Margin Accounts

Most retail brokerage accounts are retirement accounts. Retirement accounts are cash accounts in which customers must pay in full either at the time of the transaction or no later than 2 days after settlement. Because retirement accounts cannot be approved for margin trading, no short sales are executed in IRA or 401(k) accounts, either. And, that makes sense, as selling short involves potentially unlimited risk.

Investing on margin is a high-risk strategy that involves buying securities on credit, hoping to make more on the securities positions than the interest the broker-dealer charges on the margin loan. Another use of such accounts is to profit when a stock's market price drops by selling short.

Broker-dealers offer margin accounts to earn interest on the loans and to encourage more trading activity. Institutional traders including hedge funds utilize margin or leverage at high levels. Some retail customers also have their taxable accounts approved for margin. A new account number is not provided when they do. The account is simply approved for margin trading and borrowing after careful review of suitability by the member firm.

In a margin account, customers pledge the securities they buy on credit to the lender, the broker-dealer. If things go wrong, the broker-dealer can sell the stock or bond to recover the money they lent. So, the interest rate they charge is lower than what we pay on a credit card, since the broker-dealer has collateral backing the loan.
People talk about the equity in their houses. Maybe they bought the house for $200,000 and borrowed $180,000 to do that. If so, their account starts out like this:

$200,000   Market Value
-$180,000 Money Owed
$20,000    Equity

Equity is the difference between what someone owns and owes. If the value in¬creased 15% three years running, while the principal was being reduced, the account now looks like this:

$304,175 Market Value
-$170,000 Money Owed
$134,175 Equity

What can these homeowners do with that equity? They can borrow against it.
In a margin account, we don't buy houses on credit. Rather we buy stocks and bonds on credit. If their market value rises, we win. What if their market value drops? Then, we have a problem. This is where margin accounts get their bad name.

Regulation T
The Securities Exchange Act of 1934 gave the Federal Reserve Board the authority to regulate margin accounts. The Fed regulates credit, and one form of credit is the margin account, in which the broker-dealer advances the customer half the purchase price of a security. Regulation T also covers cash accounts, preventing customers from freeriding or being late to pay for securities transactions.

To purchase stock on margin, the broker-dealer follows Regulation T (Reg T), which states that a margin-eligible stock can be pledged as collateral by the customer in exchange for a loan from the broker-dealer up to a maximum percentage of its value.

eg T tells broker-dealers how much credit they can extend to their customers. That percentage is 50%. The industry sometimes refers to the amount a customer puts down as the "Fed call."

When a customer buys $200,000 of stock, he puts down 1/2 or $100,000. The other $100,000 is provided by the broker-dealer, who charges interest on that debit balance for as long as the customer owes them. The amount the customer puts down is referred to as "the margin." The margin refers to the money the investor is required to deposit. The rest of the market value is extended on credit.
Regulation T requires 50% of the purchase price to be deposited by the customer within two business days after the settlement date of the transaction. Any market price change between the purchase of the security and the required payment does not affect the amount of the deposit the customer is required to make. If the stock purchased on margin rises from, say, $50 to $60, or drops from, say, $50 to $40, the margin call is based on $50 per-share. It is figured at the time of purchase.

Marginable Securities, Accounts
Not everything can be purchased "on margin," but that doesn't mean it can't be purchased within a margin account. A "margin account" is an account that has been approved for margin. The following securities are "marginable," meaning they can be purchased using margin:
•    NYSE, NASDAQ, AMEX stocks
•    OTC securities on the FRB's approved list
•    Exempted securities: Treasuries, municipal securities

The following can be purchased inside a margin account, but must be paid in full:
•    Non-NASDAQ OTC securities not on the FRB's approved list
•    Options
•    IPOs or any new issue for 30 days
•    Mutual fund shares

 options can be purchased "on margin,"؟      the answer is no.
options can be purchased "in a margin account,"؟     the answer is yes.

Maintenance Requirements
Regulation T requires the initial margin a customer must deposit, either in cash or securities. For example, when purchasing $20,000 of stock on margin, the customer must deposit either $10,000 or fully paid stock with a market value of $20,000. Fully paid stock has a loan value of 50%, so whatever amount the customer is buying, that's the amount the stock must be worth when used to meet the Fed call.

If the Reg T requirement is less than $2,000, the customer must deposit $2,000. For example, if he purchases $3,500 of stock on margin, he deposits $2,000 rather than $1,750. $2,000 is the minimum equity for a long account. Just as a customer cannot borrow money if it would take the equity below $2,000, he must deposit at least that much initially.

With one exception. If the total amount of the purchase is less than $2,000, the customer pays in full. If the stock is worth just $1,500, he pays $1,500. He does not pay more than the stock is worth. He has an account approved for margin. He hasn't used the feature yet.

For a short position, the customer deposits 50% of the proceeds from the short sale initially.

That addresses the initial margin. Going forward, the margin account is subject to maintenance margin. For margin-eligible stocks held long, the minimum maintenance is 25% of the current market value. For any equity security that is not margin-eligible, the customer must pay in full to establish a long position.

Reg T does not apply to exempt securities such as U.S. Treasuries and municipal bonds.

 FINRA rules establish the maintenance margin for such securities based on their maturity and current market price. The following applies to bills, notes, bonds, and STRIPS issued by the Treasury.
                 Maturity                                Percent of Current Market Value
Less than one year to maturity                                1%
One year but less than 3 years to maturity               2%
Three years but less than 5 years to maturity           3%
Five years but less than 10 years to maturity            4%
Ten years but less than 20 years to maturity             5%
Twenty years or more to maturity                             6%

Although the above applies to zero coupons such as STRIPS, there is also a requirement for any zero coupon with 5+ years to maturity. The rule states, "Not¬withstanding the above, on zero coupon bonds with five years or more to maturity the margin to be maintained shall not be less than 3 percent of the principal amount of the obligation."

For other exempted securities besides Treasuries, the maintenance margin is 7% of the current market value, for both long and short positions.

Securities Lending
FINRA requires that customers receive a margin disclosure document explaining how interest is charged and pointing out many of the things we've considered. For example, customers are informed they can lose more than they initially deposit in some cases and the firm can liquidate securities without notice or consultation with the customer.

The customer signs a margin agreement. The margin agreement either includes a hypothecation agreement, or a separate document is signed. To hypothecate means to pledge securities as collateral to secure the loan. Without the customer's written consent, a broker-dealer cannot hypothecate a customer's securities. And, the firm only hypothecates enough to secure the loan, called the margin securities. The excess of that are the excess margin securities, separated clearly on the firm's books and records.

More correctly, the customer hypothecates his margin securities to the broker-dealer. The broker-dealer then re-hypothecates them to the bank providing the margin loan.

Some customers also opt into the firm's securities lending program. Typically, these are customers with account balances of $250,000 or more. Short sales require cash collateral, and the broker-dealer earns interest on this cash. Therefore, customers in the lending program providing their fully-paid securities to short sellers share in some of that interest as an incentive to make their shares available.

There are also disadvantages, which must be disclosed to customers signing the loan consent agreement for the securities lending program. For example, securities loaned out confer voting rights to the borrower, rather than the owner. The borrower must pay any dividends to the lender of the stock, but the tax code treats such payments less favorably than a typical dividend received from the issuer. Also, securities loaned out are typically not protected by SIPC.

The agreements here can be combined into one margin agreement provided they are made clear to the customer before he signs. And, the hypothecation, margin, and lending agreements can be incorporated into the customer agreement signed when he opens an account at the broker-dealer, provided nothing is slipped by him in small print or opaque language.