Margin Investors Learn the Hard Way That Brokers Can Get Tough on Loans

For many investors, Friday, April 14, was a frightening day, as the Nasdaq Composite Index plunged a record 355.49 points, or 9.7%. For Mehrdad Bradaran, who had been trading on margin—with borrowed funds—it was a disaster.

The value of the California engineer’s technologyladen portfolio plummeted, forcing him to sell $18,000
of stock and to deposit an additional $2,000 in cash in his account to meet a margin call from his broker,
TD Waterhouse Group, to reduce his $52,000 in borrowings.

At least the worst was over, Mr. Bradaran figured, as tech stocks soared the following Monday—only to learn Monday evening that Waterhouse’s Santa Monica, Calif., branch had sold an additional $20,000 of stock “without even notifying me,” he says. His account, which had been worth $28,000 not including his borrowed funds, is now worth just $8,000, he says. “If they had given me a call, and I had deposited the money, I would have gained back at least half” of the $20,000 in losses when the market rebounded, he claims.

Mr. Bradaran is one of many investors who have discovered that buying stocks with borrowed funds—always a risky strategy—can be riskier than they ever imagined when the market is going wild. That’s because some brokerage firms exercised their right to change marginloan practices without notice during the market’s recent nose dive.

The result: Customers were given only a few hours or less to meet a margin call, rather than the several
days they typically are given to deposit additional cash or stock in their brokerage account, or to decide which securities they want to sell to cover their debts. And some firms, such as Waterhouse, also sold out some customers’ accounts without any prior notice, as they are allowed to under margin-loan agreements signed by customers.

Investors generally can borrow as much as 50% of the value of their stocks. Once the purchase is completed

an investor’s equity—the current value of the stocks less the amount of the loan—must be equal to at least 25% of the current market value of the shares.

Many brokerage firms set stricter requirements. If falling stock prices reduce equity below the minimum,
an investor may receive a margin call. The actual amount an investor must fork over to meet a margin call can be a multiple of the amount of the call. That is because the value of the loan stays constant even when the market value of the securities falls.

Many investors were stunned by their firms’ actions, either because they didn’t understand the margin rules
or ignored the potential risks. There aren’t any public statistics on the number of investors affected, but the
margin calls accompanying April’s market roller coaster have clearly hit a nerve.

Some clients of other brokerage firms were affected as well. Larry Marshall, the owner of an executivesearch
firm who lives in Malibu, Calif., says Merrill Lynch & Co. told him the Monday after the market’s  drop that he would have to meet an $850,000 margin call immediately. Normally, he says, the firm gives him three to five days to come up with additional funds.

A Merrill Lynch spokeswoman says “as a matter of good business practice in periods of extreme volatility,
offices may be asked to exercise the most prudent measures—clearly outlined in our margin policy—to responsibly manage the risk associated with leveraged accounts.”

Clearly, a lot of investors would have benefited from additional time because of the market’s sharp rebound.
But they, and the brokerage firms on the hook for their loans, could have been in even worse shape if stock
prices had continued to plummet.
SOURCE: Abridged from Ruth Smith, “Margin Investors Learn the Hard Way That Brokers Can Get Tough on Loans,” The Wall Street Journal, April 27, 2000.

Long-Term Loans

Plant and equipment purchases and other long-term investments,
including acquisitions of other companies, are typically
financed with term loans covering periods of one to 10 years,
with terms between three and five years being the most common.

Term loans are designed to finance a major cash outlay
and spread the repayment of the loan, including interest, over
a period of time roughly corresponding with the cash flow that
will be available to service the debt. Permanent increases in
working capital, such as those that may arise from entering
new markets, may also be financed in this way.

Term loans are usually tailored to the needs of the borrower,
so no two are exactly alike. However, these loans typically
include a common set of terms and conditions. Besides
the obvious elements required in any loan contract, such as the
interest rate and the payment period, borrowers are subjected
to a series of covenants that mandate certain actions while
prohibiting others. For example, the contract may specify that
the borrower agrees to continue in essentially the same business
over the term of the loan, to grant the bank access to its
books, and to maintain adequate insurance. Submission of financial
statements on a regular basis will also be required. In
addition, the borrower may be prohibited from taking on
other debts without the bank’s consent.

It is also common for banks to impose certain financial tests
on the borrower. For example, the company will be required to

maintain minimum levels of working capital and not to exceed
maximum levels of indebtedness, lease obligations, and dividend
payments. There may also be constraints imposed on the
pay raises that are granted over the loan period to certain corporate
employees. Failure to meet any of these requirements
will put the borrower in “technical default.” This means that
even if all interest and principal payments are made on time,
the company has still violated the loan contract. As a result, the
borrower may be required to renegotiate the debt, with new
terms that are certain to be more onerous and expensive than
the original contract. For many banks, technical defaults are
more common than borrowers defaulting because of their inability
to make the required cash payments.

Another popular form of bank lending is the “revolving
credit,” which combines elements of term loans and lines of
credit. These are formal agreements that require the bank to
lend money provided the borrower is not in default on any of
the terms and conditions in the agreement. The terms and conditions
of the loan are extensive, and the bank expects a commitment
fee in exchange for the service. As with lines of credit,
revolving credits are used mostly for funding working capital.

But there are two important differences. First, the term for revolving
credits can be far longer than for informal lines of
credit, with one, two, or three years being the most common.
Second, revolving credits are not subject to the “cleanup” provision
that is a normal requirement for unsecured lines of
credit. Under a cleanup, typically invoked on an annual basis,
the borrower is expected to pay off all outstanding borrowings.

The cleanup is designed to demonstrate that a company’s need
for the bank’s funds is only temporary and that it has adequate
capital resources to operate the business. Secured lines of credit

don’t follow this practice because the collateral pledged against
the loan is considered sufficient protection for the bank. Likewise,
revolving credits don’t require cleanup. Instead, the borrower
expects to be on the bank’s books for the entire term of
the agreement. But just as for any line of credit, banks insist on
commitment fees before agreeing to revolving credits.



Read More : Long-Term Loans

Short-Term Loans

Short-term loans often take the form of lines of credit, also
known as “loan commitments,” in which the bank and the
borrower agree in advance that the latter can draw against the
credit line as needed up to some maximum limit. Within this
limit, the borrower decides on the timing and the amount of
the borrowings. In this way, lines of credit function much like
credit cards. The main advantage of such arrangements is their
flexibility, allowing the borrower who may need temporary financing
as it accumulates inventory to obtain the funds it
needs to operate, while then paying off the loan after sales
have occurred and cash has been collected from customers.

Bankers like these arrangements, too, because they take up
less of the loan officer’s time. Of course, before such financing
can be extended, a detailed analysis of the borrower’s creditworthiness
must be completed. The loan officer evaluates the
purpose of the credit line, the prospects for repayment, the
maximum amount that the bank is willing to lend, compensating
balance requirements (i.e., bank accounts that the borrower
is required to maintain), and the interest rate charged.

The line of credit can be secured (with specific assets pledged
against it) or unsecured; it can be fixed-rate or floating; and
the underlying note can be a demand note or fixed-term. But
in nearly all cases, the line of credit is short-term, often lasting
only 90 days. Although lines of credit are normally confirmed
in writing, the nature of the agreement is informal, with
bankers reserving the right to cancel or amend the agreement

at will. In addition, letters of confirmation typically state that
loans may not be available if the borrower’s financial condition
changes for the worse.
Read More : Short-Term Loans

Bank Loans

The profound changes that have occurred in the financial services
industry over the past half century are nowhere more evident
than in banking. Given that banks are typically the first
financial institution growing businesses turn to for capital, we
now consider the structural changes that have occurred in the
banking sector, and what all this means for entrepreneurs who
seek debt finance. Any business owner seeking to access the
capital available from the global banking system should have
at least a basic understanding of these changes and how they
have shaped today’s financial services industry.


The most important reality for traditional banking over
the last generation has been its decline in both size and profitability.
At the core of traditional banking’s problems have
been declines in its cost advantages in acquiring funds (the liability
side of the business), while at the same time losing
some of its income advantages (the asset side). The result has
been an effort by banks to leave, or at least curtail, the traditional
business of deposit taking and conventional lending,
while engaging in a range of new and potentially more profitable
activities. One problem with these activities, however,
is that they are often riskier than more traditional banking
functions, as evidenced by the large number of banks that
have failed in recent years or that had to be taken over by
more profitable rivals.

One important contributing factor to the declining profits
of traditional banking in the United States was the effect of
rules that prohibited banks from paying interest on checking
accounts. These rules worked to the advantage of banks, at
least until the 1960s, because their major source of funds was
checkable deposits. Given that the cost of these funds was
zero, banks had a very low cost of capital. Although savings
accounts did pay interest, the rate was capped at little more
than 5 percent. But the good times for bankers didn’t last.

Rising inflation in the late 1960s and early 1970s led savvy
investors to seek more attractive alternatives. By the late 1970s,
money market mutual funds began to appear. These funds offered
checking accounts but were structured in a way that allowed
them to circumvent the restrictions on paying interest. As
a result, millions of people took their money out of banks and
put it into these higher-yielding investments. Today, checkable
deposits account for less than 20 percent of bank liabilities; as

recently as the 1960s, such deposits accounted for more than 60
percent of the total. The regulatory structure of the banking industry
gradually caught up with these realities with a series of
rules changes, starting in 1980, overturning the interest-rate
ceilings. But by then the damage to the competitiveness of banks
had already been done.

Just as banks were suffering on the cost side, they lost
their advantages on the income side, too. Traditionally, businesses
relied mainly on bank loans for new debt capital, offering
bankers an effective monopoly on the provision of debt
finance, apart from the largest, most creditworthy firms that
could access the bond markets. But within the past 25 years,
the banking industry has been badly hit by a seemingly
nonending stream of financial innovations, including junk
bonds, securitization, and the market for commercial paper.

Perhaps the most important effect of this development is that
traditional commercial banking lost the advantage it once enjoyed
in the commercial lending business (and the higher returns
that came with that advantage), while businesses of all
sizes now have more avenues available to them for raising
debt capital.

These changes have not been limited to the United States.
Similar effects have been observed in Canada, in Europe, and
in some Asian countries. The impact of these changes on the
banking industry is much as one would expect: A growing
number of bank failures and extensive consolidation of the
sector through mergers and acquisitions. But bankers have responded
in other ways, too. For example, some have tried to
maintain their commercial lending businesses by expanding
into new and riskier areas of lending such as commercial real
estate and leveraged buyouts. Another response has been to fo-

cus on off-balance-sheet services and various forms of financial
innovation, including those mentioned earlier, that offer
the prospect of higher margins than are found in traditional
banking. As a result of these changes, banks today bear only a
superficial resemblance to banks of the 1960s.

Off-balance-sheet activities involve the trading of financial
instruments and the generation of income from fees and loan
sales, activities that affect profits but do not appear on bank
balance sheets. As the term loan sale implies, the bank sells all
or part of the cash stream from a specific loan, thereby removing
the loan from the balance sheet. The profit comes from
selling the loans for amounts slightly greater than those of the
original loans. But the interest rates on these loans are still
high enough to be attractive for investors, mainly large institutions
such as pension and mutual funds. Fee income is generated
by providing banker’s acceptances (in which the bank
promises to make debt payments if the party issuing the security
cannot), making foreign exchange trades on behalf of customers,
and a range of other activities.

Financial innovation has been the catalyst behind many of
the changes observed since the 1970s in the financial services
industry. Some of these innovations have become so integral
to the industry, it is hard to imagine a modern financial sector
without them. Innovations take on many forms, but they have
always been driven by the never-ending desire of banks and
other major players in the capital markets to improve their
competitive positions. Changes in the economic environment,
combined with regulatory changes and advances in information
technology, have helped to create these opportunities.

Automatic teller machines and home banking via the Internet
are just two examples among many. So, too, are the futures,

swaps, and options contracts that allow corporate clients
to better manage currency, price, and interest-rate risks.

To banks, one of the key attractions is that these riskmanagement
tools have become important sources of fee income
and commissions, as well as allowing banks to manage
their own business risks.

Another important innovation has been the development
of “securitization,” in which a wide range of assets—such as
mortgages, credit card loans, accounts receivable, automobile
loans, and computer leases—are converted into marketable securities.

The process works like this: A bank combines loans in
pools with similar features, and sells certificates that are secured
by the interest and principal payments on the original
assets. This arrangement offers several advantages to bankers.

First, the activity is profitable, with banks collecting fees from
the securitization process. In addition, as long as the bank sells
the certificates without recourse (which means that they have
no liability on loans in the pool that go bad), they are not required
to allocate loan-loss reserves.

A further advantage of securitization is that it frees up
funds for further loans (and more profits). Just about any type
of loan can be securitized as long as the candidates for the loan
pool are similar regarding size, collateral, pricing, and maturity.

Also, they must show reasonably predictable losses over
time. Commercial loans are one type of loan that normally do
not fit these criteria, because they tend to be negotiated on a
contract-by-contract basis and exhibit substantially different
characteristics. For this reason, commercial loans are not good
candidates for securitization. More specialized lending, such as
car loans and credit card receivables, are more standardized
than commercial loans and have been successfully securitized.

Nevertheless, growing businesses do benefit from securitization
because of its effect on capital requirements.

Capital requirements exist to protect deposit insurance
funds in case a bank fails. If a bank should fail, regulators,
such as the Federal Deposit Insurance Corporation (FDIC) in
the United States, can either pay off depositors or arrange for
another financial institution to buy the failed bank. Minimum
capital requirements provide a cushion that can lower the cost
of either alternative. But these requirements constrain growth
and thus limit the ability of banks to take on risks that might
lead to failure. One effect of off-balance-sheet lending is that
because the loans disappear from the balance sheet, the capital
that would otherwise be required for regulatory purposes is
freed for other uses, including additional loans. This is the major
benefit of securitization to growing businesses that seek
debt capital from banks.
Read More: Bank Loans