portfolio margin versus regulation T

In short

A friend of mine once told me he thought borrowing from a broker worked like borrowing from a neighbor, a simple favor between honest people. It does not, and the rules behind it are worth an afternoon of your attention. If you are holding a margin account, the broker lends against what you own, and the loan is secured by those holdings. Two different rulebooks can set how much you may borrow. The older one, Regulation T, looks at each holding by itself. The newer one, portfolio margin, looks at the risk of the whole account together. Portfolio margin can allow more borrowing, and it can also demand cash in a hurry when prices fall. Before you ask for either, find out what your broker requires, read the margin agreement, and picture the worst week you could live through.

The whole of it

What it is

I once watched a man at a county fair try to explain a card game to a table of newcomers, and he lost them all by starting with the exceptions. So let me start plain. A margin account is a brokerage account where the broker lends you money, and your stocks and other holdings stand as collateral. That means the broker holds a claim on them until the loan is repaid.

Regulation T is a rule of the Federal Reserve Board. It governs how much credit a broker may extend to a customer to buy securities. Under it, the initial requirement on most stock purchases is the current figure, which the official source publishes each year of the purchase price. Put another way, the customer pays that share in cash or equity, and the broker may lend the rest.

Portfolio margin is a different method. It does not apply a flat percent to each position. It runs the whole account through a set of price shock tests and asks how much the account could lose in a bad market. The margin requirement follows from that answer. The rules for it sit in the exchange and regulator rulebooks, including FINRA Rule 4210 and the rules of the Cboe Options Exchange. The broker must be approved to offer it, and the customer must be approved to use it.

Both systems carry a second layer. After the first purchase, a minimum equity level called maintenance margin applies. Equity is simply what your holdings are worth minus what you owe. FINRA sets a floor for maintenance margin, and brokers often set a higher one of their own.

How it works

You have probably heard that margin lets you buy more than your cash allows. That is true, and it is also only half the story, because the loan comes with a leash.

Under Regulation T, each position is treated on its own. The account is tested position by position, using fixed percentages. A stock bought on margin needs the initial deposit, and afterward the account must keep its equity above the maintenance level. If equity falls below it, the broker issues a margin call. That is a demand to add cash or securities, or to sell holdings, so the account gets back above the line. The broker may also sell holdings without asking first. The margin agreement usually says so in plain words, and few people read that paragraph.

Portfolio margin works from the other direction. It looks at how positions offset each other. Say a customer owns a stock and also holds a contract that gains when that stock falls. Under Regulation T, each side may carry its own full requirement. Under portfolio margin, the model sees that one side cushions the other, so the combined requirement can be smaller. A well hedged account may need far less margin than the old method would demand.

The same model can turn on you. It stress tests the account against a set of large price moves, and the requirement is the worst loss it finds. If holdings are concentrated, or the market becomes jumpy, the requirement can rise fast. Brokers can also raise their own house requirements on short notice. Smaller buffers mean less room for error.

Access is stricter too. FINRA Rule 4210 sets a minimum equity level for portfolio margin accounts, and brokers often set higher ones. Brokers must also approve customers for the strategies involved and give them a written risk disclosure. Not every broker offers it at all.

The numbers, and where to find yours

Here is where I would ask you to slow down, because a few figures decide everything. The initial requirement under Regulation T is the current figure, which the official source publishes each year. The FINRA minimum maintenance requirement for long positions is the current figure, which the official source publishes each year. The minimum equity a customer must hold to open a portfolio margin account is the current figure, which the official source publishes each year. The pattern day trading equity minimum, which applies to some active margin customers, is the current figure, which the official source publishes each year.

To find your own numbers, open your margin agreement and the margin section of your broker's website. Look for the house maintenance percent, which may be higher than the FINRA floor. Look for the rule on how quickly a call must be met. Look for the broker's right to sell without notice. The Federal Reserve Board publishes Regulation T, and FINRA publishes Rule 4210 and a plain language guide to margin for investors. The SEC also has investor pages on buying on margin. Those are the primary sources, and your broker's agreement is the final word on your account.

A worked example

Let me tell you about a woman named Dana. She holds $60,000 in stocks, all bought with her own cash. She wants to know what each method would allow, so she asks her broker for the figures.

Under Regulation T, assume the initial requirement is 50 percent, just to keep the arithmetic easy to follow. A purchase of $20,000 in new stock would need $10,000 down, since 50 percent of $20,000 is $10,000. The broker could lend the other $10,000. Her existing $60,000 of holdings could count toward that $10,000 down, so she could make the purchase without sending new cash.

Now watch the leash. After the purchase, Dana owns $80,000 in stock and owes $10,000. Her equity is $80,000 minus $10,000, which is $70,000. Suppose her broker sets maintenance at 30 percent. The required equity is 30 percent of $80,000, which is $24,000. Her $70,000 sits well above that line.

Then the market falls hard. Say her holdings drop 40 percent. The $80,000 becomes $48,000. She still owes $10,000, so her equity is $48,000 minus $10,000, which is $38,000. The requirement is 30 percent of $48,000, which is $14,400. She is still safe, with room to spare. Her cushion was real because the loan was small.

Now picture a larger loan. Suppose she had borrowed $40,000 against an $80,000 stock position. A 40 percent drop takes $80,000 to $48,000, so equity is $48,000 minus $40,000, which is $8,000. The 30 percent requirement is $14,400. Her equity is short by $6,400, and she faces a margin call. Same market, different loan, very different week.

Portfolio margin would test that same account against a range of shocks instead. If her holdings were spread out and some were hedged, the model might show a worst case loss smaller than the flat percentages imply, and the broker might ask for less. If the stocks were all one sector, the model could ask for more. I cannot give her a figure here, because each broker sets its own inputs. That is why asking for the numbers in writing matters.

Where it goes wrong

I have known careful people who got hurt by margin, and the hurt rarely came from one dumb choice. It came from a small chain of ordinary ones.

The first trouble is speed. A margin call can arrive during a fast market, and the broker may sell holdings before the customer has time to react. The sale can happen at a bad price, and it can create a tax bill. Portfolio margin can tighten faster than the older method, since the model reacts to volatility, so the call may come sooner than expected.

The second trouble is cost. The loan carries interest, the broker sets the rate, and the rate can change. Interest builds each day whether the holdings are up or down. A borrower who forgets that cost can lose ground even in a flat market.

The third trouble is hidden concentration. A hedge that looks solid on paper can fail when the two sides stop moving together. Portfolio margin assumes the offsets will hold, and in a real crisis they sometimes do not.

The fourth trouble is the loss itself. A borrower can lose more than the amount put in. If holdings fall far enough, the account can owe the broker money after everything is sold. The borrower has to repay that shortfall.

That is worth repeating. Losses can exceed deposits.

The last trouble is plain confusion. Many people never learn which system their account uses, or what its house percent is, until the call comes. A good broker will answer these questions before the loan, and I would ask them first.

Questions to answer before you leave this page

Do you know which system your account uses, Regulation T or portfolio margin, and have you read the margin agreement paragraph that lets the broker sell without asking? Can you name your broker's house maintenance percent, and do you know how many days a margin call allows? If your holdings fell 40 percent next week, what would your equity be, and could you meet a call from cash you already hold? Have you added up the loan interest for a full year, at today's rate and at a rate two points higher? Are your holdings spread out, or do they all rise and fall together? And if the answers feel shaky, what is the one thing you could do this week to make them firm?