Excessive Margin: Double or Nothing | Cold Spring Advisory Group

Excessive Margin: Double or Nothing

February 2015

Excessive Margin is another tool used by “transactional” broker dealers to make money at the expense of their clients. Unlike markups and markdowns, which leech money from an investors account over time, excessive margin can swiftly cause severe to total loss before the investor realizes what is happening. In our opinion, the goal of these broker dealers is to get as many of their clients on margin as possible. They do this by burying a margin agreement in the stack of new account forms an investor receives when they open an account. The agreement is marked for signature like everything else in the package and goes completely unnoticed by the new client. These small “transactional” broker dealers and their brokers have tremendous incentive to use margin. First, the broker can double the amount of stock or bonds and therefore charge double the commission. Second, the broker dealer makes profit on the margin interest. For example, if the clearing firm charges the broker dealer 3.5% margin interest, the broker dealer can mark-­‐‑up another 3.5%, so the investor ends up paying 7% interest on a loan he isn’t aware he took out. A broker dealer with $20 million on margin at 7% interest will profit $58,300 per month. That’s fast money at no risk. In a scenario Cold Spring Advisory sees with alarming frequency, the broker will trade the new client very conservatively at first to start building equity in the account. Next, he will start calling the investor urging him to buy stocks almost guaranteed to be “sure things” and “home runs.” When the broker can no longer raise money from the client, he will tell him his account has the buying power to purchase more stock. At no time will the broker tell the investor he will be on margin. Because he doesn’t need to send additional funds, the investor will usually go ahead with the purchase. After all, his broker is a registered, licensed professional bound by the rules of the Financial Industry Regulatory Authority (FINRA) and the Securities Exchange Commission (SEC), so he trusts his advice. Once on margin, the investor is in a very high-­‐‑risk situation. When the stocks in his account lose value, the investor loses his equity first at double the rate. At the usual 50% margin, a 5% drop in the value of his stocks results in a 10% loss of his equity. When you consider that these firms tend to put their clients in highly speculative positions, a devastating amount of damage can be done in a very short period of time. When an account declines to 35% margin, a margin maintenance call goes out, and additional funds are required. A number of our clients reported that their brokers told them to ignore the call or that the call was a mistake. Many others were told that the margin call would correct itself in a few days. At this point, the alarm bells should be ringing in an investor’s head because his account is losing equity. When the margin call is not met and the equities in the account do not increase in value, the brokerage firm and the clearing firm can, at any time, increase the amount of required margin to protect themselves. Further, the brokerage firm and the clearing firm can – without warning or consent – sell any stock in the investor’s portfolio to cover the margin, or even sell the entire portfolio. Investors should also be wary of low-­‐‑priced stocks on margin. Most clearing firms will not margin stocks valued at under $5.00 per share. Hypothetically, if a broker buys a stock at $5.50 per share and it closes at or below $4.99, the clearing firm will call for the margin balance to be paid immediately. The investor is faced with the ultimatum to either pay the entire balance or sell out. Cold Spring’s Opinion: We believe FINRA should change its rules to require broker dealers to send margin agreements under separate cover. Too many of our clients state that they were not aware they were being traded on margin and did not recall seeing – much less signing – a margin agreement. Others reported they instructed their broker to take them off margin only to be put back on margin without their consent a trade or two later. FINRA must protect investors from the predatory practices of these “transactional” brokerage firms. Investors, if you signed a margin agreement, and you do not want to be traded on margin, contact your brokerage firm to make sure it is not coded for margin. If you are not sure if you signed a margin agreement, write the Chief Compliance Officer at your brokerage firm and make sure your account is coded in accordance with your investment strategy. To learn more, or to see if your account has been affected by excessive margin, please contact us at (212) 566-­‐‑6060 or www.coldspringadvisory.com.