The failure of a Falls Church brokerage firm, the suicide of a Wisconsin investor and the explosion of gunfire in a Florida investment office last week were triggered by two words dreaded by market speculators: margin call.
A margin call from a broker means an investor must put up more cash to avoid losing what he has already invested.
A margin call means investors have used up the safety cushion in their brokerage accounts. They have already lost a substantial amount and face a difficult decision: They can either come up with additional cash to protect their investments or they can sell out, losing part of those investments in the process.
A margin call is a moment of truth not only for the investor, but also for the broker and the entire national economy. If the customer can't or won't pay, the broker must absorb the loss. And if the broker can't pay, it goes out of business, stiffing its creditors with further losses. After the crash of 1929, unpaid margin calls contributed to a domino chain of failing brokers and banks that led to the Great Depression.
Federal regulations imposed since then have both limited investing on margin and restricted the potential damage to the markets. As a result damage to the markets. As a result, margin calls today are far less threatening to the system, but still frightening to those who get them.
In the tumultuous two weeks just past, three groups of players have been hit by heavy margin calls in the stock, stock index futures and stock index options markets.
Some stock investors who bought shares "on margin" -- or borrowing from their broker -- faced substantial losses when the stock market plummeted.
Even greater losses were suffered in the stock index futures and stock options markets, where aggressive investors trade promises to buy or sell imaginary portfolios of stocks at some future date.
Financial professionals stress that the term "margin" has different technical definitions in the stock and futures markets, but the words "margin call" mean the same thing: The customer has to come up with money to cover losses.
In stocks, margin is a down payment, the first installment of the purchase price of the shares. The investor puts up half the price of the shares in cash and borrows the rest from the broker.
In the futures and options markets, what is called margin is not a down payment, explained John Damgard, chief Washington representative for the Futures Industry Association. Such traders aren't making a down payment on anything: They are making a promise to buy or sell something in the future. The margin is really a good faith deposit, a sum of money the customers put up to show their intent to keep their promise.
Since the Great Depression, the Federal Reserve Board has regulated credit for purchasing stocks, but since futures margins are not down payments on loans, they are not regulated.
For many years the Fed has required a 50 percent margin on stocks. Futures margins run about 7 percent to 10 percent of the value of the contract, and options margins are even smaller.
As a rule of thumb, futures margins usually amount to what the customer might reasonably expect to lose in one bad day in the market. That rule has been splintered by recent stock market volatility, which has produced single day losses up to four times the minimum margin requirements set by the exchanges.
Purchases of stocks on margin have been rising steadily since the stock market began to take off. Five years ago total margin debt was only $10 billion; as of September it was $44.2 billion, according to the New York Stock Exchange, which collects the data from brokers in all stock markets. Margin debt grew from $25.3 billion as of September 1985 to $34.6 billion a year ago and jumped by almost $6 billion between June and September of this year.
Much of the stock buying on margin has been done by investors who saw the stocks they owned climb in value by 50 or 100 percent but who did not want to sell their shares. Instead, they used their increasingly valuable stock as collateral for margin loans to buy more stock.
Stock brokers have encouraged their customers to buy stocks on margin -- and to use their profits to buy still more stock on margin -- because the practice enables both customers and brokers to make more money. Customers made more, because they invested borrowed funds; as long as stock prices increased by more than the cost of borrowing, the customer came out ahead.
The brokers, in turn, made money on the interest they charged their customers on margin loan accounts. And they collected commissions on the stocks their customers purchased with margin loans.
Unmet margin calls was blamed for two brokerage problems last week. Charles Schwab & Co., the nation's biggest discount broker, revealed Thursday it lost $22 million because a corporate customer failed to make good on loses suffered trading stock options. The closing of First Potomac Securities Corp. of Falls Church a few days earlier was blamed on the failure of two large customers to meet margin calls.
In the Chicago futures markets, margin calls the week following Black Monday totaled more than $6.1 billion. About $1 billion of that money was to cover increases in margin requirements imposed by the exchanges. The other $5.1 billion was to cover losses, said Roger Rutz, president of the Board of Trade Clearing Corp., which processes the paperwork of futures transactions.
Futures contracts and options are promises to buy or sell something at some future date at a price agreed upon today. A bakery can buy a futures contract for a carload of wheat to be delivered next July and be sure it will not only have the wheat when it needs it, but know in advance what it will cost.
Since their origin as the nation's principal market for agricultural commodities, the big Chicago futures markets have applied similar techniques to everything from bacon and orange juice to Treasury bonds and blue chip stocks.
Someone who thinks stock prices are going up can buy a stock index futures contract based on the Standard & Poors 500 stock index.
The futures contract represents a basket of the 500 stocks. Every time the S&P index moves up 1 point, the value of the stocks -- and the contract -- increases by $500.
Stock index futures traders never actually get the 500 stocks, but they can cash in their contract any time, collecting any profits or paying any losses they have suffered.
Futures margins are not regulated by the government; instead they are set by the rules of the exchanges and by the broker's own house rules, which often require bigger margins than the exchange minimums.
Until earlier this month when margins were increased in a series of steps, the Chicago Mercantile Exchange required a minimum margin deposit of $10,000 on its popular S&P 500 Stock Index Futures Contract.
Most brokers, however, required small investors to put up at least $25,000 and in some cases as much as $40,000 as margin.
Even the $40,000 figure proved only adequate to cover losses on Black Monday, Oct. 19. On that day, the price of each S&P futures contract plunged from about $141,000 to $101,000, requiring traders to meet margin calls of as much as $40,000.
In the financial futures markets, such as the Chicago Mercantile Exchange, margin calls are handled electronically and are made twice a day. The exchange's computers total up the profits and losses on all accounts and automatically tell each exchange member how much they owe. The members have half an hour to send the money by a wire transfer or lose their trading privileges.
On the busiest days last week, the Mercantile Exchanges made two extra margin calls, to be sure the member brokers could meet their obligations. All the calls were met, said exchange president Jack Sandnor.
The brokers in turn generally give their customers three days to come up with the cash, but last week, brokers began calling immediately to be sure the customers would make good.