Margin Cuts Both Ways

The surge in margin debt since late last year, along with the recent bloodletting in Nasdaq names, has financial writers hissing with contempt for foolish investors that are now (or have ever been) margined. However, margin is like a chain saw: a very useful tool -- if you don't cut off your leg.

For example, did you buy your house on margin? Or did you pay cash in full at the time of closing? (Yes, of course you did -- but I'm not writing to you, Mr. Gates.)

The conventional view today seems to be that it is prudent to have big margin on your house but imprudent to have any margin at all on your stock portfolio. What's wrong -- and what's right -- with this thinking? Can experience with one sort of borrowing inform the other?

There are differences -- critically important differences -- between mortgage loans and margin debt, but they both constitute leverage. Knees jerk at the mention of margin debt, but mortgages are like opinions -- everybody's got one. In a fairly typical situation, the prospective homebuyer puts down 20% and takes a mortgage on the balance, which is to be paid down over 30 years in regular monthly payments of principal and interest (with interest at a rate fixed at the time of loan origination). This pattern is so American that it belongs in the ditty with baseball, apple pie and Chevrolet.

But 80/20 is leverage, and a lot of it. So, from a perspective of financial prudence, is it a bad move? No, not for most of us. In the typical case, it turns out to be a terrific deal. Snug under the thatch, we build equity instead of a collection of rent receipts, and the mortgage interest and real estate taxes are deductible on our federal tax returns.

Margin debt is, as the saying goes, exactly the same ... only different. At 50% initial margin, it may seem at first to be less risky than a 20%-down mortgage loan. But that's about the only metric on which margin looks tamer than mortgages. Two issues are critical: market volatility and the duration (or term) of the loan involved.

Volatility: The market value of a house tends to move gradually with time and, in most locales, the direction has been towards moderately higher prices. In the case of common stocks, market values are adjusted, sometimes violently, on a minute-by-minute basis. Recent action should have established, even for skeptics, that the market is not a ratchet set: What goes up can, in fact, also go down.

Duration: With a long-term fixed-rate mortgage, the lender cedes full use of the money to the borrower on terms that typically prevent the lender from "calling" the loan for repayment on short notice. The house is a long-lived asset financed with a long-term liability. In the case of margin on common stocks, you finance a very long-term asset -- with no maturity. You're in it until a buyer or a bankruptcy court takes you out of it -- with an immediately callable short-term liability. That sort of mismatch is inherently risky. This, when combined with the stock market's potential for volatile price actions, can do to your financial well-being what a chain saw accident can do to your graceful gait.

But isn't there something to be learned from our successful usage of leverage when buying homes that is pertinent to our portfolio investing? Yes, I say.

One, recognize the duration mismatch in margin and dial back the degree of usage accordingly. Just because the Fed and the broker will let you use 100% leverage (i.e., $50 of your money, $50 of the broker's) doesn't mean you have to go there. How about $10, or maybe $20, of the broker's money for every $100 of your own sweet cash?

Two, stocks aren't houses, but some, and most decidedly not others, have price characteristics -- history and prospects -- vaguely akin to a house's. Established franchises with solid balance sheets in relatively stable businesses are inherently less risky than cash-starved start-ups seeking to exploit new technologies. You get plenty of risk in the latter, even if you pay 100% cash for your position. With the former, you can add a little juice to your total return potential by financing somewhat bigger positions in lower-risk stocks through the inherently risky use of margin.

Those who have compounded risk with more risk by aggressively using leverage to position second-tier Nasdaq names, have learned that margin is indeed very much like a chain saw. But those who go to school on their experience with home mortgages might use margin advantageously, to be modestly bigger in some established large-cap blue-chips that they are willing to view as core holdings.

Snug in those securities, they have a good chance of riding out the bumps -- economic, financial and psychological -- without fear of being shaken out. And this while hoping for the long-term prosperity of a great country to do for the market value of their portfolios what it has done for their happy homes.

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