Margins calls? Human error? Whatever the reason, billions and billions of dollars in capital vanished in the blink of an eye on May 6, the day the Dow Jones Industrial Average witnessed nearly a 1,000-point drop. Individual and institutional investors alike felt the pain – and will for some time to come. For those needing further proof of the repercussions, just look at your next 401k or brokerage statement. The losses rendered from May 6 will be poignantly clear.

Many are blaming the market’s crash on the debt crisis in Greece. Others point the finger at high-frequency trading. And some fault human error. Specifically, a number of people contend that the crash was tied to someone hitting “B” instead of “M” on the keyboard, resulting in a billion shares of a certain investment sold instead of a million. Various news sources have reported that the firm behind the trading error is Citigroup. Citigroup denies the claims.

Other analysts believe stocks plummeted on May 6 because of massive forced selling by big hedge funds that were responding to margin calls. Margin calls happen when people borrow heavily against their assets and then see their value plummet drastically. This, in turn, forces them to sell part of their holdings in order to make good with their lenders. The end result affects not only individual investors or institutional investors like hedge funds but also the entire economy.

Federal regulations limit the amount of margin trading that individual investors can conduct. This isn’t the case, however, with hedge funds, which are essentially unregulated and can typically borrow many times over the real value of their assets.

Regulators continue to review the financial free-fall that occurred on May 6. Regardless of what they determine, the end result will be the same: Investors are going to feel considerable financial pain for a long time to come.

When stock markets plunged to their lowest level in four years in October, it quickly became news that margin calls were a key culprit to the problem. In the weeks since, the volume of margin calls has steadily increased, exacerbating issues for investors and adding turmoil to an already battered financial environment.

Investors who buy stock on margin – meaning the money is borrowed from a brokerage or lender – stand to reap big returns if their bets turn out positive. On the downside, if the value of a stock plummets, as they have recently, investor losses can grow fast and furious.

Margin calls affect more than just the wealthy. When the stock market is overloaded with sell orders, stock prices often fall further in value, thereby causing additional financial losses for ordinary retail investors who sell their shares at deflated prices. 

Hedge funds also are feeling the effects of margin calls these days, particularly funds with billions of dollars worth of positions in Lehman Brothers Holdings. Despite the fact the funds cannot touch their assets at Lehman, which are frozen because of the firm’s Sept. 15 bankruptcy, they nonetheless may be forced to meet margin calls on their positions. 

PricewaterhouseCoopers, which is handling Lehman’s bankruptcy and liquidation, confirmed in mid-October that it would not rule out demanding additional collateral via margin calls on some $60 billion in frozen Lehman assets if the value of those securities falls.

Making a bad situation even worse is it may take months, or even years, for PricewaterhouseCoopers to determine which assets clients actually are entitled to and which they are not.

Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.

The downturn in the economy is shedding new light on two dreaded and unwanted words no investor wants to hear: margin calls. Recent margin calls – in which shares of stock are bought using borrowed money – have created a margin blowout lately, sounding the alarm for CEOs and fund managers at companies from Chesapeake Energy to Williams-Sonoma and forcing them to sell billions of dollars worth of stock in order to make good on their loans with lenders.

Meanwhile, investors in companies whose executives must meet margin calls often learn after the fact about the selling sprees and ultimately bear repercussions of their own. Why? Because a margin call can subsequently mean investors are forced into liquidating their portfolios at a time when a company’s stock is at its worst possible low.

Moreover, when CEOs or other senior-level management borrow heavily against their portfolios to buy large amounts of stock, it can send a false message to other investors, who may believe the buying is reflective of a company’s financial position or future performance potential. Should a margin call arise, the investors are at risk when the stock price plummets.

An Oct. 23 article in Forbes reports on how margin calls sealed the fate recently for some of the world’s richest people – and the not-so-rich people who invested in their companies. On Oct. 8, Aubrey McClendon, CEO of Chesapeake Energy, owned more than 32 million shares in the nation’s largest natural gas producer. Forty-eight hours later, most of it was gone.

McClendon had bought a majority of his Chesapeake Energy shares on margin. When the stock began to tank in value, he was forced to meet margin calls. According to the Forbes article, “McClendon sold 1.8 million shares of Chesapeake for $12.65 per share in one of his Oct. 10 transactions. Just four months earlier, those shares traded as high as $74 each.”

Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.