It's Debt Defying

By Bernard Baumohl

Money managers call it the doomsday scenario, forseeing an event that could wipe out investor portfolios and wreak havoc on the stock market. The danger stems not from new financial woes erupting abroad but from something happening here. It is the explosive growth in margin debt--loans Americans take out to buy stocks. Margin debt has shot up to $180 billion at midyear, a 25% increase in just six months and by far the most ever recorded. It now accounts for 1.2% of the stock market's total capitalization.

That doesn't seem like much, but it's a level not seen since the last speculative bubble burst, in 1987. And it's still growing, almost exponentially, rising faster than credit-card or mortgage debt. "We've had an expansion of margin debt the likes of which haven't been seen since the 1920s," says Tom Schlesinger, executive director of Financial Markets Center, a research institute.

When buying on margin, an investor who wants, say, $5,000 of AOL shares need put up only 50% of his own money. The rest ($2,500) is borrowed from a broker. It's a tantalizing deal. If AOL's stock moves up, you make twice as much profit as if you had paid all cash. If the stock dives, though, that leverage works in reverse. But few investors seem to focus on the downside.

How could margin investing turn cataclysmic? Here's the scenario most feared--and most plausible. The combination of rising interest rates, lofty P/E ratios and some unexpected Y2K problems in the period ahead could jolt the market into a major sell-off. Internet stocks would be most vulnerable, but the damage could spread to other equities as well. If a stock bought on margin falls 30%, the stockbroker typically grabs the phone and utters the dread words "margin call." It means you've lost so much money on the stock you bought with borrowed funds that you have to dig into your own pocket to meet the margin requirement or dump stocks you already own to raise the money. If you don't, the broker can sell your securities--and will he ever!--without notifying you. Given the historic level of margin debt out there, a wave of forced selling could lead to a violent downdraft in prices and possibly end the nine-year economic expansion.

Who's to blame for the surge in margin debt? Aha. Some responsibility goes to Federal Reserve boss Alan Greenspan, who complained as far back as 1996 about the market's "irrational exuberance." Yet it is within his purview to raise margin requirements above the current 50%. However, that might tick off Wall Street, which earns more than 8% interest on margin loans. (Brokers are free to raise requirements on their own, and some have.) No Fed chairman since 1974 has moved to lift the limit. Individual investors--and not just day traders--also share part of the blame. Intoxicated by the hot market, many have abandoned all fear of losing money.

What to do? Investors already in hock must prepare a game plan on how they'll raise cash if they face a margin call, says Lloyd Woelfle of American Express Financial Advisers. If you're a novice investor tempted to buy on margin, using leverage is O.K., but you may need to set aside more money than you think to play this game. If you buy on margin, better to stick to high-quality equities, which have a lower downside risk. Borrowing to buy volatile Internet stocks is walking the high wire. And right now that wire is really, really high.

Bernard Baumohl is TIME's senior economics reporter. Personal-finance columnist Daniel Kadlec is on vacation.