What is margin?
Margin sounds great. But in our experience, most investors have little understanding of the substantial risks that margin poses to their accounts. Just as margin magnifies the ability to make profits, it also magnifies the ability to incur losses – quickly.
This is because margin accounts are subject to margin calls. Under the rules that govern brokerage firms, a firm cannot lend more than 50% of the initial purchase price of a given stock. If a customer purchases $10,000 worth of stock ABC, for example, the customer must have at least $5,000 in cash to make the initial purchase, while the brokerage firm can loan the remaining $5,000. At that point, the customer has $10,000 worth of stock and a debt of $5,000 to the brokerage firm. The customer’s equity interest in the stock is $5,000, or 50%.
As we know, however, the value of stocks can fluctuate. Sometimes they go up; sometimes they go down. As the market value fluctuates, so does the investor’s equity interest in the stock.
Every brokerage firm sets minimum equity percentages that investors must maintain in their accounts. These are called house maintenance requirements. House maintenance requirements are intended to protect the brokerage firm; the firm wants to make sure that it has sufficient collateral at all times to secure the loan it has made to the customer.
In the above example, suppose the firm maintains a 40% maintenance requirement, and the value of ABC stock drops to only $7,500. The customer’s equity interest has now dropped to only $2,500, i.e., ($7,500 market value minus the $5,000 outstanding debt to the brokerage firm). This means the customer’s equity percentage has dropped to 33% ($2,500 ÷ $7,500).
The customer will now face a margin call. This is a demand by the brokerage firm that the customer immediately deposit sufficient cash or securities or sell existing securities necessary to bring the equity interest back up to 40%.
The easiest way to satisfy the margin call will be to deposit additional cash or stocks equal to $500. (A deposit of $500 brings the equity interest up to $3,000, which is 40% of $7,500).
But what if the customer does not have additional cash or stocks to deposit? Then, the investor must sell enough of his or her existing ABC stock to generate $500 in cash. This is a problem for two reasons. First, it forces the investor to sell the ABC stock while it is low, thus realizing a loss. Second, the investor must sell more than $500 worth of ABC stock order to generate $500 in cash. This is because the ABC stock is still leveraged. When an investor liquidates securities to satisfy a maintenance call, he or she must sell an amount equal to the call divided by the maintenance rate on the securities being liquidated. To satisfy the above $500 call, therefore, the customer needs to sell $1,250 worth of ABC stock, since it carries a 40% maintenance requirement: $500 ÷ .4 = $1,250.
This means the investor must lock in even more losses to satisfy the call. And this is just the beginning. If ABC stock keeps going down, the margin calls will spiral even further.
What if the investor does not wish to sell at this low price and realize these losses? It doesn’t matter. The brokerage firm has the ability to sell the stock anyway. This is called a margin liquidation. In a declining market, heavily margined accounts frequently end with a “margin blow out.” The firm liquidates the account to make sure its outstanding loan is satisfied, and the customer ends up with little or nothing left.
On top of all this, the brokerage firm does not loan its money for free. Customers must pay margin interest rates for the privilege of taking on these additional upsides and downsides of margin.
Oftentimes, brokers do not fully explain all of these risks when recommending that their customers invest on margin. Instead, the broker only explains the upside, the chance for greater profits, and the potential benefits of using margin. Clients who have been misled about the risks of margin as an investing tool may have a claim against their brokers.
Please Note: McCabe Rabin, P.A. provides these FAQ’s for informational purposes only, and you should not interpret this information as legal advice. If you want advice as to how the law might apply to the specific facts and circumstances of your case, please contact one of our attorneys.