As of May 2018, the Financial Industry Regulatory Authority (FINRA) reported that the aggregate margin balance (i.e., debit balance) of customers’ accounts at FINRA member brokerage firms is more than $665 billion. Margin balances have been steadily increasing since the 2008-2009 financial crisis and have done so in tandem with the surging equities market. The S&P 500 and the aggregate margin exposure in customers’ accounts have both nearly tripled since 2010.
Margin is one of the most powerful tools that an investor can use to maximize gains. However, if not managed properly, it can have a devastating impact. This article will examine both the benefits and risks of using margin.
What Is Margin?
Margin is a credit that a facility brokerage firm’s customers can access to borrow against the value of their investment portfolio. For example, if a customer has an account worth $100,000, the brokerage firm will allow them to borrow additional funds on margin to purchase securities or, in some cases, withdraw the funds for personal use. In exchange for the use of these borrowed funds, the brokerage firm charges an interest rate each month. Depending on the size of the account and the amount borrowed, the brokerage firm has discretion to charge a lower interest rate.
How Much Money Can I Borrow On Margin?
Each brokerage firm has what is called a “house maintenance requirement,” which is a mathematical formula used to determine the amount of money an investor can borrow based upon the value of the collateral assets the investor holds in the account. If the value of collateral assets falls below the maintenance requirement, a margin call is issued.
In calculating the maintenance requirement, the brokerage firm assigns a “release” value to specific investments based upon a variety of factors, including liquidity and volatility. Treasury securities, generally considered to be the safest collateral, have the highest release. On the other hand, stocks, which are subject to volatility, carry a significantly lower release. This means that investors can borrow more money on margin when the collateral is treasury securities that they could if the collateral was stocks.
Of course, the calculation of the maintenance requirement and release given to specific classes of securities are at the full discretion of the brokerage firm. A brokerage firm can decide on any given day that it will no longer allow customers to borrow against the value of certain securities. In this instance, the customer either needs to deposit additional assets to reduce or eliminate the margin balance or sell securities (potentially at a loss) to reduce or eliminate the margin balance.
What Are The Benefits Of Margin?
The primary benefit of using margin is that a customer has the potential to enhance investment returns and purchase securities that they may have otherwise been unable to purchase. In an appreciating stock market, investors can reap large benefits from using margin. For example, Customer A deposits $100,000 into their account and purchases a basket of stocks. Customer B deposits $100,000 in their account, borrows an additional $50,000 on margin, and purchases the same basket of stocks. If the stock portfolio appreciates 10 percent in year one, Customer A stands to end the year with an account value of $110,000 whereas Customer B stands to end the year with $115,000, less margin interest paid. If those same stocks also pay a dividend, the returns are further enhanced.
If Customer A and Customer B hold municipal bonds (instead of stocks) as collateral, they may be able to borrow an additional $80,000 against the initial value of their $100,000 municipal bond portfolio. As set forth above, most brokerage firms provide a greater release against lower volatility securities like municipal bonds. If the borrowed funds are used to purchase more municipal bonds, the investors will enhance the amount of income they receive and can, in some instances, mirror equity like returns with fixed income investments. Borrowing against a bond portfolio is known in the industry as the “carry trade” and in a low interest rate environment can be an effective (but riskier) way to generate high levels of income.
What Are The Risks Of Margin?
In appreciating markets, investor love margin because they experience higher investment returns. However, in a depreciating market, the inappropriate use of margin can have a crushing impact on an investor. In the value of the investors’ collateral securities declines below the maintenance requirement, the brokerage firm will issue a margin call which must be resolved on the date and time proscribed by the brokerage firm, which is usually three days. If the investors do not satisfy the margin call, the brokerage firm will liquidate the collateral securities (possibly at a loss) and reduce or eliminate the margin balance.
In addition, brokerage firms are not required to give investors any notice before issuing a margin call. If, for example, on January 15, the brokerage firm decides it no longer wants to recognize stocks as valid margin collateral, it has the ability to do so at its discretion. Similarly, if the brokerage firm decides it no longer wants to permit margin use at all, it can “call” your margin loan completely.
There are several more risks associated with margin:
- If the margin collateral declines in value, you will receive a margin call and it may come at the most inconvenient time
- If you don’t meet a margin call, the brokerage firm will liquidate your securities and you may possibly realize a capital loss
- If interest rates rise, the cost of borrowing may exceed the investment returns; thus eliminating the benefit of using margin
- You are at the mercy of the brokerage firm. They control how much you can borrow, the terms of borrowing, and when the money is due. No notice is required before they “call” your loan.
With margin balances at FINRA member brokerage firms ballooning to nearly $700 billion, the current risk in the market is tremendous. If there is a significant correction, and margin calls are issued, it will cause massive selling pressure in the market, which will negatively impact the value of all securities.
What Are The Best Practices When Using Margin?
Margin is only suitable for customers who have an aggressive risk tolerance and are willing to accept significant fluctuations in the value of their account. Even if you are an aggressive investor, using margin should be done in moderation. The overuse of margin can quickly convert a profitable account into a dangerously volatile and risky account.
The Wolper Law Firm is a nationwide securities litigation and arbitration law firm devoted to recovering investment losses on behalf of aggrieved investors. Matt Wolper, the Managing Principal of the Wolper Law Firm, is a trial attorney who has tried myriad cases involving the inappropriate use of margin. If you have lost money due to the inappropriate use of margin, you may be entitled to sue your brokerage firm and recover your investment losses. The Wolper Law Firm offers free consultations and works on a contingency basis, meaning we only get paid if you recover money.
For a free consultation and case assessment, contact the Wolper Law Firm at 800.931.8452.