Margin Credit: Is It Too Close to the Edge?

In another sign of small investors’ huge appetite for stocks, loans used to buy securities have now apparently surpassed the previous all-time high of September, 1987--just before that year’s market crash.

Margin credit--the amount of debt outstanding against brokerage accounts--reached a near-record $44.02 billion in January, according to New York Stock Exchange data.

And because many brokerages say there has been a surge in margin borrowing in recent weeks, it’s expected that the February margin total will top the September, 1987, peak of $44.17 billion.

The continuing heavy demand for stocks by individual investors--on credit and with plain old cash--is helping keep the stock market moving up despite doubts over President Clinton’s economic plan. The Dow Jones industrial average leaped 45.12 points to 3,400.53 on Tuesday, nearing the record high of 3,442.14.

Robert Reed, executive vice president at discount brokerage Jack White & Co. in San Diego, says margin borrowing has rocketed 30% in recent months to “the highest we’ve ever seen it.”

Even heartland brokerages such as Edward D. Jones & Co. in St. Louis, whose clientele normally are the epitome of conservatism, are doing much more lending for securities purchases. “Margin is up 5% to 6% in the last 10 business days,” says John Sauer, a principal at Jones.

Bearish market analysts point to the margin surge, and to the public’s unprecedented purchases of stock mutual funds, as two powerful signals that market speculation has reached dangerous levels--suggesting that stock prices are ripe for a sharp fall.

But some Wall Streeters argue that margin credit, at least, isn’t yet flashing a warning light.

For one, although borrowing against securities has finally topped 1987 levels, the stock market is 25% higher today than it was at the 1987 top. So proportionately, margin credit should be 25% higher to match the same level of speculation in September, 1987.

Some brokerages also say that a relative few investors play the margin game, despite the large dollar total of loans outstanding. “It’s not unusual for only 10% of our investors to be using margin” at any time, says Chuck Humm, senior vice president at Merrill Lynch Credit Corp. in New York.

*

Brokers say margin borrowing has a bad image among many individuals, who see it as a terribly risky practice. That is true, to an extent.

The maximum amount you can borrow to buy securities is 50% of their value. (The Federal Reserve sets the rules.) On 50% margin, your capital multiplies twice as fast in an up market, which is why margin becomes such a sexy idea in bull markets.

What investors forget, however, is that if stock prices crash, you lose capital twice as fast when you’ve borrowed half the purchase price. Example: A $5,000 block of stock bought on 50% margin becomes worthless to the investor if the share price drops 50%, because the brokerage is owed the remaining $2,500 to cover its loan.

Leslie Quick III, a principal at discount brokerage Quick & Reilly in New York, says a few of his clients discovered firsthand the dangers of margin borrowing in February, when biotech stocks plummeted.

As the stocks tumbled, some investors who had purchased the shares on margin were ordered by Quick & Reilly to put up more cash against their loans--or face liquidation of the stocks, so that Q&R; could safeguard the credit it had extended. “We had to jump in there and do some selling,” Quick admits.

Still, brokerage officials note that margin credit can make good business sense if used wisely.

Indeed, because margin loans now constitute one of the cheapest forms of credit available--you can borrow from some brokerages at rates as low as 5.75%--many experts argue that the recent jump in borrowing indicates that individuals are showing investment savvy, not speculative excess.

“We’ve been trying to make people more aware of margin” as an option, says Merrill’s Humm.

Though the overall margin debt figure is $44 billion, not all of that is credit extended to buy securities up-front. Much of the debt represents money borrowed against securities that investors already have sitting in their accounts.

What’s more, brokerages say a significant but undocumented portion of margin debt is being used not to buy securities, but to retire more expensive debt, such as credit card balances that may be costing the investor 18%-plus in annual interest.

Even those investors who are using margin solely to make new securities purchases shouldn’t necessarily be considered speculators, some brokerage officers say.

Humm notes that margin debt interest is tax-deductible when used for investment purposes, while consumer interest generally is not deductible. So some investors figure it’s logical to pay cash for big-ticket personal goods and use margin credit to help fund their investment purchases--perhaps the opposite of what they might have done in the 1980s.

*

Also, most margin users typically don’t borrow the full 50%, Humm says. The level of risk from declining securities prices drops “exponentially” when margin credit use is 20% of the securities’ value, versus the full 50%, he says.

Of course, credit is still credit, and it always adds some additional risk. Likewise, there’s no mistaking that greater borrowing to buy stocks indicates a frothier market.

The question is, how much is too much? As long as interest rates stay low and the economy remains on track, the incentive for individuals to borrow--and to buy stock--remains high. That suggests margin borrowing can reach much higher heights.

“I don’t know where it stops,” says Jack White’s Reed.