NEW YORK - They are dreaded words on Wall Street, and they're becoming more common: margin call.
More money invested in the stock market is borrowed from brokers than ever before, and some investment houses are asking for theirs back through what are known as margin calls. It's one of the reasons why Wall Street has sold off so sharply in recent days.
"It's being referred to as the biggest global margin call in history," said Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors. A flood of margin calls is typical in a market correction, he said, and "it can turn small declines into large declines. That's why leverage is dangerous." - TBO
To reinforce my belief that you should not be trading on margin, comes the news that even professionally-managed hedge funds are getting margins calls.
Why is a hedge fund like Global Alpha affected by events in markets far removed from its bread-and-butter exposure? The root of the problem is high leverage. For example, when this debacle hit, one of Goldman's funds was leveraged 6 to 1, so every dollar of investor capital claimed six dollars of positions. This is the dry kindling for a market firestorm. When things go bad for a highly leveraged hedge fund, it gets a margin call and has to sell assets to reduce its exposure. Naturally, as it sells, prices drop. The falling prices mean a further decline in the fund's collateral, forcing yet more selling. And so goes the downward cycle.
Hedge funds that hold the toxic CDOs (collateralized debt obligations) can easily undermine those that don't. It can be difficult to sell the stuff that's causing the problem; those markets are beyond redemption. So if you can't sell what you want to sell, you sell what you can sell. The fund looks at its other holdings, focusing on the more liquid positions and reduces its exposure there. This causes pressure on these markets, markets that have nothing to do with the original problem, other than the fact that they happened to be held by the fund that got in trouble. Now that these markets are feeling the heat, other highly leveraged funds with similar exposure will have to sell. This leads to another cycle of selling, but in what was up to that point a healthy market unrelated to the initial turmoil. - Time
There is an important difference between you and them getting a margin call. They can go and borrow money to pay their margin call. Part of the recent Fed action was loans made for this purpose. You unfortunately, will have to pony up the money yourself, if you have it. Chances are, given the severe declines recently, your broker did not give you time to meet your margin call and sold some/all of your holdings before you could even react.
Margin accounts make you an investing partner with your brokerage. Unfortunately, their goals are not always the same as yours, and that can really cost you.
Feel free to add in the comments your own experience as there is not much information available on what is happening to small investors.
One issue that apparently has increased the volatility of the market has been a change in the rule for shorting stocks. Before, to short, you could only do so on an up-tic, meaning that the stock just traded up. That rule is now gone. This now allows brokers to short a stock while it nosedives, adding their shares to the pile of those already looking to sell. As supply increases....
You should not be trading on Margin - 9 Jan 2006 (READ)
Congress Should Investigate Short Selling Records - 9 June 2006
Are Brokers 'Screwing' Stockholders through Short Selling? - 6 April 2006
Criminal Charges for Hedge Fund Over Naked Shorting - 9 Dec 2006
Morgan Stanley fined $2.9 Million for Rogue Trading - 26 Oct 2006
Do You Know If You Have A Margin Account? - 2 May 2007