Investors return to dangerous margin buys

NEW YORK -- Such short memories these investors have. They got burned before by borrowing cash to buy stocks. And now they are right back doing that again.

Buying on margin, as it's called, is going on at a pace not seen in some parts of the market since the height of the last bull market. And individual investors seem to be behind much of these gains.

Margin buying can result in big returns if stocks go up, but losses can be magnified and holdings wiped out if prices tumble.

"This creates an illusion that people think that they can buy things that they really can't afford," said Brian Orol, president of Strategic Financial Planning Group in Raleigh, N.C.

Margin buying isn't new to Wall Street. Back in 1929, so many investors had bought on margin that it added to the panic when stock prices tumbled during that year's crash.

In the late 1990s, investors, anxious to participate in Wall Street's dramatic rally, saw it as a way to finance their stock buys if they didn't have the cash. Unfortunately, when the market collapsed in 2000, many were left with nothing or even owing money.

But it seems they haven't learned from their past mistakes.

No sooner did the market resume its climb last spring with the most risky and volatile stocks -- including technology, Internet and semiconductor shares -- once again leading the way, than investors increased their margin buying.

Margin loans through brokerage firms registered with the National Association of Securities Dealers have quadrupled this year to $26 billion in July, the latest data available. That tops the $21.4 billion borrowed at the top of the bull market in March 2000.

Margin debt has climbed 10 percent this year to $148.5 billion in July for firms regulated by the New York Stock Exchange, trailing what was reached at the market's last peak.

It's the sharp rise seen at online trading sites that indicates average investors, not just professionals, are doing big buying on credit. At Ameritrade, for instance, margin activity jumped 46 percent to $1.9 billion from April to June, the most recent data available.

This upsurge even spurred the NASD, the brokerage industry's self-policing group, to issue a warning last month reminding investors of the risks of margin buying.

Under Federal Reserve rules, investors can borrow up to 50 percent of the purchase price of a stock.

Brokerage firms don't extend these loans just out of the goodness of their hearts. There is big money to be made on margin accounts, all at investors' expense.

For starters, they charge interest, so investors typically pay around 5 percent on the money they borrow. And that is owed no matter if the stocks rise or fall.

Should a stock bought on margin decline, brokerage firms can issue a "margin call." That comes when investors' accounts fall below certain required levels allowing the brokerage firm to demand payment of part of the loan with cash, a deposit of securities from outside the account or by selling some shares in the account.

Consider this scenario:

You have $5,000 in savings but want to buy $10,000 in stock, so you borrow the remaining $5,000 on margin.

Then the investment suddenly tumbles to $6,000. That causes the account's equity to be worth $1,000 -- the $6,000 market value minus the $5,000 margin loan. But the term on the margin loan may have an account minimum of $1,500. Since that level isn't met, you get a margin call.

This is exactly what forced so many investors to liquidate their margin accounts, often at substantial losses, when stocks plunged during the recent bear market.

"It's not in individual investors' interest to margin themselves because they really can't handle the volatility in the market," said Mitch Zacks, director of research at Zacks Investment Research in Chicago. "They don't have the same discipline of professional traders. ... Individuals have a nasty habit of getting in and out of stocks at the wrong time."

The good news is that not every stock can be bought on margin. Brokerage firms usually set a certain criteria and price levels, usually around $5, that shares must trade above to reduce volatility to some degree.

The trouble right now is that many shares trading below that threshold a few months ago have soared since then, making them eligible for margin purchases.

"You don't want investors buying fly-by-night companies on margin," said Chris Johnson, manager of quantitative analysis at Schaeffer's Investment Research in Cincinnati. "But now some of those companies have managed to climb above those requirement levels."

And it doesn't take a look too far back in history to show how devastating borrowing to buy those shares can be.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck@ ap.org.