Living On The Margin (1)

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When a person gets a loan from a stock broker, it is called margin.  Short sellers borrow stock instead of money, but it is still the same thing, margin.  The amount of margin an individual can borrow is limited by the amount of equity, i.e., the combined value of all of the securities in the person's stock account with the broker.  In the US, the percentage of margin available to the account owner is set by the Federal Reserve Bank (FRB).  Stock exchanges and individual brokerage firms have their own rules as well, but they take the lead from the FRB.  The margin percentage has changed over the years depending on whether the FRB wants to depress or stimulate stock market action.  The lower the margin rate, the more people can borrow; the higher the rate, the less they can borrow.  The minimum margin requirement rate today is 50%.

In addition to margin requirements, only certain securities are "marginable."  Only the securities which qualify can be used in the individual's brokerage account as collateral for the margin loan.  These securities can be liquidated (sold) to cover the margin loan if their values decline to the point that the percentage of margin exceeds the required amount.  If the stocks decline in price, the broker contacts the customer and demands additional collateral (cash) be deposited in the account, a margin call.  If the customer does not respond on a timely basis, the broker sells enough securities in the account to pay down the loan.  It is said that one of the primary causes of the 1929 Wall Street crash was a vicious circle of unmet margin calls which triggered stock sales by brokers resulting in reduced stock prices, which led to another round of unmet margin calls, stock sales and price declines, over and over.

What is the attraction of margin?  It may be nothing more than the old philosophy, "More Is Better."  If you were to ask those folks wiped out during the Dotcom bust of 2000, they may ruefully tell you that more is just more.  In any event, using margin holds the promise of large gains with little invested equity.  Here is a simple example.  Assume that you have $10,000 to invest in a stock trading at $50 per share.  Ignoring fees, commissions and interest charges (this is just an example, remember), you can buy 200 shares.  If the stock is qualified for margin loans, you buy 400 shares with your $10,000, half of which is on margin lent to you by your broker.  One year later, the stock is trading at $75 per share and you sell at a profit.  If you had not used a margin loan and purchased only 200 shares with your $10,000, you would have a profit of $5,000 ($15,000 - $10,000).  With the sale of your 400 margin shares, your profit  is $20,000 ($30,000 - $10,000).  A $5,000 profit on a $10,000 investment is a 50% annual return on your investment.  A $20,000 profit on a $10,000 investment (remember, we're ignoring fees, commissions and interest) is a 200% annual return.

Sounds too good to be true, right?  Well, if the stock had dropped to $25 per share at the end of that year, the losses are magnified as well.  If you had just purchased the 200 shares, you would still own stock worth $5,000 in your account.  Assuming the broker issued a margin call on your account which you did not meet, the broker would have sold enough stock to cover the price decline (400 shares @ $25 = $10,000) and you would have nothing left.  You would have lost your entire initial investment of $10,000.  In reality, you would have lost more since the broker would still be looking for those fees, commissions and interest charges to be paid as well.

A very good explanation of margin loans is provided by Interactive Brokers at their website.  Here is a link.  We will continue our look at margin loans in the next blog.

Comments are always welcome.