I saw a sexy advertisement from a brokerage firm bragging about its rock bottom borrowing rates.
“While the Fed is lending money at almost zero interest rates, why not take advantage of it? Our company will lend $1 million at 1.3% for every $200,000 in a portfolio margin account.”
Instead of proceeding with caution, many investors are diving in head first.
During the first and second quarter of 2012, the Federal Reserve reports that brokerage margin loans increased 9% to its highest level since 2008. (Does anybody remember what happened that year? Help me out, because I forgot.)
Margin or “margin loans” allow investors to buy additional securities by borrowing money from their broker and using the value of their brokerage account as collateral.
Here’s an example: Let’s say you buy a stock or ETF for a client at $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, your client will earn a 50% return on the investment. But if you bought the stock on margin—paying $25 in cash and borrowing $25 from the broker—they’ll earn a 100% return on the money they invested. Of course, they’ll still owe the broker $25 plus interest.
The broker’s advertisement continued: “See our high dividend scanner for the many hundreds of stocks that yield over 5%.”
The problems of this strategy should be obvious. Even if you’re borrowing money at a low 1.3% and getting a much higher dividend yield from stocks or ETFs, a lot can go wrong.
What if the stock decreases in value? For example, let’s say the stock your client bought for $50 falls to $25. If they paid for the stock with unborrowed money, they’ll lose 50%. But if they bought on margin, they’ll lose 100% and that’s not all. They must still come up with the margin interest they owe to the bookie, I mean broker!
There are a few more caveats.
In volatile markets, investors who put up an initial margin payment for a stock or ETF could be required to provide additional money if the price of their securities falls. What if they don’t pony up the additional cash? The brokerage firm has the right to sell securities they bought on margin without prior notification. And if the broker sells the stock after the price has plummeted, the client has lost out on the chance to recoup their losses if the market bounces back.
For good reason, it makes sense to have a fireside chat with clients who are toying with the idea of margin. Here are a few things to tell them:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities;
- Your brokerage firm may sell some or all of your securities without notifying you to pay off the loan it made to you.
Even though it may appeal to sophisticated investors or those with lots of money, leverage via a margin account is always a double edged sword. It’s true that gains can be magnified, but so can losses.
Remember: Trading on margin is only for people with a high tolerance for risk. Even if clients are borrowing money at rock bottom 1.3% rate, dividend yields can be cut, equity prices can fall and borrowing rates can jump.