Margin Accounts a Three Part Series

Part 1: Would you like to own a Bank?

How does "My Own Bank of My House" sound to you? Do you know that your household, family, or your inter circle of friends can own their own bank? All you, your family, or your friends have to do is come up with some capital, form a club with family or friends, and open a margin account at a brokerage firm. You may want to borrow money to buy a house, car, furniture, or some securities. Why not go to your bank and set your own terms? Your children may need a loan for college/trade school or to get out in the world starting a family. Why not help with the financing of that new house? All you need is your bank to do that.

I can see people now telling me that the average person can’t do that. Well I am average. Some say that I am below average. I have been doing this since 1976. All you have to have is some start up money, some common sense, and know how Margin Accounts work.

"Margin" is borrowing money from your broker to buy assets and using your investments as collateral. Investors generally use margin to increase their purchasing power so that they can own more stocks, bonds, or other securities without fully paying for it. They also use it to get loans to buy hard assets such as cars, houses, or even take vacations. But margin exposes investors to the potential for higher losses. This is why it is best to understand how margin works before you use it. Here's what you need to know about margin.

Know the Good and the Bad About Margin

Let's say you buy shares of "Darnell Corp" for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you'll earn a 100 percent return on the money you invested. Of course, you'll still owe your firm $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50 percent of your money. But if you bought on margin, you'll lose 100 percent, and you still must come up with the interest you owe on the loan.

In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor. If your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back.

When talking about creating your own bank, you don’t want your cash invested in a volatile investment and you want to have a safety margin in a volatile market. This is why I suggest using bonds instead of stock because bonds are more of a stable investment than stocks. You can borrow more on bonds than you can on stocks as well.

Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:

1. You can lose more money than you have invested;

2. You may have to deposit additional cash or securities in your account on short notice to cover market losses;

3. You may be forced to sell some or all of your securities when falling security prices reduce the value of your securities; and

4. Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the securities purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to analysis whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

Part 2: Know the Mechanics of a Margin Account

Do not rely on other people to create your business model for your personal bank. Remember, other people such as your banker, broker, investment advisor, and others have their own interest. In most cases, they will have no idea what you are talking about in the first place. They will be driven by profits for themselves not for you.

To open a margin account, your broker is required to obtain your signature. The agreement may be part of your account opening agreement or may be a separate agreement. The margin agreement states that you must abide by the rules of the Federal Reserve Board, the New York Stock Exchange, the National Association of Securities Dealers, Inc., and the firm where you have set up your margin account. Be sure to carefully review the agreement before you sign it.
As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.

The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and FINRA, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules. Know these key rules;

1. Before You Trade Know The Minimum Margin

Before trading on margin, FINRA, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price, whichever is less. This is known as the "minimum margin." Some firms may require you to deposit more than $2,000 no matter what securities you will invest in or trade.

2. Amount You Can Borrow – Initial Margin Percentage

According to "Regulation T" of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of stock that can be purchased on margin. This is known as the "initial margin." Some firms require you to deposit more than 50 percent of the stock purchase price. The Initial Margin requirement is different depending on the security purchased and collateralized. Also be aware that not all securities can be purchased on margin. Some firms restrict the type of securities that can be margined. Here is the reason why I do business with a Bond Broker/Dealer instead of a general stock broker.

3. Amount You Need After You Trade – Maintenance Margin Percentage

After you buy securities on margin, FINRA requires you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the "maintenance requirement." In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent, and sometimes higher depending on the type of securities purchased.

Here's an example of how maintenance requirements work. Let's say you purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in your account will fall to $4,000 ($12,000 - $8,000 = $4,000). If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000). In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40 percent, you would not have enough equity. The firm would require you to have $4,800 in equity (40 percent of $12,000 = $4,800). Your $4,000 in equity is less than the firm's $4,800 maintenance requirement. As a result, the firm may issue you a "margin call," since the equity in your account has fallen $800 below the firm's maintenance requirement.

Many times Corporate Bonds have a 25 percent your money to 75 percent borrowed money requirement. Here is another reason why I use Corporate Bonds and a Bond Brokerage House. If a bond increases in rating, the power to borrow will increase as well.

Recently:
Aaa down to Baa3 -- Initial: 100% * Bond Market Value, Maint.35%;
Ba1 down to B3 -- Initial: 100% * Bond Market Value, Maint.50%;
Caa1 down to C -- Initial: 100% * Bond Market Value, Maint.70%.

4. Understand Margin Calls – You Can Lose Your Money Fast and With No Notice

Please remember, your brokerage firm is not a baby sitter or a hand holder. If your account falls below the firm's maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.

Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

If you, family, and friends are going to start your own bank, write up a business plan first. Know what requirements you are going to have for you and your members before you start investing and conducting business. Make sure that your investments are valued higher than your liabilities at least initially. Make plans to take care of decreasing values before it happens.

Part 3: Make Sure You Understand Your Risks

Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase? Are you aware you may lose more than the amount of money you initially invested when buying on margin? Can you afford to lose more money than the amount you have invested?

I had a friend who bought a commodity on margin, invested $5,000 of his money and cashed in with $33,000 in 6 months. In the next year, he lost his house, his savings, his in-laws money, and his wife because his margin account went "south" on him. I would say, he did not understand the risk.

Make sure you take the time to read the margin agreement? Ask your broker questions about how a margin account works and whether it's appropriate for you to trade on margin with the investments that you want to use? Make sure your broker explains the terms and conditions of the margin agreement?

When I was a "young Pup," I shorted warrants that were 24 months before expiration. One day, I started getting these margin calls. Then I found out that the broker can force me to cover my warrants when the broker needed them covered. It was in the agreement that I really did not read. It cost me money!

Are you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return? Are you aware that your brokerage firm can sell your securities without notice when you don't have sufficient equity in your margin account?
In my bank model, I always made sure that I had at least a two percent spread between the interest of my bonds and the interest that the broker charged my account. That way my costs were covered by my bonds at all times. But my brokerage interest fluctuated so I had to make sure that I had sufficent equity at all times. When the business became unprofitable because of increasing high rates, I shut down the business until it became profitable again.

Having your own bank based on a margin account can be very rewarding and very profitable. But it can also be a head ache when things start going wrong. I have used them to buy cars, make down payments on homes, and to help out my children. But I have also seen people loose their homes, their cars, and their family just because they did not understand the risk involved in Margin Accounts.

To learn more about Margin Accounts Requirements read the following: http://www.interactivebrokers.com/en/p.php?f=margin&ib_entity=llc