Margin: A High Risk, Red Flag For Possible Investor Abuse
argin borrowing to buy stocks is very risky and should be avoided at all costs. That is the opinion of former SEC Commissioner Arthur Levitt, in his book,
Take On the Street
(2002). Mr. Levitt is correct.
Margin involves buying a security but not paying for it in full, instead obtaining a loan from the brokerage firm and using the security as collateral for that loan. One significant risk of margin borrowing occurs when the price of the security falls. If there is a "margin call" (whereby the brokerage firm demands more collateral to be deposited in the account), the investor must comply. Otherwise, the brokerage firm will exercise its right to sell the security. That involuntary sale can result in substantial losses. Thus, the "power of leverage", a sales pitch often made to encourage margin use, quickly turns against the investor, who possibly would have chosen to hold the security hoping for a rebound.
Why do stockbrokers and their firms promote the use of margin? There are several reasons. First, in commission-based accounts, margin allows additional purchases, which generate additional commission income. Second, in fee-based accounts (where the investor pays the stockbroker a percentage of the value of the account in lieu of commissions), the use of margin increases the value of the account, thereby increasing the fee paid to the stockbroker. Third, stockbrokers may receive a portion of their customers' margin interest as compensation. Fourth, brokerage firm branch managers may receive margin interest "credits" for purposes of determining branch office profit, and hence, branch manager compensation.
Investors should heed the warnings of securities regulators. Both the SEC and the National Association of Securities Dealers (NASD) have issued several publications on the topic of margin investing. For example, the SEC published, "Margin: Borrowing Money to Pay for Stocks" (available at
(http://www.sec.gov/investor/pubs/margin.htm).
Cautioning that margin accounts involve "a great deal more risk" than cash (non-margin) accounts, the SEC tells investors to ask themselves four key questions:
Can you afford to lose more money than the amount you have invested?
Did you read the margin agreement and ask your broker whether margin trading is appropriate for you?
Do you know that margin costs you money and that these costs affect your overall return?
Are you aware that brokerage firms can sell your securities without notice when you do not have sufficient equity in your account?
Likewise, the NASD has published, "Investing with Borrowed Funds: No 'Margin' for Error (available at
http://www.nasd.com/investor/alerts/alert_borrowed_funds.htm).
One NASD warning is that some brokerage firms automatically open margin accounts for investors. The NASD stresses that if an investor does not want a margin account, insist on opening only a cash account.
In September, the NASD issued an alert to investors because investors' purchases on margin "have grown dramatically" - 25% since the start of 2003. The alert states that "many investors may underestimate the risks associated with trading on margin and misunderstand margin calls and how their holdings can be liquidated." Accordingly, investors must educate themselves as to the risks associated with purchasing securities on margin. Begin by reading the publications discussed above.
Likewise, lawyers who learn that their clients have utilized margin should consider that to be a "red flag" for possible customer abuse. If the use of margin was unsuitable, or if the risks of using margin were not disclosed, those clients may have a cause of action to recover their investment losses in securities arbitration.
Research
Take On the Street: What Wall Street and Corporate America Don't Want You to Know
Rating:
Levitt, the Securities and Exchange Commission's longest-serving chairman, supervised stock markets during the late 1990s dot-com boom. As working Americans poured billions into stocks and mutual funds, corporate America devised increasingly opaque strategies for hoarding most of the proceeds. Levitt reveals their tactics in plain language, then spells out how to intelligently invest in mutual funds and the stock market. His advice is aimed squarely at small, individual investors, as he explains how to look for clues of malfeasance in annual reports, understand press releases and draw more from reliable sources. Woven throughout are his recollections about the SEC boardroom fights he oversaw. While most of them serve to illustrate a point about the market and its machinations, some passages, often outlining a failure or frustration, are oddly apologetic. In particular, when addressing the origins of recent corporate scandals (e.g., those involving Enron and Arthur Anderson), his effort to lay the responsibility equally on indifferent legislators, special interest groups, greedy CEOs and, perhaps most of all, lazy investors, makes it clear that Levitt wishes to avoid criminalizing corporate officers' actions. (After all, many of them are his friends and colleagues.) The final chapters, detailing how stocks are bought after they're ordered ("Pay Attention to the Plumbing") and retirement plans are structured ("Getting Your 401(k) in Shape") return to practical, profitable advice. One in particular, "Beware False Profits: How to Read Financial Statements," is worth the book's price. Levitt's mini-MBA course-sans the lifelong club connections-should be mandatory reading for anyone with a dollar invested in the stock market.
(Review by Amazon.com)
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