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To Margin or Not To Margin?

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Debt: properly used can be very beneficial, but misused can lead an individual down the path of financial ruin.

Many financial firms espouse the benefits of acquiring debt by using securities portfolios as collateral for margin loans. Getting a loan against your securities portfolio may seem very simple and straightforward. You agree to use your securities as collateral and the brokerage firm agrees to loan you money based on the value of those securities. What could be easier? 

Not so fast!

It is imperative that you read the fine print and understand how these loans operate. You must educate yourself about the almost immeasurable risk that using leverage adds to your portfolio. This article will examine the ins and outs of margin loans and present suggestions for anyone contemplating a margin loan.

First and Foremost!

Always read the fine print. NEVER sign ANY paperwork without first carefully reading all documentation having to do with a margin loan. It is a common practice for firms to put all margin loan disclosures in a separate “booklet”. This booklet typically includes disclosures for multiple products. It may take a little digging to identify the sections pertaining to margin loans, but your diligence will be rewarded by becoming fully educated about the terms of the margin loan.

How does a margin loan work?

It is important to understand that the margin loan interest rate charged by most brokers is not a fixed rate and will fluctuate over time as determined solely by the broker making the loan. The margin loan business is very competitive and interest rates charged by brokers vary greatly from broker to broker, so shopping rates is a good idea.

Also, most brokers will negotiate a lower rate for larger margin loans. There is no predetermined payment schedule for margin loans. In fact, as long as your equity remains above a certain minimum equity requirement you do not have to make any payments. The interest you are paying is charged to your margin account and ends up increasing the amount of your loan. As a result, you pay interest on the interest that you are charged. If you are going to utilize a margin loan it is advisable to make at least a minimum monthly payment that covers the interest charges.

Minimum requirement to open a margin account is $2,000 in cash or securities. Regulation T of the Federal Reserve Board sets the initial equity to loan ratio at 50%. Simply put, an investor must have initial minimum equity of 50% of the value of the securities.

As an example, assume an investor wants to purchase 5,000 shares of Company Y at a price of $10 per share. The total cost in a cash account would be $50,000. Instead of paying cash an investor can establish a margin account and deposit an initial margin requirement of $25,000, which would then give the investor a total purchasing power of $50,000.

This is how leverage is created.

In this case the investor purchases $50,000 worth of stock using only $25,000 of his own money, or equity, in fully paid for securities. He has established a stock position with 2-to-1 leverage.

Maintenance Requirement

Once the position is established, the minimum required level of equity could fall below 50%.  This lower equity requirement is known as minimum maintenance or the “maintenance requirement.” The New York Stock Exchange (NYSE) has set the minimum amount of equity that must be maintained at 25%. However, most brokers set a minimum equity level above 25%. This is known as the “house maintenance requirement.” This level is typically between 30%-40%.

Going back to our example. If we assume a 30% maintenance requirement and the price of our stock position goes from $10 to $7, our total market value would then be $35,000 (5,000 shares x $7 per share). Total debt is still $25,000 so our total equity (market value – debt) is $10,000 ($35,000-$25,000). Because our equity, as a percentage of market value, is now 28.57%, we would experience a $500 “margin call,” which I will discuss later.

Several factors are considered when setting the house level:

  • How quickly the position can be liquidated
  • The price of the individual security
  • The collateral is all one security or diversified

The house maintenance requirement is established to protect the broker, not the investor, and provide some confidence that the broker has enough of a cushion to recoup the loan proceeds should they need to liquidate the position.  Before establishing a margin position make sure you understand how much equity is required for the house maintenance.

Most margin agreements have a provision that allows the brokerage firm to put a lien on all accounts you have with them or their affiliates. This provides them additional collateral to secure your margin loan over and above what is in your margin account. The only accounts excluded from the lien provision are IRAs.

Margin Calls

If the equity in a margin account falls below the house maintenance requirement you will receive a margin call for the amount needed to bring the equity back to the house requirement. You will have trade date plus 3 days to meet this call. Keep in mind that if the securities in the account decline further in value, the amount of the call will increase.

You can meet the margin call by:

  • Selling securities in the account
  • Depositing additional cash
  • Depositing additional fully paid for securities
  • Market appreciation in the value of the securities

If you choose to sell securities in the margin account, then you will need to sell enough to release sufficient equity to meet the call. Depending on the maintenance level you may need to sell 3 times the amount of the call to raise enough equity to satisfy the call.

In our example, the investor has the option of meeting the $500 “margin call” by:

  • Selling $1,667 worth of Company Y Stock ($500/Maintenance Margin of 30%)
  • Depositing $500 in cash
  • Depositing $715 of fully paid for securities ($500 x 1-Maintenance Margin of 30%)
  • Have the price of the stock increase to $7.15 within trade date plus 3 days

If you do not satisfy the margin call the brokerage firm reserves the right to sell your securities without notifying you in advance. When the brokerage firm sells securities to meet your margin call you are not entitled to choose the securities they sell. Also, most margin agreements include language that allows the brokerage firm to liquidate securities in your account “at their discretion”. If they decide to not liquidate and the securities decline to zero you will still be liable for the full amount of the margin loan plus any interest that has accrued. If the equity in your margin account falls below 25% you will receive an exchange call. Typically you must satisfy this call by the end of the next business day to prevent liquidation.

Permission to Lend Securities

It is important to understand that when you sign a margin agreement you are giving the brokerage firm permission to lend out the securities in your account. This is typically done to facilitate the short sale of the security being lent. When someone sells a security short they are selling something they do not own. In order to settle this type of transaction the seller must “borrow” the amount of securities they sold short.

Frequently, the brokerage firm earns a fee for loaning out your securities and you do not receive any portion of that fee. If any of your securities are considered “hard to borrow” the fee earned by the brokerage firm can be quite substantial. In some instances your securities being loaned out could limit your ability to exercise your voting rights in those securities.

Other Uses of Margin

In addition to purchasing securities, some brokers may allow you to use margin loans for a variety of personal or business financial purposes, such as buying real estate, paying off personal credit, or providing capital. Using margin loans for non-securities purposes does not change the way these loans work. These loans are still secured by the securities in your margin account and thus subject to the same risks associated with purchasing securities on margin described above. The terms and conditions of these loans vary between brokers and are generally specified in the margin agreement. You should carefully consider the margin risks described above as well as any fees that may be associated with these loans before using them for any non-securities purpose. 

Risks of Financial Leverage

Leverage essentially amplifies the gains or losses experienced in your account, which is why it is very popular amongst hedge fund and private equity managers. Small gains can become substantial depending on how much leverage you have (i.e. how much debt as a percentage of market value).

Let’s use the example of Bob and Tom. Both invest in IFA Index Portfolio 100, but Bob utilizes a margin account while Tom has a cash account. Both deposit $100,000 into a regular brokerage account at the beginning of 2007. Bob has $200,000 in purchasing power given he can utilize margin up to a 2-to-1 ratio (50%). The $100,000 in additional purchasing power carries an annualized interest rate of 5%.

During 2007, IFA Index Portfolio 100 experienced a 2.51% return.

  • Tom’s total account value is now $102,510 for a total return of 2.51%
  • Bob’s total account value is now $205,020 for a total return of 2.51%. With $100,000 of debt, Bob’s equity grew by $5,020, but remember that Bob has to pay 5% interest on the $100,000 margin loan. This means that he would also pay $5,000 in interest cost during this year. Although IFA Index Portfolio 100 had a positive return for the year, the interest cost paid by Bob essentially wipes away almost all of the gain that he earned. His total personal return ends up being 0.02% ($20/$100,000) with a total account value of $200,020 and total equity of $100,020.

As you can see, because Bob was leveraged at a 2-to-1 ratio, he was able to double his profits compared to Tom before interest costs are taken into account. But this also means that he could potentially double his losses as well. 

In 2008, IFA Index Portfolio 100 experienced a -40.55% return.

  • Tom’s total market value is now $60,942 for a total return of -40.55%
  • Bob’s total market value is now $118,912 for a total return of -40.55%. With still $100,000 of debt, Bob’s equity shrunk by $81,108 for a total personal return of -81.10% ($81,108/$100,020), before interest costs. After we take into account another $5,000 that Bob would pay, Bob’s total equity shrinks by a total of $86,108 for a personal return of -86.09% (-$86,108/$100,020) with total account value of $113,912 and total equity of $13,912.

Bob would also experience a margin call of about $20,300 assuming a 30% maintenance margin requirement. He would have the option of:

  • Selling $67,667 in securities and locking in his capital losses
  • Deposit $20,300 in cash
  • Depositing $29,000 in fully paid for securities
  • Or hope that the value of his portfolio appreciates by 18% in total value over the next 3 days. As we all know, the market continued to decline all the way through the beginning of March in which Bob would have experienced many more margin calls along the way.

A much more reliable and prudent strategy for taking risk is not to amplify your returns and losses through the use of margin, but to control your risk exposure through your asset allocation between risky stocks and safer bonds. This way, you can avoid “margin calls” during severe market contractions, which forces you to liquidate securities at exactly the wrong time, and ride out the upside when markets eventually turn around.

Key Questions You Should Consider Before Utilizing a Margin Account

  • Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase?
  • Are you aware you may lose more than the amount of money you initially invested when buying on margin?
  • Can you afford to lose more money than the amount you have invested?
  • Did you take the time to read and understand the margin agreement?
  • Did you ask your broker questions about how a margin account works and whether it’s appropriate for you to trade on margin?
  • Did your broker explain the terms and conditions of the margin agreement?
  • Are you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return?
  • Are you aware that your brokerage firm can sell your securities without notice to you when you don’t have sufficient equity in your margin account?
  • Are you aware that all of your accounts at the brokerage firm, with the exception of IRAs, are subject to a lien to secure your margin loan?

Conclusion

As you can see margin loans are more complicated than one might think at first glance. Using margin lending to create leverage in your investment portfolio is a form of gambling. When the equity markets have gone up you feel good because you got lucky and leverage worked in your favor. When equity markets have gone down, like late 2008 and early 2009, you subject yourself to the potential of losing all of your hard earned savings. The potential lucky benefit is not worth the risk. You will be much better off to invest in a globally diversified portfolio of index funds. Only then will you be able to invest and relax.