margin. The Federal Reserve sets the initial margin on stocks, which
has been at 50 percent for many years. This means, in our example
above, that you could not margin more than a $1,000 purchase of
Corporation X with a $1,000 cash purchase because, of the $2,000
purchase, only 50 percent, or $1,000, of it can be on margin. If, however,
you had securities in your account with a value of, say $50,000,
then your margin-buying power would be $100,000. When you make
a stock purchase on margin without sufficient collateral (cash or securities)
in your account to cover the 50 percent margin requirement,
you will get a Reg T margin call requesting you to deposit
sufficient collateral.
Brokerage firms are allowed to set what is called “maintenance
margin,” the percentage the stock price can drop before a margin
call is triggered. Through their computer systems, brokerage firms
monitor the value of the stock purchased on margin, and when the
stock starts to drop in value, usually to around 30 percent, firms
issue a maintenance margin call. Both Reg T and maintenance margin
calls can be satisfied in a number of ways; investors can send in
additional cash or deposit additional marginable securities, or some
of their current holdings can be liquidated to cover the margin call.
We promised not to deluge you with investment advice, but
we can’t help it when it comes to margin. Most people who take a
bloodbath from using margin blame it on the fact that their stocks
or the market went down. The price movement of stocks is a necessary
component of a margin call, but the problem is that no one
ever knows when a particular stock or the market as a whole will go
down. If you are still dead set on using margin, the trick is to never
be heavily margined. Far too many individuals figure that if they buy
their stock at 50 percent margin, the 20 percent spread between 50
percent margin and the 30 percent margin that triggers a maintenance
margin call is an adequate cushion. This is no longer true in
these days of volatile markets and volatile securities. It would be
wiser to not allow your account to be margined more than 25 percent,
as opposed to 50 percent, at least initially. This way, you are
more likely to be able to sustain a major drop in stock prices without
being forced to liquidate at the worst possible time.
In addition, take a look at the price history of any security you
are thinking of buying on margin. This is easy to do on the Internet;
review the historical up and down swings in price over the preceding
two years on a percentage basis, which should give you a
pretty good indication of how this stock might move after you purchase
it. A term in the securities industry—beta—is a measure of
volatility in a security in relation to the S&P 500. Beta can be used
as a quick measure of volatility, but it may not let you see the actual
swings in price.
Investor inquiries and complaints about margin have ballooned
in recent years, certainly as a result of the increasing number of individuals
employing margin in their online brokerage accounts.
This increase in inquiries and complaints prompted the NASD in
August 2000 to approve a proposed amendment to NASD rules
that would require member firms to provide retail customers with a
written statement that fully describes the risks associated with trading
securities in a margin account. The margin disclosure statement
must be provided to customers prior to, or at, the opening of an account
and annually thereafter; the statement can be delivered electronically
or on paper. The NASD permitted firms to create their
own disclosure statement so long as it contains the following specific
information:
• A customer can lose more funds than he or she deposits in
the account if the value declines.
• A firm has the right to force the sale of securities in an
account.
• A firm may notify the customer of a margin call and allow
the customer a few days to meet the call, but the firm also
can sell a customer’s securities without contacting him
or her.
• A customer cannot decide which securities should be sold
from his or her account.
• A firm can increase maintenance margin requirements at
any time.
• A firm does not have to grant a customer an extension on
a margin call.
What many would perceive as one of the biggest tricks of the
brokerage industry, at both traditional and online firms, is the manner
in which firms will “sell out” your portfolio to cover a margin
call with no notice to you. This is happening much more often at
online firms. Even at traditional firms, however,
customers are feeling the pinch as a result of the significantly higher
numbers of volatile stocks in which they are trading today. The
higher the volatility, the more margin calls are issued.
Tracy has a case pending in which her client received an e-mail
on a Saturday afternoon from his brokerage firm to inform him that
he had a maintenance margin call in the amount of $33,651. The
e-mail provided her client with wiring instructions on how to cover
the call. Acting promptly, Tracy’s client arranged for the wire transfer
of $35,000 over the weekend, and the wire transfer process was
put into effect first thing Monday morning. On Monday morning,
her client began telephoning the firm and after several tries, each
met with a busy signal, he finally got through. The firm representative
notified her client that his entire position had been liquidated
at market. The firm received Tracy’s client’s wire transfer of $35,000
that Monday afternoon.
Pertinent portions of the firm’s Brokerage Account Agreement
stated:
You are responsible for acting immediately on any buy in
or sell out notice given verbally or in writing. Your failure
to promptly deposit additional money or securities in
response to a margin call may result in the liquidation of
part or all of the securities in your account. Although we
will generally attempt to notify you of a margin call and
give you an opportunity to deposit additional equity to secure
the account, we reserve the right to institute imme-
diate discretionary liquidation without prior notice and
without giving you the opportunity to deposit additional
equity.
Tracy’s argument is that her client did act promptly and it wasn’t
his fault that the firm’s phone lines were busy. An interesting point
is that Tracy’s client might not have had a case if the firm had simply
liquidated the account Monday morning without having sent
the Friday e-mail. But the fact that it sent the e-mail and Tracy’s
client acted as promptly as possible under the circumstances (as the
agreement requires) gives rise to a viable claim.
There are also horror stories about brokerage firms permitting
customers to purchase stocks on margin well beyond their means, a
phenomenon that hardly existed before hoards of unsophisticated
investors opened online accounts. If you deal with a traditional firm
and call up to tell your broker you want to buy $100,000 worth of
XYZ Corporation with your sole remaining $50,000, ideally we
hope your broker would say, “Now wait a second, let’s take a more
careful look at doing this.” There’s no one to give you any sage
words of advice on the Internet.
Even when margin is used on less volatile securities, investors
can be severely damaged, as is often the case after a sharp market
drop. Often a rebound occurs, and the stocks that plummeted recover,
leaving investors who were sold out wringing their hands and
full of anguish. The majority of investors who were hurt in the 1987
market crash were those who were forced to sell their investments
at severe discounts because of margin calls. This happened again in
August 1998 with the Southeast Asian crisis. In both of these cases,
the market turned around almost immediately, leaving margined investors
with stinging losses.
It is hoped that with firms adhering to required disclosures, a
greater awareness will spread that brokerage firms will basically sell
you out at whim. Just because you may have gotten margin calls for
years and promptly paid them, don’t expect that you will get notification
of your next margin call. If the value of your stock drops
fast, the firm has the right to act fast, with or without you. And the
firm can pick and choose which of your securities to sell. We don’t
agree with this new trend in how margin is being handled. It is
mostly online firms that have adopted these new hasty tactics, which
deviate from the industry standard and show a total disregard for
the interests of the customer. As the rules now stand, you have a
tough, uphill battle.
You must be on your toes when it comes to margin. And, for
most of you, that means not agreeing to use margin at the drop of
a hat. When you consider that the consequence of a margin call
could be the loss of your entire portfolio, margin can be viewed as a
highly speculative venture. If your stockbroker recommends margin,
examine your downside. If, for example, he recommends margin
to purchase long-term investments, such as municipal bonds or
conservative mutual funds or stocks or bonds you intend to hold,
question how the margin cost might be greater than your return in
dividends or interest. Question the margin interest and how much
more of a return you need to overcome it. The ability to get specific
answers is one of the now highlighted benefits of having a human
stockbroker, as opposed to entering your own trades online with no
individualized input. Finally, if you receive a margin call, act fast.
Don’t assume that the firm will wait for you to come up with the
money. It may not, and the language in the customer or margin
agreement may support its action.
Source: Brokerage Fraud: What Wall Street Doesn't Want You to Know
