Margin accounts and margin calls

In short

A friend of mine once told me that borrowing money to buy shares felt like driving a borrowed truck. You enjoy the extra power, but the owner still wants it back in one piece. A margin account is a brokerage account that lets a person borrow from the broker to buy more than the cash on hand would allow. The borrowed money charges interest, and the borrower has to repay it whether the shares rise or fall. If the account value drops too far, the broker can demand more money or sell shares to cover the loan. If you are thinking about opening one, the margin agreement and the broker's fee page are the two papers worth reading line by line first. Know the exact point where your own account would trigger a call. Plan for a bad week, not just a good one.

The whole of it

What it is

I once watched a neighbor of mine stretch his budget to buy a bigger tractor than he strictly needed. He felt good about it in the spring. By autumn he felt every payment. A margin account works a little like that tractor loan. The broker lends money against the shares already sitting in the account, and those shares act as collateral, which means the broker holds a claim on them until the loan is repaid.

You have probably heard the word leverage tossed around. It just means using borrowed money to control a larger position than your own cash could buy. Leverage cuts both ways. A gain on the bigger position is bigger. A loss is bigger too. And the loan stays the same size no matter what the shares do.

A margin account differs from a plain cash account. In a cash account, the owner can only spend what has been deposited. In a margin account, the owner signs a separate agreement, and that agreement gives the broker wide rights over the account. Those rights can include selling shares without asking first. Read that part twice. It surprises people.

How it works

If you are holding a margin account, three ideas matter most. The first is the loan. Say a person deposits $10,000 and borrows another $10,000 to buy $20,000 of shares. The loan is $10,000. The owner's stake, called equity, is the share value minus the loan. Right now that is $20,000 minus $10,000, which is $10,000.

The second idea is the initial requirement. Federal Reserve Board Regulation T sets the starting rule for how much a customer may borrow when buying. The rule lets a customer borrow up to the current figure, which the official source publishes each year of the purchase price on many stock purchases. That is why the example above is allowed. The Federal Reserve Board publishes Regulation T on its website, and the broker applies it.

The third idea is the maintenance requirement. After the purchase, the account has to keep a minimum equity level. FINRA Rule 4210 sets a floor of the current figure, which the official source publishes each year of the current market value for many long positions. Brokers are free to set higher levels, and many do. Some set higher levels for risky or thinly traded shares. The broker's own number is the one that counts, so find it.

A margin call is what happens when equity falls below the maintenance level. The broker asks for more cash or more shares to be deposited. The margin agreement sets the time allowed, and the broker can act quickly. The agreement can allow the broker to sell shares right away, choose which shares to sell, and do it without a phone call first. That is not rude of the broker. It is what the signed paper says.

Interest is the quiet cost. The broker charges a rate on the loan, and the rate is posted on the broker's margin rate schedule. Interest adds up each day and is usually charged to the account each month. It is owed even when the shares are flat. A loan that costs money every day needs the shares to earn more than the interest just to break even.

The numbers, and where to find yours

Every reader has a different set of numbers, so I will tell you where to look rather than guess. The initial requirement comes from Regulation T, published by the Federal Reserve Board. The minimum maintenance level comes from FINRA Rule 4210, found in the FINRA Manual on the FINRA website. Those two are set by rule.

Your broker's house requirement sits in the margin agreement and on the broker's margin requirements page. It may be higher than the FINRA floor. Your interest rate sits on the broker's margin rate schedule, and it often changes with the size of the loan. Ask the broker how often the rate can change and whether it follows a published benchmark.

The Securities and Exchange Commission and FINRA both publish plain English investor pages about margin. They are worth a read before you sign. Look for the sections on risk, on what a broker may do without notice, and on how a call is handled. A borrower who writes down the account's maintenance percent and the interest rate has the two numbers that matter most in plain sight.

A worked example

Let me tell you about a woman named Dolores. She has $12,000 of her own money in a margin account. She buys $24,000 of shares, borrowing the other $12,000. Her equity is $24,000 minus $12,000, which is $12,000.

Suppose her broker sets its maintenance level at 30 percent of share value. That is the broker's own figure for this story, not a legal limit. Now the shares fall 40 percent. The shares were worth $24,000. A 40 percent drop is $24,000 times 0.40, which is $9,600. The new value is $24,000 minus $9,600, which is $14,400.

Her loan is still $12,000. Her equity is now $14,400 minus $12,000, which is $2,400. The maintenance requirement is 30 percent of $14,400, which is $4,320. Her equity of $2,400 is below $4,320. The shortfall is $4,320 minus $2,400, which is $1,920. She gets a margin call.

Dolores has choices. She can deposit cash, deposit other shares, or sell some holdings to pay down the loan. If she does nothing, the broker may sell shares for her. Watch what that does to her. Her original $12,000 has shrunk to $2,400 of equity. That is a loss of $9,600 on her own money, or 80 percent, from a drop of only 40 percent in the shares. That is leverage at work.

Now add interest. Say the broker charges 9 percent a year on her $12,000 loan. That is $12,000 times 0.09, which is $1,080 a year. Over six months it is about $540. She owes that on top of everything else. The 9 percent is a made up figure for the story. Your broker's rate will differ.

Where it goes wrong

I have seen smart people get hurt here, and it is rarely from carelessness. It is from believing the call will come with plenty of warning. A fast market move can push an account below the line in a single day. The broker may sell before the owner has finished a cup of coffee. Sales at a bad moment lock in the loss.

Another trouble spot is the broker's right to raise requirements. The margin agreement lets the broker raise its maintenance level on certain shares, and the agreement spells out how notice is given. An account that was fine on Monday can be short after the broker raises its level, even with no change in price. The broker's notice policy tells the borrower how much warning to expect.

Interest is another trap. A small rate feels harmless. But the loan balance sits there month after month, and the charges stack up. Short term trades feel cheap. Long holds get pricey.

Borrowers can also lose more than they put in. If the shares fall hard and the sale does not cover the loan, the borrower still owes the difference. The account can end up with a negative balance, and the broker may collect it. Ouch.

Last, the fine print about which shares the broker sells. The agreement may let the broker pick, and the picks may not be the ones the owner would choose. The broker may also sell shares in a taxable account, which can create a tax bill. A tax professional is the right person for that question.

Questions to answer before you leave this page

Do you know the exact maintenance percent your broker applies to the shares you own, and have you found it in writing? If your account fell 30 percent tomorrow, could you work out the shortfall with your own numbers, the way Dolores did? Have you read the part of the margin agreement that says whether the broker may sell without calling first? Do you know your interest rate, how it is set, and how often it may change? Could you cover a margin call from cash outside this account without selling anything at a bad moment? And have you asked what happens if the loan is bigger than the shares left, so that you are not surprised by a bill?