Tuesday, 22 January 2008

What to do about Margin Calls

Some readers probably have borrowed "on margin" to fund part of their stock portfolio. A margin loan is basically a loan secured against the value of the stocks in the margin account. The lender will determine the "margin" applicable to each stock, based on it's perceived volatility and liquidity. For example, a blue chip stock that is slightly less volatile than the overall market and is highly liquid (traded in large volumes each day) might be allocated a margin of 80%, whereas a small, speculative company with low capitalisation and daily market volume might be given a margin of only 40% (or 0%). The concept is basically the same as a home loan, where the lender may fund up to, say, 90% of the purchase price of a house. As stock prices fluctuate more than house, lenders require a larger "deposit" to buy stocks on margin. [note: this is how margin lending works in Australia, the situation in the US is similar, but different, with generally lower margins being allowed by the regulator).

Margin lenders may "freeze" borrowing against a particular stock if their clients have a large overall holding in that stock. A more annoying behaviour is when a margin lender suddenly decides to reduce the margin allotted to a particular stock when it announces bad news - the borrower then gets a double whammy from both the drop in the stock price and the reduced margin value of that stock.

In times when the market volatility has increased and the market is down (such as now), margin lenders may even make across the board reductions in the margin values of stocks. This reduces the risk to the lender that the stocks may be worth less than the amount loaned against them, but it's pretty poor customer service as it can precipitate margin calls when the market is down and therefore force stocks to be sold when the price is down. Although the loans are secured against the stocks, the lender would still be able to pursue any outstanding debt with the customer, so decreasing margins when the market gets choppy seems too self-serving.

The ratio of the total margin loan balance to the margin value of the stocks in the margin loan account is known as the Margin utilisation (MU). Assuming margins don't change, the dreaded "margin call" will occur if the value of the stocks in the margin loan account drops to the extent that the margin loan balance is more than the margin loan value of the stocks (plus a "buffer" allowed by the lender). The "buffer" allowed by each lender varies, but is often around 5%. In that case a margin call would be made if the MU went above 105% at any time during trading.

When a margin call is made, the customer has a short time (say, until 5pm the next business day) to get their MU back below 100%. When a margin call is made - DON'T PANIC! There are number of ways to handle a margin call, in order from best to worst:

1. Add some extra collateral to the loan account. This is done by transferring some other stocks you may have (that haven't been used as collateral for a loan) into the margin loan account. Assuming these stocks have some margin value, this will reduce the ratio of the loan amount (which stays the same) against the margin value of the margin loan account (which you have just increased). You'd have to negotiate this transfer with the margin lender as it wouldn't be completed within the usual margin call time frame. You should also check that there won't be any capital gains tax issues resulting from the transfer (some margin lenders require the stocks to be held by a trust account, which can be deemed a change in beneficial ownership and thus trigger a CGT event). Because this isn't an instant process, you're probably better to transfer any "spare" stocks into your margin loan account if you get close to 100% MU, rather than wait for a margin call to occur.

2. Use some cash to pay off some of the margin loan balance. This has a big impact on MU.

3. Use some cash to buy some more stock within the margin loan account. This may be attractive if you are cashed up when the market drops, as it may be a good buying opportunity. However, it won't have as big an impact on your MU as option #2 as although you've paid 100% cash for the new stock purchases, only 70%-80% of the stock value (their margin value) with count in the calculation of your new MU.

4. Sell some stocks to pay off some of the margin loan balance. This has the same effect as option #2 from the lenders point of view, but you will be selling off stocks that have probably dropped considerably in price. You get to decide which stocks to sell, taking into account your CGT issues and which stocks you feel should be retained and which should be ditched.

5. Do nothing. The lender will sell some of your stocks to achieve option #4 as soon as the time limit for the margin call has passed. As you don't get to decide which stock they sell off you may not like the result.

If you have a margin loan account is always a good idea to borrow less than the maximum permitted. For example, if the overall margin allowed for the stocks in your margin loan account is 70%, you may just borrow 50% of the purchase cost. This would mean your MU is (50/70) = 71.4%, and the value of the stocks in your margin loan account would have to drop by 32% before you'd exceed a MU of 105% and get a margin call.

It's also good to check your current position and keep an eye on your margin utilisation. A quick "what-if" calculation will show you how much further the market would have to drop before you started getting margin calls.

For example, at the present time (after today's massive 5% plunge, coming on top of 12 straight days of market decline) my margin loans are as follows:

Account #1
Loan balance $166,819
Account value $282,307
Margin value $209,126
MU 79.8%

A further decline of 24% in the overall market would probably see me get a margin call on this account.

Account #2
Loan balance $121,129
Account value $315,189
Margin value $153,908
MU 78.7%

A further decline of 27% in the overall market would probably see me get a margin call on this account.

Account #2 has a much lower overall margin value compared to the value of stocks in the account because this account holds the $100,000 worth of IPE shares I recently bought. This stock has been allocated 0% margin by the lender.

Overall, I have margin loans of $287,947 with an account value currently around $445,047. An further drop of around 25% in the stock market would see me get a margin call. By that time my equity in the portfolios would have dropped from $309,548 to around $157,100 -- so I'd be pretty unhappy. However, with the market already 22% off it's recent high, that would mean an overall market plunge of around 42%, so I wouldn't be the only unhappy investor around.

Copyright Enough Wealth 2007

1 comment:

ZachStocks said...

I personally can think of very few times when adding cash to meet a margin call would be a good idea. Typically a margin call comes if an investment decision has been wrong and on top of that, the account is leveraged. Usually the best thing to do is to liquidate the position(s) and take a step back to understand where the investment process went wrong, and then slowly begin to invest using a more conservative approach.