Smooth talking brokers will tell you that when buying on margin, an investor is using his broker’s money. That’s nonsense. The margin buyer is borrowing his own money and, adding insult to injury, paying interest and commissions to his or her broker for the privilege. The broker makes money, no matter what. The investor is out on a limb and often loses his securities followed by his shirt.
To trade on margin, sometimes called securities based lending, an investor must enter an agreement with his or her broker. It is different than a regular cash account agreement but, nonetheless, may be quietly “slipped in” by a broker as an additional term in the opening account agreement. Cross it out.
The maximum that an investor can borrow is fifty percent of the value of his or her securities purchase. That alone should suggest that margin buying is a risky adventure. Even today, after the financial crisis, 80 and even 90 percent mortgages are available to credit worthy home buyers. Yet, only 50 percent financing is available to securities buyers, even though there are ready markets to buy and sell securities on a daily basis. Moreover, an investor’s securities account is instant collateral for a margin loan.
Unlike a mortgage loan, there is no court to examine the fairness of a “foreclosure”. As soon as the investor’s account falls below a value of 50 percent of the margin (loan) balance, the brokerage, without any notice to you, can and will immediately sell your stocks, whichever ones it may choose, for whatever it can get, to bring the margin balance, including all the built up interest, back down to 50 percent or less. In the industry, such a calamitous event is referred to as a “margin call”.
Even, if an investor never suffers a margin call, the longer an investment remains margin funded the higher the costs and, accordingly, the less likely the already slim chance of realizing an investment profit.
If an investor has $5,000 to invest, utilizing margin can allow a $10,000 purchase. If your purchase doubles in value, you are whole, except for the commissions and interest to be paid. The amount of interest depends on how long it takes for the stock to double in value. On the other hand, a $5000 cash investment, that is an investment without resort to margin, if it doubles, generates a profit of another $5000 at no interest cost and without the high risk of the loss of twice the sum you had to invest in the first place.
The role of the lawyer is to spot when your losses are the result of unjustified broker advised margin investing. Securities lawyers are trained to identify this too common, underhanded practice. A virtual certainty is that without counsel, the margin victimized investor will be without effective recourse. The broker will never right his wrongdoing on an investor’s plea for fair play. Strong arm, unrelenting lawyering, is the only language that speaks to the predator.
Margin transactions are not for the inexperienced. In fact, they are perilous for everyone except the broker-dealer who always holds all the face cards. True, a broker may be liable if he ill-advisedly exposes an investor to the losses of securities based lending. Yet, it’s so much wiser to avoid the situation in the first place and cap investment risk to the cash you can afford to lose rather than gambling with twice as much.