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NASD issues rare warning to investors
A leading US securities regulator Tuesday issued a rare warning to investors over the record $321bn of debt being used to buy stocks and bonds.
The move highlights broader concerns expressed by financial watchdogs in the US and Europe about leverage used by investors of all kinds, including hedge funds.
NASD, which regulates brokers and trading, said the amount of debt taken on by investors to buy securities – known as margin – reached a new high of $321bn in February. Since December, the figure has exceeded the previous peak of $300bn set in March 2000, near the top of the internet stock bubble.
"We are concerned too many investors are unaware they could suffer substantial financial losses by using debt to purchase securities," said Mary Schapiro, chief executive officer of NASD. "By updating our alert on this topic, we hope to remind investors not to underestimate the risks involved."
The regulator's last such alert came in 2003.
An investor who uses margin borrows money, with interest, from a broker to buy securities. When the value of an investment falls, the broker can demand that the investor pay additional cash – known as a margin call – or sell securities to cover the call.
Jim Paulsen, chief market strategist at Wells Capital, said the greater use of margin reflected the growth of sophisticated trading strategies. But he noted that investors now use margin both to buy stocks and to sell them short, meaning the net risk could be lower than during earlier periods.
Stocks tumbled in late February and early March, resulting in margin calls being made to investors. In recent weeks, stocks have recouped most of their losses.
In a sign of broader concern over margin borrowing, watchdogs from the US and Europe are jointly examining whether the collateral that banks require of big clients such as hedge funds is sufficient.
Timothy Geithner, president of the Federal Reserve Bank of New York, said last year that allowing hedge funds to borrow too aggressively could weaken the financial system. Dealers and big banks should take "a cold, hard look" at the amount they lend to hedge funds and their margin practices for derivatives transactions, he said. Mr Paulsen, however, said today's market practices did not seem excessive.
"We are a long way off the frothiness that typified the bull run of the late 1990s," he said.
But Jack Ablin, chief investment officer at Harris Private Bank said the rise in margin was still a good indicator that investors were taking more risk.
"Stocks have had a terrific run and the recent rebound in the market has probably encouraged further risk taking," he said.
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