--but the investor will have lost 50% of his original $5,000 at that point.

Should a stock bought on margin collapse, an investor could face huge losses. That's why margin should be used with care.


Q: Can any investor use margin?

A: Yes, within limits. Investors must specifically open a margin account, which involves special paperwork. And the initial amount in the account must be at least $2,000.

Two other requirements: A stock must be designated as marginable by the Federal Reserve. (Some stocks judged too speculative cannot be margined, under Fed rules.)

Also, your brokerage must allow the stock to be margined. Individual brokerage rules regarding specific stocks may be different from the Fed's. For example, Discover Brokerage won't let customers margin any stock priced at $7 or less.


Q: How much does it cost to borrow on margin?

A: Compared with many other types of loans, margin rates are fairly reasonable. At E-Trade, for example, the annualized margin rate is 9.25% for a loan of less than $25,000 and 8.75% for a loan of $25,001 to $49,999.

Investors should shop around to make sure they're getting the best deal.

Extending margin credit is a profitable business for brokerages because the firms borrow at lower rates in the credit markets and make a profit on the spread between what they pay for money and what they charge customers.


Q: When do I have to repay a margin loan?

A: In general, margin loans don't have specified repayment schedules. Investors have the choice of deciding when to pay off a margin loan--as long as the stock price remains fairly stable or rises.


Q: What happens when a stock bought on margin falls in price?

A: The customer could be hit with a "margin call." That means the brokerage asks the investor to deposit additional cash or securities into his or her account to offset the drop in the stock's market value.

If the investor doesn't add the required funds, the brokerage might decide to sell the investor's stock to recoup the value of the loan and the unpaid interest. The investor would get whatever money is left over--if any.


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