How Margin Risk Can Devastate a Brokerage Account.
WAAAAY BACK in January of 2018, I blogged about how trading on margin, even in a prolonged bull market, can have devastating results if (when) the markets dramatically decline. See, “Investing On Margin—Will Your Chickens Come Home to Roost?” I was concerned for those investors for which margin investing might be unsuitable, as the outcome can be devastating. Certainly, there are generations of new investors with a great deal of investment dollars that only began investing real money during this bull market; meaning they have never faced a down market and the margin calls that come with. This may be a rude awakening.
With the recent Coronavirus Correction (headed toward recession), it is likely that many investors that were investing using margin have suffered significant losses, AND had to sell other securities in order to cover margin calls. In my January 2018 post, I noted that at the end of November 2017, FINRA reported there was more than $627 Billion in margin debit balances in retail customer accounts, compared to $553 Billion at the beginning of 2017, more than a 13% increase in borrowing to invest in stocks (Note: A margin debit balance represents the amount of money the investor owes the brokerage firm). Two years later, at the height of the bull market, FINRA reported there was $561 Billion in margin debit balances in retail customer accounts, a ~10% decline from the same statistic from two years before. Overall, 2019 showed somewhat lower levels of margin than 2018 and 2017, so based on this alone, it would appear that borrowing to invest leveled out at the “end” of the recent bull market. However, if one were to look at the margin debit levels in 2010-2012/13, margin balances have doubled! Clearly, investors wanted to leverage their accounts by purchasing securities using margin debt. But, as the analogy for this post goes, your chickens may come home to roost amid this market correction!
All of the statistics aside, the fact remains that there were very, very high levels (record levels) of margin debit balances in retail customer accounts. That fact combined with the very rapid and dramatic decline in markets will inevitably result in record levels of margin calls. This post is not addressing when the firm can liquidate your securities to cover the debt, so for purposes of this post you should assume that unless there are other extenuating circumstances the firm can “sell you out” or “buy you in” (if short selling) at any time and without notice and without giving you the opportunity to manage the process. In other words, the brokerage firm can liquidate those securities that are most valuable to you and regardless of the tax consequences. For the investor that is experienced, and has sufficient and liquid resources to backstop the margin borrowing, margin calls may be unwelcome, but those very sophisticated investors presumably understood the risk and will have to pay the piper. However, those investors for whom margin investing was not suitable for any number of reasons, will also have to pay the piper when their brokerage firms liquidates everything in any/all of their accounts to meet the margin call or even retire the entire debit balance, but the question becomes whether those investors should ever have been permitted to invest using margin in the first place.
The short answer is “No” or “Probably not”. The unsophisticated investor who could not afford the margin call process, or did not fully understand the margin call dynamics, should never have been permitted by the firm to invest on margin. A recommendation to invest using margin in such a scenario would be considered unsuitable, and the investor would be entitled to a return of the losses and damages stemming from the unsuitable recommendation. Of course, every case is factually distinct to some degree, but investing on margin has specific risks that must be disclosed, understood, and the investor must be financially capable of realizing the risk. What are some of the signs of an unsuitable recommendation to invest on margin:
- No prior experience investing on margin (Might be OK, but lack of experience is a suitability factor)
- Inadequate disclosures related to the risks of investing on margin (Risks of margin weren’t properly explained)
- Lack of financial resources and/or liquidity to cover the entire debit (You can’t afford to lose the amount of the debit)
- Complex strategies involving margin (You don’t understand the basis for the strategy and why it is good for you)
FINRA published its Investor Alert: Investing with Borrowed Funds: No “Margin” for Error and explained rather well the risks of investing on margin and how margin accounts work. FINRA recognized the likelihood that some brokers and firms were encouraging and recommending retail investors to invest using margin….the markets were going up, and up, and up and by using margin you could buy MORE! Of course, brokerage firms made significantly more money through the multiplier effect brought on by margin investing, as well as the interest charged on margin debit balances. FINRA also published an article in its “Advanced Investing” segment called Understanding Margin Accounts, Why Brokers Do What They Do and explained how margin calls work in volatile markets. One might wonder how many investors heeded the warnings.
So here we are. As of this post the DJIA is off ~28% from its high (or it was when I started, but it is down more now…). Inevitably, investors have paid margin calls, and have had accounts liquidated to cover both calls and the entire debit. Gold and silver are both down today, which seems to indicate that even the usual safe harbors of gold/silver are being tapped by investors in order to meet margin calls–people are having to sell anything/everything they can, either to be really defensive, or because they have to. As the markets continue down, selling pressure from margin liquidations will continue until all of the debt is washed through the market. More is yet to come…
Our firm has received several calls from investors whose accounts have been liquidated without prior notice, and some of those will be valid claims we will pursue in arbitration. Others will not. For those investors for whom margin investing was unsuitable in the first place, or at escalated levels became unsuitable, they will have valid claims for the unsuitable recommendation to invest on margin. For the very sophisticated investor that could understand and withstand the risk, they will be hurt, but likely without recourse, and will return to the high risk stakes of investing on margin in the future, as they presumably can afford the game.
Survey: Did brokers tell their unsophisticated investors that did not appreciate the real risks of investing on margin, and could not afford the downside of margin liquidation in a correcting market what it would be like when the chickens come home to roost?
Unfortunately, some didn’t and those clients may not easily recover from the financial devastation.
Thank you for reading, liking, and forwarding!!