Lael Desmond figured buying stock on margin, or with money borrowed from a broker, was like using a credit card.
So he opened an Ameritrade margin account two years ago with about $30,000 he had saved for medical school. That allowed him to borrow another $30,000 from the online brokerage. He used the money to buy shares in a handful of companies, and as the stock rose in value, he borrowed more.
The 28-year-old Indianapolis medical student admits to not reading the fine print on his margin agreement and assumed his only financial obligation was to repay the principal with interest -- just like with a credit card. He was wrong.
When the market soured in August 1998, particularly for Desmonds Internet stocks, he received a margin call. He needed to add more money into his account to offset losses. He said he quickly wired the money, but it was too late. The brokerage had sold his stocks to recoup its loan.
At no time did I ever think that Ameritrade could come in and wipe out my account, he said.
Desmond sued Ameritrade, and an arbitration panel recently awarded him $40,000.
His case raises questions about the responsibility of online brokerages to protect novice investors from getting burned by unsuitable investments. But it also raises concern that some of those buying stocks on margin may not understand, or are ignoring, the risks.
This concern prompted the New York Stock Exchange and the National Association of Securities Dealers last week to advise member firms to review their margin policies and to continue warning individual investors about the risks of investing on margin.
Margin debt rose 62 percent last year to $228.5 billion. Last month, it jumped to $243.5 billion.
In the past two months, the level of margin debt has surged even faster than the stock market, warned Arthur Levitt, U.S. Securities and Exchange Commission chairman, in a recent speech. In too many cases, investors are focusing on the upside without carefully considering the downside.
The upside is that buying on margin gives investors more buying power and magnifies returns.
Lets say you want to buy 1,000 shares of a $20 stock, a $20,000 purchase.
Under limits set by the Federal Reserve, you can borrow up to half of the value of the stock purchase. So you invest $10,000 of your own money and borrow the rest from a brokerage at an annualized rate of about 9 percent.
Now look at what happens if the stock goes up. Lets say the value of that stock jumps from $20,000 to $30,000, a 50 percent increase. Your gain, though, is 100 percent (minus interest on the loan) because you only used $10,000 of your own money. The downside is that buying on margin amplifies losses. If the stock instead goes down 50 percent, from $20,000 to $10,000, your loss is 100 percent.
The New York Stock Exchange and brokerages require investors to maintain a certain amount of equity, excluding borrowed assets, in their margin account. If equity falls below that level, usually 25 percent to 35 percent with brokerages, investors will be asked to add more cash or securities to the account.
Worse, investors may have to raise money by selling stocks in their margin account just as prices have tumbled. And sometimes, as Desmond found out, the brokerage may step in and sell the stock.
As margin buying has increased, so have complaints. Last year, the SEC received 376 investor complaints involving margin accounts, up from 198 the year before.
Robert Mewshaw, president of Van Sant & Mewshaw in Lutherville, said hes worried that some of those buying on margin are investors who have never experienced a severe market downturn. These investors have grown overly confident, giving themselves -- rather than the bull market -- credit for investment successes, Mewshaw said.
My gut feeling tells me people who are doing it now have no concept of the risks and no fear of the risk, Mewshaw said.
Once the market heads south and margin calls come up, these investors will be forced to sell their shares, deepening the downturn, he predicted.
Diane Swonk, chief economist for Bank One Corp. in Chicago, said some comfort can be taken from the fact that margin purchases have been concentrated in Internet stocks.
If margin accounts trigger a huge sell-off, it will likely be limited to that sector, she said.
Brokerages in the past year or so have taken measures to reduce the risk of buying on margin, said Frank Fernandez, chief economist for the Securities Industry Association.
Some brokerages have raised the level of equity that investors need to maintain in their accounts or have restricted margin purchases by frequent traders, he said. Some have taken other action.
Discount broker Charles Schwab & Co., for example, has stricter margin requirements for about 250 volatile stocks. And Edward Jones, a St. Louis-based broker, prohibits using margin for purchases of high-flying Internet stocks such as Amazon.com and eBay Inc.
Even with these precautions, experts said, margin accounts are suited only for sophisticated investors.
Besides needing experience, margin investors must have the financial means to add to their margin accounts if necessary and a cast-iron stomach to handle quick, hefty losses, experts said.
If you do buy on margin, you can decrease your chances of getting a margin call by using a stop-loss order, said Herman Manakyan, a finance professor at Salisbury State University. That allows investors to set the price at which a falling stock would be sold.
One drawback, though, is that a stock may be sold during a short-term dip, Manakyan said.
Others said margin calls may be reduced with a diversified portfolio, so if one stock plummets those in other sectors might not.
Desmond, the Indianapolis medical student, said he has opened an account with another online brokerage but has stayed away from buying on margin. But his experience with Ameritrade wasnt all bad. During his troubles with Ameritrade, Desmond bought stock in the online brokerage, figuring that the company will make money even if its investors lose it. He said his investment has turned a profit.
Contact Eileen Ambrose at 410-332-6984 or by e-mail at email@example.com.