February 24, 1999
Wall Street Firms Try to Keep Internet Mania From Ending Badly
By REBECCA BUCKMAN and AARON LUCCHETTI
Staff Reporters of THE WALL STREET JOURNAL
Adorning the office of Susanne Lyons, a senior Charles Schwab Corp.
executive in San Francisco, is a gift recently sent by some Florida
employees: a gale-warning flag. It refers to a huge effort Schwab has been
making, in staffing and technology, to cope with the crush of trading in
Internet stocks, a campaign Schwab calls "Market Storm."
That term resonates with Wall Street executives these days, with a
different meaning. A growing number of them are concerned that the
financial world's equivalent of a hurricane -- with a menacing "dot.com" at
the eye -- could be hurtling the market's way. The signs are all there: wild
price swings, valuations that seem from another world, rapid-fire trading
by people completely new to the game.
So now, brokerage firms and industry
regulators are battening down the hatches, to
protect both themselves and their customers in
case it happens. So fretful are firms that, in a
few cases, they are even turning away
business, the Wall Street equivalent of a
bartender shooing away a patron who has had enough. "In the case of
Internet stocks," marvels L. Keith Mullins, a managing director and head
of growth-stock research at Salomon Smith Barney, "there's enough
concern to overcome Wall Street greed."
Tuesday, Federal Reserve Chairman Alan Greenspan, in his usual
circumspect way, expressed concern about the level of stock prices,
noting that stock-market bubbles are sometimes not identified until after
they're popped.
One hopeful sign, though, is that
some of the froth in individual
Internet stocks has drained off
gradually in recent weeks, suggesting
that even if highfliers are overvalued,
they can avoid a blowup. But here is
the Street's worst fear: that the
volatile mixture of high-priced
Internet stocks, novice investors and
buying on margin is so combustible
that a shock could spread quickly
through the rest of the market,
ruining some investors and
jeopardizing the health of some smaller firms.
It also could shake the confidence of a generation of fledgling investors. In
that way, a sharp tumble could be "no different than 1987," asserts Blake
Darcy, chief executive of DLJdirect, the online-trading unit of Donaldson,
Lufkin & Jenrette Inc. "There were a lot of people in the market at that
point who got burned and sold their portfolios ... and didn't get back into
the market for a long, long time."
So the barricades go up, even as Wall Street executives concede there's
only so much they can do to head off trouble:
The Nasdaq Stock Market, which boasts in its marketing that it
rarely stops investors from buying and selling, is considering
authorizing trading halts under certain circumstances.
DLJdirect, Schwab, Salomon Smith Barney, Waterhouse Securities
Inc. and other firms are making it harder for customers to buy
Internet stocks with borrowed funds. In some cases, they are
barring clients from ordering shares of hot initial public offerings
without setting a maximum price.
Several online brokerage firms, including Schwab and E*Trade
Group Inc., are scrambling to upgrade computer systems, which
have sometimes faltered under the weight of heavy trading. Schwab,
realizing that such breakdowns amid a plunging market could be
catastrophic, has rigged its computer systems to run on two
mainframes instead of one, buying time until it can make more
permanent upgrades.
Why the sudden fuss? After all, for much of last year, Internet stocks rose
robustly and online-stock trading was heralded as the next revolutionizing
force on Wall Street. But unsettling swings in several little-known issues
around Thanksgiving jolted regulators and securities firms into action.
Around that time, tiny IPOs like theglobe.com Inc. and Ticketmaster
Online-CitySearch Inc. skyrocketed in their opening minutes of trading,
then plummeted, touching off investor complaints. Obscure companies like
Books-A-Million Inc. tripled after announcing Web upgrades. Many
investors got hurt in these swings, after placing orders when stocks were at
one price but getting them filled when prices were very different.
Amid this turbulence, Frank Zarb, chairman of the National Association of
Securities Dealers, which runs Nasdaq, hastily called a teleconference with
NASD executives. "This is not business as usual," he told his lieutenants,
calling the volatility in Internet stocks "serious." Mr. Zarb, a former
brokerage executive, told his regulatory staff to look at such drastic moves
as expanding authority for the NASD to halt trading in some stocks. The
NASD board is scheduled to consider the idea next month.
Mary Schapiro, president of NASD Regulation Inc., and her staff started
calling online brokerage firms to grill them about their clients' exposure to
the stocks of companies doing business on the Internet. How many
customers held the stocks? How much were they borrowing to hold them?
Later, regulators sent a memo to 5,500 brokerage firms listing steps they
could take, including explaining the risks to investors and limiting their
ability to buy with borrowed money.
These ideas weren't easy to swallow. Patrick Campbell, Nasdaq's
enthusiastic chief operating officer, long opposed any notion of trading
halts except in the rarest of circumstances. But he adjusted his view after
noticing that some stocks were soaring simply because investors were
mistaking their symbols for those of Internet companies.
This was a sure sign of trigger-happy investing. "We have an orderly
market to run," says Mr. Campbell, choosing his words carefully. Glancing
at a monitor on his desk, he sees that a hot computer stock has just
dropped 7% in heavy trading. "These are extraordinary times," he
concludes.
So extraordinary that Mr. Zarb phoned his chief competitor, New York
Stock Exchange Chairman Richard Grasso, about a month ago to discuss
whether Internet stocks should carry a higher margin-maintenance
requirement, the amount of overall cash and equity customers need if they
have bought stocks on borrowed funds. Mr. Grasso told him this would be
"overkill," and Mr. Zarb ultimately dropped the idea.
Some firms haven't waited for industry regulators to move. At Salomon
Smith Barney, Horace Derrick, a senior vice president who handles margin
accounts, called in two risk analysts and asked what would happen if
highfliers like Amazon.com Inc. and Yahoo! Inc. dropped 30% or more.
One of the risk analysts ran a test. The results discouraged him: Hundreds
of customers, having put up money for only part the price of a stock and
borrowed the rest from Salomon Smith Barney, could see their accounts
wiped out by a big fall. And the firm's customers had a huge $13 billion in
margin loans. It was "a very risky situation," the analyst, Colin Carney, told
his boss. Mr. Derrick agreed, and persuaded the firm to raise margin
requirements on 18 Internet stocks, and later on 85 in all.
"It's a big change," but customers were coming close to going into debt, he
says.
At DLJdirect, Mr. Darcy grew concerned about the Internet frenzy as he
prepared to board a flight to Japan the Monday after Thanksgiving. From
a club lounge at Newark airport, he called the firm's head of compliance,
Tony Festa, on a cell phone. "How are we doing?" Mr. Darcy asked, most
worried about customers with heavy margin debt. Fine so far, Mr. Festa
replied. But he was worried, too, and had a plan of action, a series of
steps that mostly involved monitoring potentially troublesome stocks more
closely and better scrutinizing each morning's queue of trade orders. The
two also hastily identified about 15 stocks to add to their list of issues with
tighter margin requirements.
Mr. Festa's parting words were, "Don't worry about it, Blake. We got it."
But Mr. Darcy didn't stop worrying. Later in December, DLJdirect
deepened its already-intense monitoring of "concentrated" accounts to
look at short positions, in which clients sell borrowed shares in hopes of
profiting from a decline. Because the client is obligated to replace those
shares even if the stock soars, "with a short position, there's no limit to the
amount of money you could lose," Mr. Darcy says.
DLJdirect is no stranger to risk. It and a few other firms have long sent
form letters to customers who do rapid-fire or high-risk trading, warning
them of the dangers and asking them to acknowledge receipt of the
warning. But the stiffened margin rules "are a really clear signal" that the
industry is concerned about the volatility, says James J. Angel, an associate
finance professor at Georgetown University. That's because the rules limit
trading, and "brokerage firms have a natural tendency not to want to slay
the goose that's laying the golden eggs."
One concern is how many unseasoned traders the Internet stocks and
online trading have attracted. At Schwab, the largest online broker, 50%
of new customers are considered inexperienced.
At Ameritrade Holding Corp., a graduate student from Indianapolis named
Lael Desmond opened a margin account in late 1997 even though he didn't
know what a margin account was. Mr. Desmond, 27, had simply heard
from his sister that "you can make a lot more money quickly" that way. He
concedes he didn't read the fine print on the margin agreement.
He took notice in August, though, when his fully leveraged, $100,000
account took a dive after stocks such as Amazon, Excite Inc., Dell and
Yahoo! stumbled. His margin calls, the added money Ameritrade required
him to put up, exceeded the equity left in his account. Mr. Desmond
wound up borrowing about $12,000 on four credit cards, though he also
filed an arbitration complaint challenging the way Ameritrade handled the
situation. Ameritrade says it hasn't yet received a copy of the complaint
and thus can't comment.
"I will never trade on margin again," declares Mr. Desmond, who says he
thought margin loans were like bank loans, requiring regular payments. He
has since taken out a loan against his house to pay off the credit-card
balances.
The same volatility and heavy trading by individuals convinced a market
veteran, Bernard L. Madoff, that his trading firm should stop making a
market in four wild Web stocks. "You're literally seeing hundreds of
thousands of orders in these stocks," Mr. Madoff says. "That puts a strain
on everybody's systems. And on the way down, it's always more
extreme."
Throughout the fall, Mr. Madoff, at his trading desk in Manhattan,
watched tiny orders scroll across his monitor for stocks like Amazon,
Yahoo, Infoseek Inc. and Egghead.com Inc. Then, he saw IPOs
skyrocketing. But what did it for him was the action in Amazon in
mid-December. An analyst from CIBC Oppenheimer Corp., Henry
Blodget, issued what seemed an outlandish price "target" of $400, which
equals $133 today after a 3-for-1 split. The stock leapt 19% in one day.
Then Merrill Lynch & Co.'s better-known Jonathan Cohen struck back
with a price target of only $50, or $17 after the split. The stock
whipsawed back down.
To Mr. Madoff, "it was insanity. This thing was getting out of control." In
January, his New York firm, which bears his name, dropped Amazon,
Yahoo, Infoseek and Egghead, even though trading them had been very
profitable. Interestingly, shares of Amazon now trade at a bit over $115 a
share -- or, presplit, very close to Mr. Blodget's forecast. Mr. Cohen has
since left Merrill. Mr. Blodget is now expected to take his job.
But Mr. Madoff lived through the 1987 crash -- as Nasdaq's chairman. "I
had to field all the unhappy phone calls when people felt the Nasdaq
market had pretty much shut down," he says. "My attitude was, I do not
want to relive that event." And now, even more of the trading is done by
individuals.
Further complicating matters is the rapid rise of online trading, to an
estimated 13% of stock transactions. On heavy days, they have jammed
computer systems. E*Trade, Waterhouse and Ameritrade have all suffered
embarrassing technology glitches that locked investors out of their systems
and away from their money. So a question concerning some Wall Street
executives is what would happen in a panicky market. To be ready for any
rush of trades, Schwab persuaded a vendor in December to deliver a new
server computer via chartered jet, a month ahead of schedule.
At a recent "town hall" meeting at a hotel near Disney World, Schwab
staffers nevertheless were restless, peppering Ms. Lyons with questions
about technological readiness. In an interview, she says that "virtually every
project that's long term has been tabled so we can devote every resource
to build up capacity."
But brokers remain on guard. On a recent day, investors who use the
phone rather than a computer were pelting Schwab broker Amy Hommas
in Orlando with requests: How much can I get for my shares of Global
DataTel Inc.? How can I unload CyberGuard Corp. now that it has been
delisted from Nasdaq? What's the market for options in Cisco Systems?
Ms. Hommas handled the requests smoothly, telling the man who was
trying to dump the thinly traded CyberGuard that "I can't guarantee you
execution while we're on the phone."
Nearly all the calls came from investors in Internet stocks. During a
one-hour stretch, Ms. Hommas handled exactly one call from a customer
trading a traditional blue chip, and even it was far from staid -- Lucent
Technologies Inc. Ms. Hommas, concerned about clients being
overexposed to Web stocks, says she tries her best to guide them, gently
asking if they are diversified beyond Internet shares.
In all this, brokers are limited in the precautions they can take. They don't
know how likely they are to face a market hurricane, and even if they do,
they can't fully prepare. Says DLJdirect's Mr. Darcy: "You can never
predict perfectly the scenario that's going to occur and how quickly it's
going to occur. ... All the planning we have will probably not have
prepared us for a 40% correction." |
