With the rapid return of volatility to the stock market, it is more important than ever for investors to understand the risks of margin use in their brokerage accounts. Investors who have time-sensitive investments in margined portfolios may suffer significant losses that trigger margin calls and account liquidations in periods of high market volatility. With the reported total of margin balances in brokerage accounts nearing approximately $550 billion as of February 2020, it is without question that this tumultuous market environment will impact investors who utilize margin in their investment portfolios.
When opening an account with a brokerage firm to buy securities, investors will either have a “cash” account or a “margin” account. In a cash account, all transactions must be made with available cash, meaning the investor must deposit 100% of the purchase price in order to buy the security. On the other hand, in a margin account the investor is allowed to borrow against the value of the assets in the account to purchase securities. The portion of the purchase price that the customer must deposit is called margin and is the customer’s initial equity in the account. Buying on margin amounts to getting a loan from the brokerage firm that is secured by the securities purchased in the account. Margin use can be costly as investors will be required to pay the brokerage firm interest on the amount borrowed until it is repaid.
While investors generally use margin to leverage their investments and increase their purchasing power, investors using margin incur additional costs, such as interest, as well as the possibility for higher losses. In fact, an investor can even lose more money than initially invested. Be aware that some brokerage firms automatically open margin accounts for investors. It should come as no surprise that margin accounts are often recommended since they can be highly profitable for the brokerage firm as well as the broker.
Under Federal Reserve Board Regulation T, a customer can borrow up to 50% of the total purchase price of a stock for new or initial purchases. After purchasing a stock on margin, FINRA Rule 4210 imposes maintenance margin requirements on the account which generally requires that the customer’s equity in the account must not fall below 25% of the current market value of the securities in the account. If it does, the investor will receive a margin call requiring the customer to deposit more funds or risk that the firm will liquidate securities to bring the account back to the 25% equity level. The use of margin has many risks which must be disclosed in writing to customers before opening a margin account, such as:
Let’s look at some of these risks in greater detail under the following hypothetical situation:
An investor with $100,000 in cash would like to buy $200,000 of stock XYZ so he borrows $100,000 from his brokerage firm using a margin loan. After purchasing the $200,000 in stock shares, the investor now has $100,000 in equity in his margin account and a margin loan for $100,000 that he must repay (plus interest) to his brokerage firm. Unfortunately, the next week the investor’s value of stock XYZ drops to $120,000 such that the account equity is now $20,000 ($120,000 stock value less the $100,000 margin loan). Since the maintenance margin requirement for the account is 25%, the account’s equity must not fall below $30,000 (which is 25% of the current $120,000 stock value). As the investor’s equity is now only $20,000, he will receive a margin call requiring him to immediately deposit an additional $10,000 into his brokerage account or risk that the brokerage firm will liquidate his investment to pay back the loan. Of course, this means that the investment will be sold at a loss and the investor will lose the ability to hold the security in case the share price rebounds.
Let’s now assume that the investor above cannot deposit additional funds to meet the margin call, but because of a rapidly declining market the investor’s value of stock XYZ is $80,000 at the time it can be sold by the brokerage firm. In this scenario, not only did the forced liquidation result in the investor losing more than the $100,000 initially deposited into the account, but because the firm was only able to sell his shares for $80,000 (which will be applied against the loan balance), the investor will still owe the firm an additional $20,000 to fully repay his $100,000 loan. In such a scenario, it is not uncommon for brokerage firms to institute legal proceedings to collect if the investor does not repay the loan balance.
Investors should take heed to fully understand how a margin account works before borrowing against the securities in their account. If your broker is recommending the use of margin, make sure you understand the basis for the recommendation and why your advisor believes that it is suitable for you. If you have lost money as a result of your broker’s recommendation to use margin in your brokerage account, you may be able to recoup your losses under applicable state and/or federal law. Please contact us for a free confidential consultation.
Gregory B. Simon Law, LLC is a national securities law firm that provides legal services to investors and financial advisors on a wide range of financial industry matters. For more information on the firm, please visit https://www.gregsimonlaw.com.