Four Hidden Risks of Margin Debt - TheStreet

Four Hidden Risks of Margin Debt

If you don't know what lurks beneath, margin trading could be riskier than you realize.
Author:
Publish date:

I was stunned to hear about the latest figures on the amount of margin debt carried by U.S. investors. For New York Stock Exchange shares alone, the figure hit a record $285.6 billion in January.

To put that in perspective, the previous peak, occurring at the March 2000 market top, was $278.5 billion.

Even more sobering is thinking that that's almost $1,000 in debt for every man, woman and child in the U.S. We're used to hearing figures like that for the national debt, not margin debt. (Don't worry, the national debt is still larger -- roughly some $27,000 per U.S. citizen.)

What's going on? More investors are leveraging with borrowed funds to chase stock-market returns. They're taking on more risk. It scares me in the big picture because we're all exposed to greater turbulence if the market goes into reverse.

But it also scares me when I consider the individual investor and readers of

The Millionaire Zone

. Margin borrowing is risky, probably more risky than any other kind of borrowing I can think of. And it isn't cheap, either. Most brokerages today charge rates ranging from 9% to 11% and higher (which, in some cases, may be deductible against investment income).

Most investors know that margin trading increases market risk. You're effectively pledging shares as collateral. Since share prices can be volatile, your equity position can rapidly change for the worse.

Safeguards known as minimum maintenance requirements trigger margin calls -- demands for equity infusions -- if equity drops below 30% of the portfolio value. Major exchanges require a minimum maintenance requirement of 25%, but most brokers have set the bar at 30%. Brokers also have different rules, some mandated by the

Federal Reserve

or the National Association of Securities Dealers, for stocks below $10, short sales, especially-risky stocks, "pattern" day traders and other specialized situations.

I'm not going to review all the rules of margin trading; most brokers, including

E*Trade, cover it pretty well on their Web sites.

Click here for the video version of this story from Jennifer Openshaw.

I'm more worried about the hidden risks and pitfalls that the average margin investor might not have considered. These pitfalls can make margin trading more risky than meets the eye -- and more risky than other forms of debt we're more familiar with.

  • Your downside risk isn't limited to the collateral in your account. We're all used to the real estate model, in which, in the event of a calamity, the most you can lose is your home and any equity value you have in it. That's not so with margin. You can be called for funds beyond the equity position in your account, and those funds must come from elsewhere.
  • Your security positions can be sold, without your consent, to meet a margin call. Now, imagine your mortgage company selling your house -- without telling you -- to meet a collateral obligation! No way. Brokerages can do pretty much what they want, when they want, without consulting you, to meet minimum maintenance requirements. And it probably won't be what you want.
  • You aren't entitled to an extension. You can work with almost any other creditor to negotiate a late payment to keep the loan in force. Not so with margin loans.
  • Minimum maintenance requirements can be changed at any time without written notice. This one's the worst of all, and for that matter, interest-rate changes don't have to be disclosed, either. So the deal you think you have with your broker can change at any time.Fortunately, recent history suggests brokers rarely change the minimum maintenance requirement and have only made minor tweaks to the interest rates. But in a panic, who knows? And that's just when you would want stability.Also, don't forget they can change the maintenance requirements for individual securities. So if you hold 500 shares of Autobytel (ABTL) in an E*Trade account, the minimum maintenance requirement is 50%, not 30%. Such a change might trigger a forced sale. And they can go all the way to 100% maintenance requirements, again without notifying you.I'm a big proponent of disclosure, and this lack of disclosure is scary.

I'm not saying you should avoid margin altogether; it has its place for those who know what they're doing. But that also means knowing the traps and pitfalls, along with the ropes.

Jennifer Openshaw, a passionate advocate for helping Americans improve their finances and build their personal fortunes, is CEO of

The Millionaire Zone and America Online's personal finance editor. In addition to appearing regularly on TV shows such as "Oprah" and "Good Morning America" and on CNN, Openshaw is host of ABC Radio's "Winning Advice" and serves as an adviser to some of America's top corporations. Her new book,

"The Millionaire Zone," hit bookstores in April 2007.