Investors: Don't Borrow Money to Buy Stocks

Much of the recent market decline has been due to forced sellers like hedge fund and mutual fund managers that have had no choice but to sell stocks they own due to redemption notices from their panicked investors. In many cases, forced selling has also taken the form of margin calls.

Consider the shares of long time Peridot favorite Chesapeake Energy (CHK) which fell 50% in just the last 3 days of last week. The stock movement felt like panic selling and late Friday we learned that the company's largest shareholder (the co-founder and CEO) was forced to sell most of his 5% stake in the company between Wednesday and Friday. Why? To meet brokerage margin calls that were triggered because he had bought the shares in part with borrowed money.

For the most part, I would never recommend that individual investors borrow money to buy stocks. Every so often there are arbitrage opportunities that can be completely hedged and therefore using margin can pay off if downside risk can be hedged away, but speculating on a stock price's future movement based on fundamental bullishness (as was the case with CHK) with borrowed money is a recipe for potential disaster.

Aubrey McClendon, Chesapeake's CEO, has paid the ultimate price by being forced to sell 94% of his stake in his own company in the middle of one of the most panicked weeks the market has ever seen. Don't make the same mistake he did by speculating with borrowed money. Leverage has crushed the investment banks, but it can get individuals in deep trouble too.

Full Disclosure: Peridot was long shares of CHK at the time of writing, but positions may change at any time.

Comments

[quick:]

So I'm wondering, how can we tell if insiders are buying on margin or not? Does anyone know if there's a way to tell in any of the forms they file with the SEC?

thanks.

2008 Oct 14 01:57 PM

[User 265729:]

But Chad,

This worked in the 1920's... Until there was a margin call, that is. But hey! Look! Bush-Paulson will bail the banks out of anything, so borrow away at those investments! Hey! We could even create a Dow Bubble -- haven't had one of those yet!

2008 Oct 14 02:16 PM

[CLH:]

Buying stocks on margin is similar to borrowing to buy a house. It makes sense if you buy the right ones and dont over leverage. Much easier to borrow too much for a house which sometimes can be bought with no money down. With stocks you must pay 50% down so they are less risky.

Of course there are ways to get around the 50% down rule with stocks which makes them more risky. (buy ultra stocks with margin). This is dangerous but very common.

2008 Oct 14 02:18 PM

[Chris B:]

Hmmm... That kind of makes me question the judgement of this CEO.

If this is his idea of portfolio management, imagine the choices he's made with other people's money in the company!

2008 Oct 14 02:44 PM

[jimmy46:]

That kind of makes me question the judgement of this CEO. """

Plus the fact that the board will probably give him millions of options at this low price.

Heads he wins, tails the stockholders lose.

2008 Oct 14 04:22 PM

[Domino412:]

Regarding CHK and McLendon , I guess he was like myself and buying up shares as they became cheaper due to the decline in Nat gas prices. When shares hit the teens Friday, I scooped up a handfull more. I've been buying CHK and other gas plays since CHK hit the 40's a few months back. I still believe Nat gas will hit 8 to 9 bucks by late winter. Come on, you know we wont see cheap heating bills this winter! And you gotta have it. I see CHK hitting 40 again by January. No, I won't be buying on margin.

2008 Oct 14 09:49 PM

[Evan Grey Owl:]

Thank you for you honesty in advising against use of margin. Some firms use complicated risk measures in which stocks can fall into one of four or more categories of marginability. The initial allowed equity to margin ratio is one thing, but the ratio rapidly changes, especially in a volatile market, and it can be VERY difficult to keep on top of what is happening when 5-6 stocks that are each rated differently, are all changing rapidly. It has been my impression that downward price manipulations may even have been engineered for the purpose of producing margin calls, to give greater liquidity to the banks and brokerages. The shares remain in street name, so when artificially depressed prices rebound days later, the benefit is all to the house.
What have we been hearing about day after day except the desperation of the banks and brokerages to have more cash - improve their balance sheets. Trouble is, some of us hadn't volunteered to donate.
One cannot be too careful in this market, or until regulation of the markets is reviewed and reformed significantly. Technicals have been rendered moot recently. It is too distressing. Not right.

2008 Oct 15 08:29 AM

[Evan Grey Owl:]

There was a recent interview (BBC?) in which a fellow who wrote a book called "The Black Swan" ( I think), has written about the problems with the risk models being used by some banks and brokerages, and the harm they are causing. I'm sorry I can't find his name at the moment.

2008 Oct 15 08:32 AM

[Evan Grey Owl:]

From Bloomberg today: "JPMorgan's investment-banking division made $882 million in the third quarter, compared with profit of $296 million the previous year, and revenue rose $1.1 billion." This is very impressive considering the stock market losses and margin squeezes going on right and left. Do they not partner with some major brokerages? Can one know which stocks they or their close affiliates are "market makers" for?

2008 Oct 15 08:49 AM