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NetTrends: How risky margin trading cost small investors

7/18/2001

Reuters

At the beginning of this year, he was a security guard working in a Silicon Valley office building, earning a modest living and keeping all his money in the bank.

But he was intrigued by the software engineers in the office who boasted about their stock options and tracked their wealth on a stock quote ticker hanging from the lobby ceiling.

Within three months, the security guard had lost $4,800 after he tried his hand not just at investing, but the much riskier practice of investing on margin.

“I had avoided getting into stocks for quite a while, but after watching the ticker all the time I got the impression that if you waited for prices to fall enough, you could do pretty well,” he said.

Although he came late to the game, this security guard, who did not want his name to be used, is like thousands of other novice investors whose losses were magnified because they bought stocks on margin.

Margin buying is essentially buying stocks with money borrowed from the brokerage, on the assumption that the stock will keep going up and the debt will be quickly repaid.

When things don’t go as planned, investors risk having their entire portfolios liquidated without warning, and may even end up in debt if prices fall so swiftly that they do not have enough resources to cover their losses.

TWO THOUSAND DOLLARS AND A PULSE

A lot of people have lost a lot of money on margin over the past year, and they often have no one to blame but themselves. But some recent developments suggest the brokerage companies that enabled so much margin trading may have failed to weed out even the most obviously unqualified customers.

Earlier this month, the National Association of Securities Dealers fined online broker E*Trade Group Inc. for allegedly misleading advertising, citing among other things its claim that it would review customers’ credit histories before approving them for margin accounts. NASD said E*Trade cleared them for trading without running credit checks.

E*Trade declined to comment, and a spokeswoman for the NASD stressed that its complaint related to the narrow issue of the false advertising, and in no way implied any broader legal liability.

Still, some legal experts say the role online brokerages played in enabling so much margin trading may be worth a closer look. They say companies were at best a little bit irresponsible, and in select cases, could be liable for their customers’ losses.

Mark Maddox, a lawyer with the Indianapolis firm Maddox Koeller Hargett & Caruso, represented a medical student who recovered $40,000 from AmeriTrade Holding Corp in arbitration for money he had lost on margin investments.

His client prevailed because the brokerage had liquidated his account prematurely. But Maddox said the experience left him wondering about the responsibility brokerages have to protect their customers.

“It doesn’t make sense that every college student who saved $2,000 from a summer job could be a margin investor,” said Maddox. “There have to be some additional checks and balances.”

AmeriTrade maintains that it strives to educate investors about risks and bans margin trading on a long list of stocks that are especially volatile.

CUSTOMER LOSSES – BROKERAGE GAINS

The companies offering these services are often Internet businesses that stand to make a lot of money on margin loans. Lawyers say this makes their liberal margin trading policies all the more questionable.

“If the extension of margin credit is a profit center, then as part of any business model, brokerages are going to factor in what is the rate of default,” said Philip Aidikoff, a lawyer with the Beverly Hills, Calif., firm Aidikoff & Uhl, which represents investors in securities complaints. “I think it is a significant profit center.”

In its first quarter, for example, E*Trade, posted a net loss of $9.2 million, but showed a $317 million profit from interest income, representing bank loans and margin loans.

Once reserved for experienced investors who understood the risks involved and had the stomach for sudden large losses, margin investing exploded during the late 1990s, due partly to the extended bull market that made it look like stocks only went up.

Thanks to limited requirements from his online broker, Datek, the hapless security guard was able to graduate from first-time investor to margin buyer in a matter of days.

“In the beginning, my experience was so positive that I thought I could amplify my gains by using margins,” he recalled. The security guard, like so many people, thought he was a smart investor when he made more than a thousand dollars within minutes after he first bought stocks in January.

Actually, there had been another factor at play. By sheer coincidence he got into the market minutes before the Federal Reserve made a surprise cut in interest rates, triggering a strong stock rally.

Those gains did not hold for long and the security guard, who had put all his money into volatile tech stocks, was soon scrambling to sell shares to meet margin calls on other holdings that had started to plummet.

If the bull market enticed wide-eyed investors to gamble more than they could afford, the online brokers MAY HAVE nudged them along. Some aggressively promoted the notion of individual investor as a renegade who didn’t need professional advice.

In doing so, some critics said they neglected a NASD rule that brokers must consider an investor’s so-called suitability before making any recommendations. This issue of suitability has never really been resolved with respect to online brokers who advocate hands-off investing.

Requirements for margin investing vary somewhat from company to company, but they are generally minimal. A spokesman for Charles Schwab said it advises its customers about the risks involved, although it still allows anyone it clears for an account, to go ahead and buy on margin.

Now, it looks like the practice of letting investors loose with just their money, their wits, and a disclaimer printed on the Web site may not be enough. In April the NASD sent out a notice reminding members to observe the suitability rule, in view of the “dramatic increase” in online trading.


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