BUSINESSWEEK ONLINE : APRIL 24, 2000 ISSUE
FINANCE Commentary: Margin Debt Isn't the Problem The volatility story you often hear is this: Americans are borrowing like mad from their brokers to buy stocks. Leverage is making the stock market seesaw violently. So the Federal Reserve should raise margin requirements on broker loans to calm things down. The logic seems impeccable, but the facts are different. The Fed should stick to its current plan: Crack down on the few brokers that overlend to unprepared investors, and leave margin requirements at 50%, where they have been since 1974. For the most part, the system is working. Brokerage firms are taking the unpopular but necessary step of raising margin requirements on scores of volatile stocks, or barring loans on them entirely. The first problem with the case for cutting back on broker loans is that they aren't all that big in the first place. Even though margin debt has risen recently, it is still well below 2% of total stock-market capitalization. It's hard to see how margin calls could trigger or exacerbate a stock crash. Second, a slew of studies over the years have failed to show that higher margin requirements reduce volatility. A 1997 survey of the literature by Paul H. Kupiec, a former senior economist at the Fed, concludes that there is ''no undisputed evidence... that margin-related leverage is an important source of 'excess' volatility.'' How could that be? Well, if many of the investors who buy on margin tend to buy when prices get low and sell when they get high, they could actually dampen market swings. If that's so, restrictions on broker loans could actually add to volatility in downturns by making it harder for cash-short optimists to borrow to buy shares when they're down. Volatility isn't something that can or should be stamped out. Choppiness naturally increases when markets are losing altitude, as the Nasdaq has lately. Plus, volatility tends to be high when price-earnings multiples are high. Why? Investors are pinning their hopes on earnings far in the future, so any tidbit of news that alters expectations about that future will have an outsize impact. Long-term investors ride out dips and swells in the overall market. And they protect themselves from volatility in individual stocks by diversifying. A new study by Harvard University economist John Y. Campbell and others finds that while market volatility comes and goes, company-level volatility has seen a steady upward trend since 1962. One reason is that companies today are more focused--placing bigger bets on narrower markets. Campbell says it takes 50 stocks from different industries to give you as much stability as you got from 20 stocks a decade or so ago. That may come as a surprise to people whose idea of diversification is to own both Cisco Systems and Amazon.com. UPWARD TREND. It could be that stocks have gotten too high. But if the stock market is a bubble, should the Fed really be trying to prick it? While increasing margin requirements probably wouldn't dampen volatility, it just might put a scare into a market that's already plenty nervous. Goldman, Sachs & Co. economist Edward F. McKelvey recalls that in March of 1980, the Fed imposed credit controls at the direction of President Carter. Although the target was credit-card borrowing, the move chilled auto and home lending as well--and contributed to the steepest quarterly decline in GDP in 40 years. The lesson: Be careful about spooking the public. A study by Bhagwan Chowdhry, a finance professor at the University of California-Los Angeles Anderson School of Management, concludes that the Fed should raise margin requirements when stocks go up without justification, but leave them alone if stocks go up for a good reason. The trouble is you never know which is the case. What you should never do, says Chowdhry, is raise margins when stocks are falling. With the Nasdaq gyrating chaotically and moving lower in recent weeks, now is not the best time for tough love. By Peter Coy Coy is associate economics editor. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS Commentary: Margin Debt Isn't the Problem CHART: Market Volatility Returns INTERACT E-Mail to Business Week Online

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