Margin Credit: Is It Too Close to the Edge?

Small investors are borrowing money to buy stocks at a pace not seen since just before the October, 1987 market crash--adding new fire to the debate over just how frothy this bull market can get before it ends.

Margin credit, the amount of debt outstanding against brokerage accounts, reached a near-record $44.02 billion in January, up from $41.59 billion last fall, New York Stock Exchange data show.

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

Investors’ interest in borrowing to buy stocks has risen sharply over the last few months, pushing so-called margin debt to just under the all-time high in 1987-- right before the crash. Source: New York Stock Exchange

Because many brokerages say there has been a surge in margin borrowing in recent weeks, it’s believed that margin credit now has topped the previous all-time high of $44.17 billion in September, 1987.

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 strong signals that market speculation has reached dangerous levels--suggesting that stocks 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 apparently finally topped 1987 levels, the stock market is 25% higher today than it was at the 1987 peak. So proportionately, margin credit should be 25% higher to match the same level of speculation.

Some brokerages also say that relatively few investors play the margin game, despite the large dollar total of loans out. “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 retained a bad image among many individuals since 1987. Even experienced investors often view margin use as a risky practice--which is true to an extent.

The maximum amount you can borrow to buy securities is 50% of their value, by Federal Reserve rule. 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.

But 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 sank.

As the stocks tumbled, some investors who owned 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 new securities, but to retire more expensive debt, such as credit card balances that may be costing the investor 18%-plus in interest.

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

Humm notes that margin debt interest is tax-deductible when used for investment purposes, while consumer interest generally isn’t deductible. So some investors figure it’s logical to pay cash for big-ticket 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 additional risk. Likewise, there’s no mistaking that big margin use indicates a frothier market.

The question is, how much is too much? One encouraging sign is that, while margin borrowing has risen, many other typical signs of excess speculation by individuals aren’t present. In the latest weekly poll of investor sentiment by the American Assn. of Individual Investors, for example, only 34% of investors were bullish, down from 47% three weeks ago.

So people don’t feel that good about stocks. Yet as long as interest rates stay low and the economy remains on track, investors are likely to keep coming back to two conclusions: It’s a good time to borrow, and it’s a good time to buy stocks. That combination suggests margin borrowing can reach much higher heights.