Margin Acounts

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Margin Accounts

A margin account enables you to purchase securities without having to advance the total purchase price. The wholly owned securities are used in your account as collateral for borrowing cash. In essence, a margin loan is simply a secured loan.

The main advantage to having such an account is that it gives you the ability to borrow cash quickly and without red tape, at a competitive rate. You can make use of assets you already own without moving or selling them. Many investors use their borrowing power primarily for business or investment purposes. Generally, the borrowed funds are used to purchase securities. However, once you borrow the money, there are no restrictions on how you use it.

Currently, the Federal Reserve Board (FRB) permits securities firms to extend credit of up to 50% of the value of a customer’s fully paid marginable stocks. Virtually all stocks traded on the major exchanges and many OTC stocks qualify, as well as a large number of corporate and government bonds. On many of the latter, the credit that can be extended is greater than 50%. Some securities firms also allow you to utilize credit of up to 50% of the value of selected closed-end unit investment trusts and open end mutual funds. Money-market funds and municipal bond funds are generally not marginable.

Open an account by signing a margin agreement form. All of your fully paid marginable securities will be priced, and you will be advised of the value of the portfolio. Then, you need only call the securities firm in order to obtain a loan.

THE MARGIN CALL

However, like most financial transactions, there are risks. The risk always associated with margin use is that the value of your securities collateral will decline below the required equity level. If this happens, the office servicing your account will contact you to advise that additional funds must be deposited in order to maintain the required equity level. You must usually maintain an equity level of 50% of market value for common stocks, with a $2,000 minimum.

Margin account leverage is a fair weather friend to investors. If you can pick a stock that is poised for a long upward move, buying on margin will magnify your profits. If you cannot find a winner, you will discover that borrowing your anticipated gains can quickly increase losses

In margin accounts, three things can happen to you, and two of them are bad. After you buy stocks, they can only rise in price, remain at the same level or drop. In two of these three situations, if you have bought on margin, you lose.

Even if the stock is a gainer, it must rise by at least as much as you are paying in interest charges before you break even. In addition, if the securities that serve as collateral in your margin account drop sharply in value, you could get a margin call.

This call from your broker demands (requires) that you add cash or securities to your account, thereby increasing the collateral on your loan.

Still, margin investing is more alluring than it has been in years. In today’s market, millions of brokerage customers borrow on margin nearly four times more often as was the practice 10 years ago. In that same decade, the amount of debt incurred by margin investors on the New York Stock Exchange listed shares alone has increased almost five times.

If margin borrowing is risky, why is it so popular? Among the reasons for the leap in leverage:

· The widespread use of asset management accounts, those obliging arrangements that automatically place securities on margin so customers can use their debit cards or write checks against the balance in their accounts.

· The promotional efforts of brokerage houses and online brokers, which have touted margin as an inexpensive and easy way to borrow.

· An old bull market, which has prompted a run among investors eager to use leverage to double their stock profits.

MARGIN EXAMPLES

Let us take a look at how margin investing can work profitably. Suppose you bought 1,000 shares of a computer stock selling on margin at about $14 a share. As is required with any margin account, you put up 50% of the stock’s purchase price (approximately $7,000) and borrowed the rest from the brokerage firm.

In about two years, the shares are valued around $57 each. Total gains on a transaction that required you to ante up only $7,000 initially would have been $40,000 after commissions and interest charges. Had you not borrowed to buy this larger slice of the stock, your gains would have been halved.

But suppose that flush with financial success you tried again. Looking to capitalize on a turnaround, you might have used margin to buy 1,000 shares of a railroad company at about $9 a share. You put up $4,500 and borrowed the other half. Three months later the stock was trading around $3.50, and you sold your shares. The loss was about $6,000, roughly twice the loss had you paid cash and bought only 500 shares.

THE PROCEDURES

When you purchase shares of stock on margin, the shares you pay for in full constitute collateral for your brokerage margin loan. For this reason, the stock you have bought cannot be delivered to you; it must remain in your margin account in what is called “street name.” If your margined stock pays a dividend, it is credited to your account. Until you sell the margined stock, the broker charges you interest that varies according to prevailing rates and the size of your borrowings. The more you borrow, the lower the rate.

If the value of your collateral rises above the amount you started with, which is no small feat, you are ahead of the game. At this point, you can withdraw the surplus from your account or use it to buy other securities on margin. If your margined stock falls in price after you buy it, however, you have double trouble: a swooning stock, interest charges and, if you are truly unlucky, that most-dreaded of investment events, a margin call that might force you to cough up more money.

Most firms require you to maintain collateral worth at least 50% of the margin loan. If your equity sinks below that level, you will receive a telegram or telephone call from the broker directing you to deliver enough cash or other marginable securities.

This might be stocks, bonds and, in a recent liberalization of the law, mutual fund shares to bring your losing position to a level above 50%. If you have neither cash nor securities to deliver, sometimes by the next day, the brokerage firm will sell your stock, take back what was lent you and collect interest. You receive the remainder.

It is not essential that your margin loan funds be used for the purchase of more securities. With a margin account, all you have to do is call your broker and request a check. After you have confirmed the amount available, a check can be issued, usually the same day. In addition, if you have an asset management account, you can access your margin loan by simply using your special charge card or checks. There is no fixed repayment schedule. Your loan and interest charges can be paid back as you wish, the very next day if you would like. There are no other fees, charges or points. The status of your loan will be shown on your monthly statement.

When you buy a security on margin, you pay only a portion of the total cost and your broker extends credit on the balance. An interest charge is made monthly to your account on the amount borrowed. From then on, the price of your security may go up or down, but the amount you owe on your margin loan will remain relatively unchanged except for accruing interest costs.

The amount you are required to deposit in your brokerage account when you buy stock on margin is determined by the Board of Governors of the Federal Reserve Board (FRB) and is binding on all brokers.

Initial margin requirements have remained at a constant 50% from 1974 to the present. Changes in initial requirements are not retroactive. If you put up $5,000 to buy $10,000 worth of stock at a time when the margin requirement is 50%, you do not have to deposit additional money for that stock because the FRB later rises the initial margin requirements to 70%. However, if the margin requirement climbs, your loan value on that particular stock drops to the current prevailing rate, and this will affect your subsequent margin trades.

There is another initial requirement that you must meet. It is commonly referred to as the New York Stock Exchange minimum initial equity requirement. Under this requirement, you must have equity equal to at least $2,000 every time you enter into a new commitment in your margin account. If the market value of your stock increases after you have met the initial margin requirement, you can generally withdraw a percentage of the increase or use it to buy additional stock.

RESPONDING TO THE MARKET

Once you have bought stock on margin and have met the initial margin requirements, the New York Stock Exchange requires that the equity in your account must always represent at least 50% of the current market value of the stock. (Your equity is determined by subtracting from the current market value of your stocks the amount you owe on your margin loan.)

This rule is commonly referred to as the NYSE Minimum Maintenance Rule, and it exists for the protection of all member firms of the New York Stock Exchange. Most brokers set their own maintenance requirements higher than the NYSE Minimum.

SERIOUS IMPLICATIONS

Whenever a margin maintenance call is incurred, cash or collateral must be deposited to maintain your account. If you deposit securities instead of cash, only a percentage of their market value can be used to meet your maintenance call. This percentage varies with margin maintenance requirements. Such securities must be marginable under Federal regulations and also acceptable in accordance with your brokerage firm’s maintenance requirements. If for any reason you cannot meet your margin call, the brokerage firm has no alternative but to sell sufficient securities in your margin account so the account meets maintenance requirements

One of the biggest problems with margin is that when a stock starts to drop, investors often freeze. Nobody likes to admit they have been wrong about a stock. Be prepared to monitor the value of your collateral on a daily basis.

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