Seems like everyone is down on margin lending these days, but these relatively low-interest loans from brokers to investors can, nonetheless, be valuable tools for sensible investors.
In February, the New York Stock Exchange and the National Association of Securities Dealers asked brokerage firms to consider adopting more restrictive margin-lending rules. The Securities and Exchange Commission and Federal Reserve also have expressed concerns about margin loans.
What’s the worry? Basically, that easy-lending practices among brokerages have combined with investors’ excessive confidence to make the stock market too risky.
Margin lending among NYSE members has increased about 36 percent in the past few months, with outstanding loans totaling a quarter of a trillion dollars in January. Regulators worry this could amplify turmoil if stocks dive.
Basically, margin loans are secured loans that use an investor’s stock, bond and fund holdings as collateral. An investor generally can borrow up to half the cost of an investment at a single-digit interest rate. There’s no minimum monthly repayment requirement; you can let the interest build up and compound as long as you want, though obviously it’s not smart to owe interest on interest. And most brokerages allow customers to withdraw cash from margin accounts, so these loans can be used for any purpose, not just investing.
Moreover, margin loans can be tax-deductible so long as the proceeds are used to buy taxable investments. (The deduction cannot exceed the investor’s net investment income, which is interest and dividends earned minus investment expenses other than interest.)
Once your margin account is set up, you need no approval for individual margin loans, and there are no application fees. You must simply keep your loan balance below your limit, which is based on the value of your portfolio. At many brokerages, you can draw cash from a margin account with a debit card and checkbook.
All these features make margin loans attractive for all sorts of expenses, though their main use is for making additional investments. If you used $50,000 worth of stocks in your account as collateral for a margin loan to buy another $50,000 worth of the same stocks, you would double your profit if those stocks rose in price. (Although you would have to subtract the interest cost from that gain.)
The problem is, of course, that investments also can fall in value. Invest $50,000 and a 10 percent decline means a loss of $5,000. Use a margin account to boost the investment to $100,000 and a 10 percent decline means a $10,000 loss, plus the cost of margin interest.
Regulators are concerned that the huge increase in margin lending over the past few months exposes many investors to tremendous risks. If those investors start frantically selling to cut losses, a market decline could spiral downward in a vicious circle, hurting all investors.
In the worst case, margin “maintenance requirements” could force stock-dumping even among investors who would prefer to hang on in hopes of a rebound. Regulations require margin accounts to hold equity of at least 25 percent, and many brokerages go further, requiring 30 percent or 40 percent. Equity is the value of the securities in the account minus the amount of margin debt owed the brokerage.
In an example prepared by the SEC, an investor who owns $8,000 in securities and borrows to buy $8,000 more would start with equity of $8,000–$16,000 in securities minus $8,000 debt, meeting the “initial margin” requirement of 50 percent.
If the value of the securities fell to $12,000, the equity would fall to $4,000–$12,000 in securities less $8,000 in debt.
That’s not a problem if the maintenance requirement is 25 percent, or $3,000 (.25 x $12,000).
But if the brokerage’s requirement is 40 percent, the equity would have to be $4,800 (.4 x $12,000) and the account would be $800 short. The brokerage would issue a “margin call” requiring the investor to add cash or securities to make up the shortfall. If the investor failed to do so, the brokerage would sell some of the securities in the account to reduce the debt. Securities would be sold even if the investor preferred to wait for a rebound.
It’s easy to see why regulators worry about this becoming a widespread problem. But does that mean investors should shun margin accounts?
No. Even the most prudent of us needs to borrow from time to time, and a margin account is a convenient way to borrow at low interest rates. The hazards of margin calls can be minimized by keeping the debt well below the limits.
