You, too, can be a hedge fund manager  [a Sentinel excerpt]  

by Pat Huddleston, Investor's Watchdog

I tried to make this article about trading on margin more entertaining. At first I made up a story about a man who lost his inheritance after letting his broker convince him to trade on margin. It was a good story. But after reading it, I was concerned that not everyone would identify with the man’s predicament – one common theme I see running through the cases I handle is the “I’d never fall for that” syndrome. Getting ripped off is something that happens to other people.

Some topics are too important to risk obscuring the message with an illustration. This is one of those. So, let’s get on with the unvarnished truth.

It's a Loan

Margin is a loan, a loan that the broker gives you to allow you to buy more stock. Your broker loves margin. It allows him sell you twice as many shares for the money you have available. More to the point, he can generate twice the commission for himself and supplement his income with his share of the monthly interest you will pay.

How It Works

Under rules promulgated by the Federal Reserve Board, your stockbroker is allowed to loan you up to fifty percent of the purchase price of most stocks. The loan is secured by your account. As the price of your stock declines, the collateral evaporates. Every brokerage firm has an official level of discomfort with that evaporation, after which they will insist that you give them additional collateral for the loan. The industry term for that level of discomfort is the “margin maintenance requirement.” It is expressed in terms of the equity percentage of the account. If the equity in the account falls below the determined percentage (typically 30-40%), the firm will insist upon additional collateral (Federal Reserve rules require additional collateral if equity falls below 25%. Firms cannot therefore set a minimum equity percentage below 25%). The industry calls the request for additional collateral a “margin call,” but that term is really a sophisticated way of saying that it is time for a . . .

Fire Sale

Because all stockbrokers are trained to convince you, by any means necessary, to deposit with them all of your liquid assets, and your retirement accounts, and your insurance policies, and your children’s accounts, and any other assets you may have, the chances are slim that you will have a pot of cash or marginable securities elsewhere to give the firm as additional collateral for the margin loan. When you receive the margin call, then, you will have to sell the securities in your account to pay down the margin debt. Because the decline in the price of the stocks was the event that triggered the demand for more collateral, you will be selling the stocks at the lowest price they reached while you held them. Few things are certain with the stock market; selling at the bottom to meet a margin call is a sure thing.

I Signed That?

When you opened your margin account, you signed a document that provides, in substance, that the broker (lender) may sell the assets in your account if it gets nervous about the collateral securing the margin loan. You agreed that they can sell your assets without your notice and over your express objection. If you have experience with a margin call, you probably are comforting yourself with the knowledge that your brokerage firm has always given you notice of the potential sale of your assets and allowed you a certain period of time to make other arrangements to increase the equity in the account. You suspect that there must be a law requiring them to give you notice and to allow you time to avoid the fire sale. You are mistaken.

The Law Will Not Protect You

The laws and regulations regarding margin loans were promulgated to protect the brokerage firms (lenders) and our financial markets as a whole. They are not consumer protection laws. They are lender protection laws. Your only recourse in a dispute over a margin fire sale will be to appeal to industry custom and argue from there that the firm had some duty to observe that custom. Your chances of succeeding with that argument, though, are about as good as the chances that your broker cares more about your assets than he cares about his own.

The Truth

With a margin account you can lose all of your money very quickly. If you chose to trade on margin despite these warnings, how valuable is it to know the background of your broker? The correct answer is “the current balance of your account.” That’s what’s at stake. Let Investor’s Watchdog protect you by investigating your broker’s background and keeping and eye on him while he has access to your account.