By Lawrence C. Melton, [email protected]
THE HAYES LAW FIRM, www.dhayeslaw.com
1923 to 1929 marked a six-year bull market in stocks. The Dow Jones Industrial Average soared from 85.76 on October 27, 1923 to an all time high of 381.17 on September 3, 1929. Fifty five days later on Monday, October 28, and continuing on Black Tuesday October 29, 1929, the stock market crashed. Measured from the peak attained on September 3, the index has lost nearly 40%. Many economist believe the crash and the resulting damage was due to the widespread use of margin.
Using margin allows an investor to borrow part of the money needed to buy stock from a broker. The portion of the purchase price that the customer must deposit in called margin and is the customer's initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer.
A large percentage decline in your equity triggers a margin call from your broker. This means that the broker is demanding more money (or securities) to bring your position back up to its minimum margin requirement. If you do not come up with the money in time, your position may be closed out. This means that the broker can sell your stock in order to recoup the money you owe.
MARGIN: When the customer borrows funds from a broker, the customer will open a margin account. The customer will pay for part of the securities and borrow the rest from the broker. The portion of the purchase price that the customer must deposit is called margin and is the customer's initial equity in the account. The margin loan is secured by the securities that are purchased by the customer.
MINIMUM MARGIN REQUIREMENT: The law requires that the customer's equity in the account not fall below a certain percentage (currently 25%) of the current market value of the securities in the margin account. If it does, the customer will be subject to a margin call.
MARGIN CALL: Broker's demand for additional cash or securities to maintain a minimum margin requirement. The failure of the customer to provide additional cash or securities will cause the broker to sell or liquidate the securities in the customer's account to bring the account's equity back up to minimum margin requirement.
In the 1920s the regulations governing the use of margin were relaxed compared to today. In the 1920s ivestors could buy stocks by paying only a small fraction of the up front cost. They would borrow most of their money from the broker. FORBES magazine provides an example of how margin was used in the 1920s:
In the 1920s you could buy $100,000 worth of stock with 10% margin ($10,000), borrowing the remaining 90%($90,000) from your broker. Each day the value of you holding is markeed market to market to ensure that minimum margin is maintained. If the price of the stock falls by 5%, the value of the stock decreases by $5,000. But you still owe $90,000. The value of your position, sometimes called your equity, has decreased 50%, from $10,000 to $5,000. The process of figuring out how much equity you have in your account is called marking it to market. A large percentage decline in your equity triggers a margin call from your broker.
Groz, Marc, Forbes Guide to the Markets, p. 46, John Wiley & Sons, Inc., 1999.
In the 1929 crash, not only were investors wiped out, but those who used margin still owed significant sums to their broker. This is because the rules at that time allowed the investor to borrow most of the purchase price from the broker. In the above example the investor borrowed 90% from his broker.
Following the crash, the Federal Reserve enacted Regulation T which provides that your broker can only lend you at most half of the money needed to buy a stock.
Here is an example on the present rules provided by the National Association of Securities Dealers:
If you buy $100,000 of stock with a 50% margin, you will pay $50,000 for the stock and borrow the remaining $50,000 from your broker. Your equity in the account is $50,000 and you receive a margin loan of $50,000 from the broker. You pay 50% and your Broker pays 50%
Assume that later, the value of the securities falls from $100,000 to $60,000. How does this change the situation? The loan remains the same amount, $50,000. However, your equity decreases to $10,000 ($60,000 market value minus $50,000, loan amount). The law requires a minimum maintenance margin of 25%. In this hypothetical, this means that your equity must not fall below $15,000 ($60,000 market value multiplied by 25%). Since the required equity is $15,000, you would have to pay a margin call of $5,000 ($15,000 minimum required equity minus existing equity of $10,000).
See NASD Investor Alert: Purchasing on Margin, Risks Involved With Trading in a Margin Account,available on NASD web page.
If you have been the victim of brokerage fraud please call THE HAYES LAW FIRM at 1-866-332-3567 and visit www.dhayeslaw.com