Monday, January 26, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Jan. 26, 1998) -- This may be the absolute worst time to choose to write about the use of margin leverage. The odds are stacking up against the market's having yet another banner year after three in a row (but who knows?); there are endless reasons to be nervous, from the Asian currency crash to the latest in Clinton's ongoing scandal-fest to the possibility of Act II of the Gulf War. But that's exactly why I want to write about margin leverage and the dangers inherent in its use.

It's important to know exactly what you're facing if you are using margin as part of your portfolio. As most of you know, buying on margin simply means borrowing a portion of your total investment from your broker, meaning that only a portion of the money you've staked is your own. The rest is "leverage."

The point in using leverage in the first place is that you believe you'll be able to achieve a better return on the money you've borrowed than the price (the interest) you have to pay to borrow the money. The theory falls apart, however, when your leveraged investments go down or under-perform your interest costs.

How bad can it get, though? The dreaded aspect of margin investing is when one gets a "margin call." That's a call from the broker when the portion of your total investment that's your money falls below a certain percentage of the total value of your holdings. For example, if your broker's margin equity requirement is 35%, that means the portion you own of the stocks you've bought must remain above 35% of the total value of the portfolio. If the portion you own slips below 35%, you have to fork over some more cash to your broker to raise that percentage, or sell some stocks (at a loss no doubt) to reduce your margin balance.

What does it take to trigger such a call? That depends on how much you've borrowed. The maximum you may borrow under current Fed rules is 50% of the total invested. So if you put up $50,000, you can borrow another $50,000.

That $50,000 amount you've borrowed is a relatively fixed sum, though. Whether your stocks go up or down, you still owe that $50,000 plus the interest. So if the portfolio drops in value by $10,000, the loss comes out of your equity. In that case, your ownership ($40,000) is down from 50% of the total portfolio to 44% of the total portfolio. You'd be safe from a margin call.

If the portfolio lost another $10,000, though, you'd have equity of only $30,000, plus the outstanding margin balance of $50,000 (and interest). Now you're getting real close to a margin call. Your equity is only 37.5% of the total, and if it slips under 35%, you'll get the call. Keep in mind that as long as your portfolio stays above the broker's call rate (it differs from broker to broker), nobody will be knocking on your door asking you to send in more cash. The brokerage house will just keep collecting interest on the loan. They don't ask you for a monthly payment or anything, so it's very easy to forget about it and have that interest build up. Pay close attention to your monthly statements to see what you're paying.

Overall, the original investment of $100,000 is only off 20%, but you're already in margin call range. Of course, if you borrow much less than the maximum allowed, your risk of a margin call is greatly reduced.

Let's say you have $50,000 and borrowed an additional $12,500. Now only 20% of your portfolio is from margin. The portfolio total would have to drop all the way to $19,231 to trigger a margin call. That's a portfolio loss of nearly 70% before a margin call would be triggered. Unless you're in very speculative investments or the market disappears, a 70% total loss is pretty far-fetched.

So be sure you understand margin leverage before using it. It's a wonderful tool when used sparingly and carefully. But used recklessly, it can devastate your equity fairly quickly. Fool on!

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