Investors Fear Dreaded Margin Call

RENEE MONTAGNE, host:

This is Morning Edition from NPR News. I'm Renee Montagne. President-elect Barack Obama will host a high-powered group of economic advisers today, to discuss the turmoil he'll be inheriting. He'll be responsible for the financial rescue plan directed at banks and we'll hear how that's going in just a moment. In the past two days, the Dow Industrials have lost most than 900 points, about 10 percent of the value. It's been a painful ride for investors and for those who practice something called, "margin trading," It's been especially brutal. A lot of people who studied the market say much of the recent turbulence is tied to margin trades that lost money. NPR's Jim Zarroli explains.

JIM ZARROLI: Until last month, Aubrey McLondon was one of the country's richest men, a major shareholder in the natural gas company Chesapeake Energy. Then he got what's called a margin call, and almost overnight he was force to sell a half-billion-dollar stake in the company at a huge loss. In a conference call with investors, McLondon sounded philosophical.

Mr. AUBREY MCLONDON (Chief Executive Officer, Chesapeake Energy): Tough deal but life isn't always fair and right, been good to me and so I have moved on.

ZARROLI: McLondon was only one of many investors tripped up by margin calls during the recent market meltdown, and it wasn't just individual investors who were hit, so were a lot of big institutional investors like hedge funds. The damage was so broad in part because of the nature of margin trading. Let's say you have a million dollars to invest. By going to your broker and opening a margin account, you can put all that money into stocks and also borrow additional money from the broker and invest that as well but there's a catch. George Jones, a professor of finance at Columbia Business School, says before you can borrow you have to pledge a certain amount of that stock as collateral.

Professor GEORGE JONES (Finance, Columbia Business School): When you borrow money to buy stocks or buy any asset, the lender basically wants to be sure that he gets paid back. And so, he will insist on having some sort of deposit in order to protect his loan.

ZARROLI: Jones says the problem occurs when your stock falls, and the collateral you've pledged isn't worth what it once was. Then, the broker gets really nervous.

Prof. JONES: Your broker dealer is going to say, look, I don't have enough cushion there anymore. I'm going to require you to put in additional cash, or deposit more stocks into your account or something that makes me confident that you are going to be able to pay back this loan that I've made to you. That in essence is what a margin call is.

ZARROLI: I mentioned investors come to dread those calls.

Prof. JONES: That's right, and I've actually gotten such a call in my life and yes, it was not my happiest day.

ZARROLI: And Jones says, if you can't raise enough money to satisfy your broker, your brokerage firm can sell off your holdings almost overnight. Only by now, they're worth a lot less, which means once the firm takes its share there may be nothing left. Aubrey McLondon is said to have lost 95 percent of his holdings in Chesapeake Energy. David Coleman, who edits a stock trading newsletter for Argus Research, says the number of margin calls going out to investors recently has risen sharply.

Mr. DAVID COLEMAN (Analyst, Argus Research Group): What has exacerbated this is the significant decline across nearly all asset classes in such a short period of time.

ZARROLI: And this is a big problem for the economy. George Jones of Columbia says federal regulations limit the amount of margin trading that individual investors like McLondon can do; that's not the case with hedge funds. They're virtually unregulated and they've often borrowed many times the value of their assets.

Mr. JONES: The word on the street is that a lot of these hedge funds are liquidating position, paring back a lot of the stock positions that they're holding. Some of that is voluntary, some of that is due to margin calls.

ZARROLI: Jones says these hedge funds have borrowed so much their losses can be considerable. And when they get margin calls, they can be forced to sell off more and more of their assets. And because the hedge fund industry is so big, too much forced selling can send asset values down even further in a kind of vicious circle. Margin calls can be a personal tragedy for investors, but they can also cause big problems for the financial markets as a whole. Jim Zarroli, NPR News, New York. Transcript provided by NPR, Copyright NPR.