INVESTORS BORROW RECORD SUMS OF MONEY TO FINANCE TRADES
by Lawrence C. Melton, Esq., email@example.com
THE HAYES LAW FIRM, www.dhayeslaw.com
Earlier this summer, the Wall Street Journal reported that investors are borrowing record sums of money to finance trades on the NYSE. (See Peter A. McKay, Margin Debt Hits Record $353 Billion on NYSE, Wall Street Journal, July 12, 2007).
Using margin allows an investor to borrow part of the money needed to buy stock from a broker. The portion of the purchase price that the customer must deposit in called margin and is the customer's initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer.
A large percentage decline in your equity triggers a margin call from your broker. This means that the broker is demanding more money (or securities) to bring your position back up to its minimum margin requirement. If you do not come up with the money in time, your position may be closed out. This means that the broker can sell your stock in order to recoup the money you owe.
MARGIN: When the customer borrows funds from a broker, the customer will open a margin account. The customer will pay for part of the securities and borrow the rest from the broker. The portion of the purchase price that the customer must deposit is called margin and is the customer's initial equity in the account. The margin loan is secured by the securities that are purchased by the customer.
MINIMUM MARGIN REQUIREMENT: The law requires that the customer's equity in the account not fall below 25% of the current market value of the securities in the margin account. If it does, the customer will be subject to a margin call.
MARGIN CALL: Broker's demand for additional cash or securities to maintain a minimum margin of 25%. The failure of the customer to provide additional cash or securities will cause the broker to sell or liquidate the securities in the customer's account to bring the account's equity back up to 25%.
Here is an example of how margin works:
If you buy $100,000 of stock with a 50% margin, you will pay $50,000 for the stock and borrow the remaining $50,000 from your broker. Your equity in the account is $50,000 and you receive a margin loan of $50,000 from the broker. You pay 50% and your Broker pays 50%
Assume that later, the value of the securities falls from $100,000 to $60,000. How does this change the situation? The loan remains the same amount, $50,000. However, your equity decreases to $10,000 ($60,000 market value minus $50,000, loan amount). The law requires a minimum maintenance margin of 25%. In this hypothetical, this means that your equity must not fall below $15,000 ($60,000 market value multiplied by 25%). Since the required equity is $15,000, you would have to pay a margin call of $5,000 ($15,000 minimum required equity minus existing equity of $10,000).
See NASD Investor Alert: Purchasing on Margin, Risks Involved With Trading in a Margin Account,available on NASD web page.
The Wall Street Journal article said that margin debt at the NYSE is at $353 billion, which is an all time high. (See Peter A. McKay, Margin Debt Hits Record $353 Billion on NYSE, Wall Street Journal, July 12, 2007).
ASK DAVID HAYDEN ABOUT THE DANGERS OF MARGIN....
On April 21, 2007, the New York Times ran an article entitled The Perils of Being Suddenly Rich. Written by Katie Hafner, the article focuses on the fall of David Hayden, a dot.com Multimillionaire who lost almost everything due to irresponsible use of margin, failure to hedge and failure to diversify.
In 1997 Mr. Hayden established Critical Path, an internet start-up company that handled e-mail for corporations and large Internet service provides. Robertson Stephens, then on of Silicon Valley's premier investment banking firms, stepped in to underwrite Critical Path's initial public offering. In 1990, prior to the public stock offering, Mr. Hayden opened up a margin account with Robertson Stevens.
In 1999 Mr. Hayeden borrowed $2 million from Robertson Stephens, pledging all his Critical Path stock as collateral, as well as any future stock he might receive. In 2000 Mr. Hayden sold $45 million worth of stock, and continued to borrow against the remainder of his stock held by Robertson Stephens. Eventually, the loan was increased, first to $5 million, then $20 million, then $30 million.
Meanwhile, Mr. Hayden became a multimillionaire. He purchased an $8 million mansion in San Fransisco, property worth $4 million in Sun Valley, Idaho, put a down payment on a jet, and purchased an original copy of the Declaration of Independence.
Eventually the use of margin caught up with him. By 2001, Critical Path was in financial trouble. Hayden had to put up his mansion and property as security against his outstanding margin loan. Robertson Stephens continued to seek repayment, which would force Hayden into bankruptcy.
Hayden filed an arbitration claim against Robertson Stephens, claiming mismanagement and breach of fiduciary duties. Hayden lost the arbitration and was required to pay $23,828,209.60 to Robertson Stephens. The arbitrator admitted that if Hayden would have employed a strategy of hedging and diversification he would still be a rich man.