TCS Daily

Should the Fed Boost Borrowing Rules for Buying Tech Stocks?

By James K. Glassman - February 23, 2000 12:00 AM

Buying stocks on margin - especially high-technology stocks -- is becoming more and more popular, and it's alarming some folks. "Margin buying" is just a fancy term for borrowing, using stocks as collateral. In the fourth quarter of 1999, brokers had $228 billion in outstanding margin debt from their customers, up 62 percent from a year ago. The Federal Reserve has the power to set margin requirements, and for many years it has kept the limit at 50 percent. In other words, in most cases, you can borrow up to half the price of the stock you buy: To own $10,000 worth of, say, Microsoft, you need to put up only $5,000. Your broker will lend you the rest - and charge you the going rate, about 9 percent interest. If the Fed pushed the limit up to 60 percent, then you would have to invest $6,000 and could borrow only $4,000.

I worry more about margin debt at the micro than at the macro level. The economy isn't threatened, but small investors might be. The truth is, leverage (that is, borrowing) is not a good idea for most people. They shouldn't indulge. Why not? Well, the thing that scares investors and causes them to make dumb mistakes is volatility - the ups and (especially) the downs of stock prices. Buying on 50 percent margin increases volatility by 100 percent. Many investors can't stand the current level of volatility; imagine doubling it!

Here's what I mean: The standard deviation of stock returns is about 20 percent on an annual basis. In other words, if you buy stocks, you can expect that in two-thirds of the years they will bounce around 20 percentage points above and 20 percentage points below the average - that is, for the typical stock, between a gain of 31 percent and a loss of 9 percent. That's pretty scary. But margin buying increases standard deviation to about 40 percent, so returns two-thirds of the time vary between a gain of 51 percent and a loss of 29 percent. That's too wild for most tastes. When stocks fall sharply, many investors bail out - at just the wrong time. Margin buying increases that tendency. Also, when the price of your stocks falls, the value of the collateral falls too, and as a margin buyer, you may get a call from your broker to ante up more cash - or else your position will get sold out. Again, the chances you will be a solid buy-and-hold investor diminish.

Still, I don't think the Fed should raise margin requirements - and I am not so sure the Fed should even set them in the first place.

Why not?
Three reasons:
1) The brokerage firms that are doing the lending are free to tighten the rules on their own, and many have already done so. After all, they have the most to lose. If a borrower defaults, the firm is on the line for the debt.

2) Margin buying gives less well-off investors a chance to get into the market. Since I think more Americans deserve to share in the economic and stock market boom, I wouldn't deny them the opportunity to use leverage to achieve wealth - despite my reservations about increasing risk.

3) Finally, if buying on margin leads to mistakes and losses, then investors will learn from their experiences. We shouldn't protect them from the consequences of error. If burned, they're less likely to do the same stupid thing again.

In the end, the answer to the question about buying on margin is to let free markets work their will. The Fed has many other tools to manage money. It shouldn't wield this one.

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