Online brokerages, suffering amid lower trading, have another headache: Their lucrative margin-trading business is in a slump.
At most stock brokerages, it's a bromide repeated to customers every day: If you borrow from us to buy stocks, you better be able to deal with the consequences. Margin trading, as the practice is known, is acceptable – but it carries grave risks. Ignore them, and the shirt that's lost is yours.
These days, brokerages may wish they'd taken their own advice, especially online outfits like Ameritrade, E-Trade and Charles Schwab (SCH) . Nearly a year after the market for tech stocks peaked, these online broker are suffering from their own over-reliance on margin loans.
At the time, it seemed to make sense. The country was stock-mad, with everyone from daytraders to schoolteachers chasing tips and pouring their assets into the market. By borrowing on margin, investors were able to buy more stock for their money. Brokerages raked in revenues from their interest payments last year, as investors rushed to borrow money for stock purchases. Some brokers, like Ameritrade, were receiving more than a third of revenues from margin interest, an alarming level considering that trading commissions, not lending, is their core business.
What's more, margin interest offered a much-needed cushion to online brokers during the bull market: As competition drove commissions below $8 a trade at some firms, margin loans were a safe way to pick up the slack.
But now the Nasdaq has lost its shine, and margin loans are drying up. The faded attraction makes sense. When investors expect stocks to slump further, they'll avoid buying them – even more so if it means taking out a risky loan. Indeed, a down market is almost doubly risky: It's not only harder to pick a winner, but if investors pick a loser, they have to put up more collateral when their stocks decline.
That aversion has helped send margin debt down to record levels. The amount of outstanding margin debt fell to $199 billion in January, its lowest level since October 1999. That's bad for companies that had gotten used to a bad habit. What makes matters worse is that sluggish trading already is cutting into commissions.
"The entire discount brokerage business has really been built around margin interest," says Gregory Smith, equity analyst for J.P. Morgan H&Q. "If you can view yourself as covering your costs through commissions, the margin interest is your profitability, so it goes straight to the bottom line."
In bull markets, margin lending seems like an ideal business for brokerages. The borrower may be in a bind, but the brokerages have more protection: They have the right to sell the investors' stock to repay the loan. It's a relatively low-risk proposition for the lender. And the profit margin can be high: The average margin lending rate at Ameritrade, for example, is 8.5 percent, while the firm pays out just between 2 percent and 2.25 percent on cash balances.
Margin lending hit its peak during the Nasdaq's zenith last March, and it's been mostly downhill since then. The amount of margin debt held by member firms of the New York Stock Exchange also peaked last March at $278.5 billion, but by December, the most recent figures available, the number had slumped by 40 percent from that high.
Through the bull market, total margin loans at the major publicly traded online brokerages – Ameritrade, E-Trade, Schwab and TD Waterhouse – crept into the tens of billions of dollars; with the Nasdaq's collapse, they hit a brick wall. Margin debt at those four brokerages fell more than 20 percent to $28.9 billion in the fourth quarter from the third quarter, according to Henry McVey, an equity analyst at Morgan Stanley Dean Witter.
The lion's share of that debt was held by Schwab, the biggest online player. At Schwab, margin interest peaked at $21.8 billion in the heady first quarter of 2000. For the company's fourth quarter, the number had fallen to $15.8 billion, off 27.5 percent from its high.
Schwab's response is to blame the bubble. "Margin loan activity was abnormally high, and it's swung back down to a level that we think is more long-term," says Greg Gamble, spokesman for the San Francisco-based firm.
But Schwab isn't the worst off. It's somewhat protected, thanks to income from other areas, such as its mutual-fund supermarket or its investment management subsidiary U.S. Trust. All told, margin interest accounts for around 14 percent of Schwab's net revenues, according to Gamble. But the smaller online brokers are more exposed. According to Putnam Lovell Securities, margin interest accounts make up 18 percent of revenue for E-Trade and 35 per-cent for Ameritrade. E-Trade has tried to get out of the trading and margin lending ghetto by opening E-Trade Bank.
Then there's Ameritrade. "Of the publicly traded firms, Ameritrade is the poster child," says Smith of J.P. Morgan H&Q. The company's revenues come from commissions and margin interest; without diversity to fall back on, this drop could cut into the online broker's ability to survive.
Ameritrade's margin loan balance fell from $3.6 billion in early 2000 to $1.9 billion, off 47.2 percent from its high. "That's a volatile revenue stream that's tied to the market," says Richard Repetto, an equity analyst at Putnam Lovell, who notes that the fall in margin loan interest is affecting the company's earnings.
Kurt Halvorson, president of Advanced Clearing, the clearing subsidiary of Ameritrade Holding (AMTD) in Omaha, Neb., says margin loan balances at Ameritrade have increased slightly from this low point over the last month. But he admits that margin loans are very "elastic," as they depend on the health of the stock market and their clients' sensitivity to interest rates.
For Ameritrade, these loans are irresistibly easy and profitable. Around 10 percent of customer accounts use margin loans, according to Halvorson. The loan money is furnished from unused cash in Ameritrade customer accounts. That makes the model all the more attractive, he adds. "The spreads from a profitability and net revenue perspective are much better" than for firms that have to borrow from outside banks, says Halvorson.
For firms like Ameritrade that, having opted not to diversify, now depend more on margin interest for revenue, it could be a long wait until investors feel comfortable with margin loans again. "There's nothing they can do," says J.P.'s Smith. "It was great in early 2000 when it was going through the roof, and now it hurts you."
There's little that brokerages can do to boost lending. Advertising a margin loan services, for example, looks shady. "I've yet to see an ad saying borrow more on margin – that's not a very positive image of a broker," says Putnam's Repetto. The most brokerages can do is acquire new clients and hope some will take out margin accounts.
Ameritrade hopes that its rock- bottom operating costs will keep it afloat in this downturn. But the specter of consolidation looms before the brokerage industry, especially for those who can't see their way to sustainable profitability, says McVey. Online brokers may begin gobbling each other up in the coming months, and the contribution that high levels of margin debt make to the bottom line could predict who will be swallowing whom.
The story of margin loans is yet another reminder to brokerages to diversify. Market corrections don't merely wipe out value for retail investors; they create havoc for any business that relies on a healthy stock market. The more brokerages turn toward other businesses – like fee-based mutual funds and less-market-dependent online banking – the steadier the ride they'll have, while those narrowly focused firms will continue to be shaken by the market's uncertain waves. |
