Although the majority of investors purchase stocks and bonds through a cash account, they may also do so on margin. This is accomplished by the investor filling out a separate margin account form (which may be part of the regular cash account form but requiring separate signature) which states that the customer agrees to hypothecate (pledge, lend) the securities purchased to a bank for a loan. He further agrees to pay interest on such loan and to keep the account at least at a minimum maintenance level.

The securities available for margin include

1. stocks and bonds listed on an exchange

2. stocks listed as eligible in the NASDAQ/NMS

3. certain OTC securities designated by the Federal Reserve Board (about 2,500)

4. warrants (for listed and designated securities only)

NOTE- new issues are not allowed to be purchased on margin. This obviously includes mutual funds which are always new issues.

Both the NYSE and the NASD have minimum margin deposits of $2,000.

The obvious advantage to investors is that they will be able to leverage a purchase (currently 50%) and buy greater amount of stocks. However, few people- save for some brokers actually working with margin accounts- are truly aware how margin works, how excess equity and Special Memorandum (Miscellaneous) Accounts are valued and what the potential risks and costs might be.

50% Margin/Reg T Requirement

Current margin to open an account is 50% and is defined under SEC Regulation (Reg T) which is the rule for extension of credit. It is important to note that the 50% is ONLY necessary for the initial purchase and that the account may drop considerably in value before any action need be taken by the firm or investor. Also, the margin requirement may be changed at any time but has been at 50% for many years.

Assume 100 shares of XYZ at $50.00 were purchased on margin. Exclude commissions. Also exclude any interest charged to the account- this will be addressed separately.

Market - Loan (Debit) = Equity - Margin @ 50% = Excess Equity
Market -Loan Equity 50% Margin Excess Equity SMA Value
$5,000 2,500 2,500 2,500 0 0

The initial cash purchase or equity needed to open the account is $2,500. The excess equity is determined by subtracting the 50% margin requirement from the equity in the account. In this case, it is obviously $0

Assume the price increases to $60 per share = $6,000
Market -Loan Equity 50% Margin Excess Equity SMA Value
$6,000 2,500 3,500 3,500 500 500

The loan remains constant for this exercise (though quite obviously it is increased on a daily basis due to interest) and the equity in the account has now grown to $3,500. The margin requirement used to determine excess equity is based on 50% of the current price and is subtracted from equity to yield $500.00.

The SMA also has increased to $500 since, by definition, it equals the greatest amount of excess equity at ANY time in the account- regardless of account value. SMA may be further described as an accounting term meaning that whatever value it has ever attained will remain on the books unless it is actually used by the investor. So, even if the account was to drop to $0 tomorrow, the SMA would still show $500- though useless in application. If cash was withdrawn of $500, it must be made as an additional loan/debit balance. The account would now look like:

Market -Loan Equity 50% Margin Excess Equity SMA Value
$6,000 3,000 3,000 3,000 0 0

Assume the $500 of excess equity had been used to purchase more stock ($60/share) on margin. Since cash would buy two times the amount of stock, the same scenario exists here- and excess equity and SMA return to $0.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$7,000 3,500 3,500 3,500 0 0


Restricted Account

But should an account drop in value where equity is below the initial 50% Reg T guidelines, it becomes "restricted." The term is somewhat symbolic since purchases and withdrawals of cash (assuming SMA is available) and stock are still allowed- though if the account keeps dropping where equity is only 25% of market value (or drops below), more limited usage exists.

Assume the account now drops to $40 but that no other purchases or withdrawals had occurred since the stock had reached $60.00. Note the remaining SMA of $500 though the excess equity has vanished.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$4,000 2,500 1,500 2,000 0 500

The equity to market value above is 37.5%. If the full SMA is withdrawn, the loan increases to $3,000 and the equity drops to $1,000.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$4,000 3,000 1,000 2,000 0 0

This account is restricted but nothing need be done since minimum equity is at the 25% minimum.

SMA could also have been used to purchase more stock. In this case, the 50% margin rule applies and allows twice the SMA of stock to be purchased. The loan increases to the full amount of the purchase since all of the funds are borrowed from the firm.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$5,000 3,500 1,500 2,500 0 0

Equity to Market Value remains at 30% and is restricted. Nothing more can be withdrawn since there is no more SMA left. However, other purchases and sales can take place in the account at the 50% Reg T requirement.


Assume the account was restricted as follows
Market -Loan Equity 50% Margin Excess Equity SMA Value
$4,000 2,500 1,500 2,000 0 0

Equity to market value is 37.5% If a purchase was made of $10,000 of stock, the investor would need to pay cash to the account of 50% or $5,000. The account would then be
Market -Loan Equity 50% Margin Excess Equity SMA Value
$14,000 7,500 6,500 7,000 0 0

It is still restricted since equity is less than Reg T 50% requirements.

If instead, the account sold $1,000 of stock, 50% of the proceeds MUST be applied to a loan when the account is restricted. The $500 increases SMA.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$3,000 2,000 1,000 1,500 0 500

If the $500 is removed, the account would tend to show:
Market -Loan Equity 50% Margin Excess Equity SMA Value
$3,000 2,500 500 1,500 0 0

But this is impossible since the equity has dropped below the 25% minimum requirements.

Minimum Maintenance

The minimum maintenance requirement is currently 25%. If the equity in the account drops below 25%, the account holder will get a "margin call" (actually an equity call) to put in more equity either in the form of cash, paid up stocks or be required to sell out part of the account to draw the account back up to minimum maintenance. It is possible to determine the minimum market value of a margin account by dividing the loan/debit balance by .75 (the complement of 25%). In this case, $2,000/.75 = $2,667. At this point, the equity is exactly 25%. If the account drops further, a "margin call" by the firm will be made.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$2,666 2000 666 1,333 0 0

$666/$2,667 = 25%


Assume however that the account had dropped quickly to $2,000
Market -Loan Equity 50% Margin Excess Equity SMA Value
$2,000 2,000 0 1,000 0 0

The broker would require an immediate infusion of $500 in cash. This would bring the equity to $500 or the 25% minimum.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$2,000 1,500 500 1,500 0 0

The investor could also deposit fully paid marginable securities where the loan value on these securities equals the equity needed -in other words, twice the margin call for a 50% Reg T- or $1,000.
Market -Loan Equity 50% Margin Excess Equity SMA Value
$3,000 2,000 1,000 1,500 0 0

The equity is now above 25%. Lastly, the investor could sell stocks equal to four times the amount needed.

Interest charges

Interest is charged at the Call Money rate to the brokerage firm. The broker may then charge the investor say, 200 basis points above that for loans under $10,000 to perhaps an extra 100 basis points for loans above $50,000. The point to note is that, irrespective of the movement of the stock, the loan keeps on increasing year after year and could reach a sizable sum that the investor might not realize.

Investor Considerations

If an investor has a good fundamental understanding of leverage and the associated risks, has a properly diversified stock portfolio that is monitored on an ongoing basis, then margin may be acceptable. But a broker recommending such use must be fully cognizant of the movements of the underlying stocks and accept the increased responsibility of informing the investor of any potential problems.

However, margin on a non- diversified portfolio is unacceptable since it is extending the unsuitability to an even greater extent. Within that same context, margin accounts with short sales and options are even more risk oriented.

Lastly, I have rarely seen many investors that truly understand margin accounts, the definition of a restricted account nor, certainly, SMA. The same goes for brokers. One other way to determine the sophistication of a broker would be to ask him/her to define SMA.

The National Association of Securities Dealers, Inc. (NASD 2000) Board of Governors has approved an amendment to its rules requiring member firms to provide written statements about the risks of margin accounts.

Although some brokerages already provide statements, this would be the first time they are required.

* A customer can lose more funds than he/she deposits in the account if the value declines.

* A firm has the right to force the sale of securities in an account.

* A firm may notify the customer of a margin call and allow the customer a few days to meet the call, but the firm also can sell a customer’s securities without contacting him/her.

* A customer cannot decide which securities should be sold from his/her account.

* A firm can increase maintenance margin requirements at any time.

* A firm does not have to grant a customer an extension on a margin call.