Gross Margin Debt Climbing at an Unsustainable Rate, Placing Investors at Greater Risk

Investing on margin—which means investing funds that are borrowed from a brokerage firm—can look attractive because of the potential for great returns. On the other hand, buying on margin can be extremely detrimental in a down market when investors must meet margin calls they might not have the money to pay for, or for investors holding unattractive stocks they aren't receiving many bids for.

Margin debt has increased dramatically since 2003 and is now at an all-time high of more than $665.7 billion, prompting FINRA to include use of margin in its 2018 priorities letter, alongside suitability, cryptocurrency, penny stocks, and high-risk brokers.

Speaking of suitability, this subject often goes hand-in-hand with use of margin, as brokers and firms sometimes have a perverse incentive to unsuitably recommend that a client employ the use of margin accounts, which can be profitable to the broker and firm at the client's expense.

For instance, FINRA sanctioned Ameriprise Financial Services brokers Jack McBride and Stuart Pearl in 2017 for unsuitably using margin to purchase $320,000-worth of securities in a client's account, placing the customer on the hook for margin debt and margin interest. When the client attempted to complain, McBride purportedly tried settling away from the firm and produced exaggerated and misleading account balance information in which he overstated account balances by up to $370,000.

Buying on margin is similar to taking out a loan with your brokerage firm acting as a bank or finance company. Interest, in the form of "broker call" aka "call money," is charged on the loan, and the firm is empowered to mitigate its own margin risk by performing certain actions in your margin account, generally in order to meet margin calls.

Your firm can sell securities in your margin account without contacting you and can force these sales in order to meet a margin call—you are not even entitled to choose which securities the firm will sell.

EXAMPLE: Imagine purchasing $100,000 of securities using $50,000 of your own equity and $50,000 in the form of a margin loan from the firm. If that $100,000-worth of securities was to fall to a market value of $60,000, you might think that means your equity has fallen to $30,000 along with the firm's margin loan also falling to $30,000—fair is fair and equal distribution, right?

Wrong.

Instead, what happens in such a scenario is that your equity falls by the full amount of loss, in this case $40,000, to just $10,000 ($60,000 market value minus $50,000 loan amount), while the margin loan remains at $50,000—the loan price will not change just because the investment performed poorly, and, on top of that, you're on the hook for broker's call at whatever the prevailing call money rate is (e.g., 3.5% as of May 2018).

On top of your equity loss of $40,000, that $10,000 of equity remaining in the account creates an imbalance in its composition: as illustrated above, the $60,000 market value of the securities in your account is comprised of $10,000 in equity plus $50,000 in margin loan—or a 20% equity to 80% margin loan ratio.

Margin accounts carry a maintenance margin requirement relative to these ratios of at least 25%. The maintenance amount varies by the type and quality of securities in the account (the lower quality securities, the higher the maintenance amount). This wasn't an issue when the account contained $50,000 in equity and $50,000 in margin loan (thus, a 50-50 initial margin ratio), but now that the equity ratio has fallen to 20%, you're five percent under the minimum requirement, which for a $60,000 market value is $15,000 (25% of 60,000 is 15,000).

In order to bring the ratio back to the 25% minimum, your firm will put out a maintenance margin call and may opt to liquidate securities in the account to meet it—up to $20,000 worth of securities to satisfy margin rules, and pursuant to the aforementioned rights of the firm to mitigate its own margin liability, the firm doesn't even have to ask you for $5,000 in equity before it decides to sell off $20,000-worth of securities in your account. Furthermore, the firm reserves the right in its margin agreement to liquidate the securities of its choosing. You can bet the firm won't take poorly performing securities.

If the market value of the security continues to decline, for instance, the firm might try to get ahead of the curve and simply liquidate what it can to mitigate expected future maintenance margin calls, which will keep occurring as long as the stock continues to fall.

This is just one reason why investing on margin makes it much more difficult to detect when your account is in trouble.

The Devastation of A Margin Account in a Down Market

Investors should be on the lookout to ensure that brokers and financial advisers act in their best interests, dispensing advice that puts the client first. If investing in margin is too risky for you given your indicated conservative- or moderate risk tolerance level, your adviser should not recommend margin to you.

This best-interests issue is sometimes referred to as fiduciary duty and is so important that FINRA put it first in its priorities list for 2015, although the Department of Labor in 2017 announced it will delay (to 2019) enforcement of the fiduciary duty rule pertaining to retirements accounts, and the 5th Circuit recently gutted the Department of Labor's rule. These corrosive changes to investor protection have emboldened several firms such as Goldman Sachs to try and sell more structured notes and other risky products.

Fortunately, regulators haven't taken all that kindly to firms selling complex products to unsophisticated investors—including pushing margin on those customers for whom margin is not suitable.

For instance, the SEC recently fined Electronic Transaction Clearing $80,000 and issued a cease-and-desist order for widespread margin securities failures, and FINRA barred former Raymond James & Associates broker Scott Allen Sibley for effecting 900 securities transaction in a disabled client's account, causing him to carry a margin debt balance without authorization.

If you have invested with a broker or financial adviser who has unsuitably recommended a strategy of taking on margin debt that has proven harmful to your investments or interests due to the incurrence of broker call fees or a financial imposition associated with attempting to meet a margin call, including a firm that has sold securities or other assets in your account, or if you believe your fiduciary has breached his or her fiduciary duty to you, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.