a query

Henry C.K. Liu hliu at mindspring.com
Sat Apr 28 21:59:27 MDT 2001

To be precise, a margin call from a broker who has lent a customer money to buy share
occurs when the spot price of the shares fall below the collateral limit, as Michael
explains.  But a margin call merely asks for more cash.  Only if the customer failed
to come up with the amount needed to make the margin whole again would the broker
have the right to sell force sell the customer's stock.  In a panic, when all brokers
are force selling, a customer not only loses the stock but may end up also owing the
broker for his loss.  When customers cannot cover, brokerages can be forced into
bankruptcy. In 1929, the margin was 90%, meaning a broker will lend a customer $90 to
buy a $100 stock.  So if a share fall from $100 to $90, the margin call will demand
$9.  If the share goes up to $110, the customer would make a 100% profit for his $10
investment.  Today, the margin is 50%.

There is a wise saying in the Street: Never meet a margin call, equivalent to
throwing good money after bad.  In finance, margin limits are the same as the degree
of leverage, in British parlance: gearing.  Margin limits are set by Security
Exchange Commission in the US.
Today, margin limits are less significant, because most portfolios are engaged in
complex, sophisticated hedging through the use of derivatives.

The most damage in the fall of the NASDAQ is focused on dot com millionaires who
chose not to sell or who were prevented from selling due to lock up provisions in the
IPO or insider restrictions. To get money for consumption, such as buying fast cars
and fancy mansions, these paper millionaires are taught by their bankers to put up
their stocks or stock options as collateral for loans, thus also avoiding capital
gain taxes.  When the market value of their shares drop by 90%, these borrowers end
up owing the bank money they cannot repay.  One senator who had a paper net worth of
$40 million borrowed $6 million to finance her successful political campaign.  Her
stocks are now worth around $3 million, leaving a negative net worth of $3 million.
There are hundred of thousands of people in similar situations today, practically
everyone who was engaged in the New Economy.

Henry C.K. Liu

Michael Perelman wrote:

> You can invest in a stock by putting up part of the value, and using the
> stock as collateral for the rest.  When a stock declines, the value of
> your collateral disappears.  Once the collateral cannot cover your loan,
> you get a margin call demanding that you sell your stock to repay the
> loan.
> On Sun, Apr 29, 2001 at 12:02:26PM +1000, Gary MacLennan wrote:
> > I am reading Galbraith's book on The Great Crash 1929.   I especially like
> > his assigning a role to "incantation".  this when everyone repeats
> > endlessly things are fine, things are fine, things are... That is exactly
> > the phase we are in at present in Australia.
> >
> > However my query is (and please excuse an economic illiterate) what is meant by
> > Soon there will be margin calls, and still others will be forced to
> > sell.'(p113) what are margin calls??
> >
> > regards
> >
> > Gary
> >
> --
> Michael Perelman
> Economics Department
> California State University
> Chico, CA 95929
> Tel. 530-898-5321
> E-Mail michael at ecst.csuchico.edu

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