Investors should think twice before deciding to use margin loans. Brokerage firms are offering customers very low-interest margin loans in this ultra-low interest rate environment, and, surprisingly, many are accepting. In fact, the use of margin accounts is up 65 percent since 2009 ( See “Borrowing Against a Portfolio Leaves Little Margin for Error,” by Ian Salisbury, Wall Street Journal).
Margin involves the use of borrowed money to buy assets, usually securities. It adds layers of risk to a portfolio. It amplifies losses as well as gains, and it subjects the customer to margin calls if the account value (which is the collateral for the margin loan) drops below a certain level.
While some investors are aware of this risk, it is our experience, that most people do not realize that a brokerage firm can sell all of your stocks and other securities at firesale prices without giving any notice in order to satisfy a margin call. While firms do sometimes give their customer time to put up more collateral, they are not required to according to the fine print of the typical account agreement. If the market is moving fast against investors, that is when firms are most likely to dispense with the margin call and simply cash investors out, leaving them with big losses and sometimes a big tax bill as well. Indeed, in a worst-case scenario, an investor can end up with nothing and owing money to the brokerage firm!
Investors may have legal recourse if a disaster like that occurs, but it can be a long, difficult road to recover these losses.
In addition to traditional margin accounts, other nontraditional lenders are making stock-based loans these days. The same cautions apply. The stocks that serve as collateral can be sold without notice if they fall below a certain level.
Investors should be very leery about margin. It’s like playing with fire.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.