Buying a security such as stocks on margin is a form of leverage. An investor uses funds borrowed from a brokerage company to purchase the equities. The Federal Reserve Board governs margin requirements for brokers such as Merrill Lynch and Wachovia.
Assume an investor contributes 50% to the purchase of $10,000 worth of a stock. The investor sends $5,000 to his brokerage firm and the brokerage firms lends him the additional $5,000 needed for $10,000 total. The term "investor" no longer makes sense because now that person has crossed the line and has become a "speculator" hoping to magnify his gains. The next day the share price falls and his speculative portfolio is worth only $4,000. But the speculator owes the brokerage firm $5,000. Ruh Roh! The speculator gets the dreaded margin call.
A margin call is a demand from a broker for additional cash or securities to bring a margin account back within minimum maintenance limits. Brokerage firms are forced to liquidate holdings if the minimum margin requirements are not met. In the above example, the brokerage firm will likely liquidate the person's holdings and demand an additional $1,000 worth of cash or securities to remain whole.
Hence the vicious spiral down in the equities market. I heard they were going to remove the word 'buy' from the dictionary due to lack of use. I would not reinvest in the markets until all leveraging has been purged.
Sunday, October 12, 2008
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6 comments:
As the market falls speculators are forced to sell. This floods the market, lowering prices even more, which can create some really good values (low P/E ratios).
At a certain point (e.g. when some good economic news comes out), people decide to scoop up those values and the market rebounds dramatically. This is what happened yesterday. I expect to see lots of days like yesterday in the next few years. 16 of the 20 highest single day gains in the dow occurred in the early years of the Great Depression.
You wrote a few days ago that you suspected Paulson of having a hidden agenda wrt/ Goldman Sachs, so I thought you would find this interesting (from today's NY times):
"Of the $250 billion, which will come from the $700 billion bailout approved by Congress, half is to be injected into nine big banks, including Citigroup, Bank of America, Wells Fargo, Goldman Sachs and JPMorgan Chase, officials said."
In response to mpc's comment regarding lpc's comment a few days ago: Amazing that someone who made (I think) 1.2 billion from Goldman can be making decisions to save the very same institution. Regardless of whether the AIG rescue is conspiracy or not, where I come from that is called conflict of interest. What is even more ridiculous was that instead of doing what the Europeans did very quickly and capitalize the banks by taking a stake/partial ownership, the Bernanke and Paulson crew didn't want to do that because they didn't want to see their buddies banks owned by the government. Instead we got a plan to reward those folks by taking away their risky investments. At least there is some indication that they are moving in the right direction although it was much delayed.
Why isn't the media talking about Paulson's potential conflict of interest? I haven't heard a peep out of them about it.
$100 M to top Lehman execs days before bankruptcy
It's nice to see people being rewarded for a job well done.
@ robot elvis
The market will experience massive up swings and sell offs, known as volatility, during this period. But one day moves should not be used to time the market except for short term traders. I would not step back into the market as a long term investor until the VIX returns to under 30% for starters. Fear is at an all time high. The P/E ratio is a backwards looking measure. The outlook for projected earnings is bearish for most companies.
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