NEW YORK (Reuters) - As thousands of homeowners are realizing it’s unwise to borrow more than they can afford, the NASD is offering a similar warning to investors: It’s risky to invest more than you have.
The brokerage regulator said on Tuesday that the amount of debt that investors took on to buy securities, known as buying “on margin,” had soared to a record $321.2 billion in February.
That topped the previous record of $299.9 billion in March 2000, at the peak of the last bull market in stocks. Margin debt has more than doubled from $141.3 billion in January 2003, the NASD said, three months after the bottom of a bear market in stocks.
With a margin account, investors can borrow money from a brokerage to buy securities. Investors must pay back what they borrow, plus interest, even if their investments lose value.
“Too many investors are unaware they could suffer substantial financial losses,” NASD Chairman Mary Schapiro said in a statement.
Margin investing is risky because investors can lose more money than they invest. Brokerages can also force the sale of securities to meet a “margin call,” causing tax consequences.
“When the Internet bubble imploded, many people were shocked to learn that firms can sell their stock, and they have no choice in what can be sold,” John Gannon, an NASD senior vice president for investor education, said in an interview. “Some firms default you into a margin account, and we’ve heard from investors who weren’t even sure they were in one.”
Regulators, including the Federal Reserve, the New York Stock Exchange and the NASD, set minimum requirements for margin traders. Brokerages are free to set more stringent standards.
Under the minimum requirements, before trading on margin, ordinary investors must deposit at least $2,000 or 100 percent of the purchase price, whichever is less.
Fed rules generally let investors borrow up to 50 percent of the purchase price of securities that can be bought on margin. NYSE and NASD rules then require equity in an account to be at least 25 percent of the securities’ market value in that account, known as a “maintenance margin.”
Here’s how it works: Suppose you purchase $10,000 of stock, paying $5,000 in cash and borrowing $5,000 on margin. If the value of the stock falls 40 percent to $6,000, the equity in your account will fall to $1,000 ($6,000 minus $5,000).
If there is a 25 percent maintenance requirement, you would need $1,500 in the account (25 percent of $6,000). As a result, the brokerage may issue a margin call. If you can’t meet it, the brokerage will sell some of your stock. Sometimes the brokerage may not even consult you before a sale.
“You can lose your money fast and with no notice,” the U.S. Securities and Exchange Commission said.
Gannon said investors must understand how margin accounts work, and their own brokerages’ rules.
“If you trade on margin,” he said, “you need to have an exit plan in case the securities you own start losing value.”