How Buying on Margin Will Break You
May 9th 2012 9:33AM
Updated May 9th 2012 9:34AM
When you're truly confident about an investing idea, it's tempting to try to make the most of it by taking a huge position. But no matter how sure you are that you've got a winner on your hands, you should never leave yourself with the risk of losing everything if it turns out that you're wrong.
That's a lesson that many corporate executives have learned the hard way after making big bets on their company's stock by buying on margin. Yet while some of them have golden parachutes to help cushion them from the financial blow, you don't. You simply can't afford the luxury of making the same mistake they've made.
Yesterday, (NAS: GMCR) announced that it had replaced Chairman Robert Stiller and lead director William Davis in their respective roles on the company's board of directors. Although Green Mountain allowed both to remain on the board, it suspended their compensation for board service until further notice.
Green Mountain took such drastic action because both Stiller and Davis violated the company's internal trading policies. Specifically, Stiller and Davis had bought Green Mountain stock on margin, financing additional purchases of shares using existing holdings as collateral. After Green Mountain's stock plunged last Thursday, the broker handling Stiller's and Davis' accounts sold stock to cover the resulting margin call. Davis sold almost 550,000 shares, while Stiller had to sell 5 million shares to cover margin loans.
If you think that the experience of those Green Mountain executives was unique, think again. Many times in recent years, company management has found itself in a jam after betting too aggressively on company stock.
(NYS: CHK) CEO Aubrey McClendon may be in the hot seat right now because of loans related to ownership interests in the company's wells, but four years ago during the height of the financial crisis, McClendon was in a different kind of bind. After the crash in energy commodities prices that brought oil prices falling from nearly $150 to eventually bottom out below $40, Chesapeake shares plunged -- and McClendon ended up losing just about his entire holdings in the company, which at their peak had represented around $2 billion in value.
The market's plunge in 2008 and 2009 prompted a number of similar episodes. Former General Growth Properties (NYS: GGP) president Bob Michaels ended up having to sell 1.2 million shares within just a couple of months, and was just one example of a number of General Growth insiders having to liquidate positions to meet margin calls. Similarly, in 2009, former Cedar Fair (NYS: FUN) CEO Dick Kinzel had to dump 13% of his shares to cover loans, while two key insiders at Heartland Payment Systems (NYS: HPY) sold out of millions in personal stock holdings after the stock lost three-quarters of its value.
In theory, margin seems very attractive. With some brokers offering margin loans at rates below 2% right now, using margin to buy dividend stocks can actually leave you with positive cash flow even after paying interest.
But if the market goes south, your margin loan can come back to haunt you in a hurry. Moreover, even if your shares don't fall in value, any change in margin requirements -- whether it comes from a stock exchange, a regulator, or the broker itself -- can leave you scrambling to come up with cash. If you can't, then the broker will raise that cash the hard way: by selling you out.
No matter how much you think that a stock you own is going to go up, it's not worth staking your entire financial health on one call. If we've learned anything in recent years, it's that anything can happen -- and if you're not prepared for the worst, you're much more likely to find out just how bad the worst can be when it comes to pass.
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At the time this article was published Fool contributor Dan Caplinger has used margin occasionally over the years, but always with the awareness that he was playing with fire. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Green Mountain and Chesapeake Energy, as well as creating a lurking gator position on Green Mountain. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy doesn't bend and never breaks.
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