Buy on Margin

Margin just means debt, or a loan, or credit...and buying on margin usually refers to an investor buying stocks, pledging their portfolio as collateral in making that purchase.

Example. Greta Greedmonger has a $100M dollar portfolio filled with very conservative stocks comprising 90 percent of it, or 90 million bucks. And 10 million in cash.

Greta, tired of flying in her measly small jet, wants to be able to afford a big jet like the kind the truly wealthy fly. She wants to be in the billionaire’s club (your membership card gets you a great discount on private planes, after all), and she's impatient to just let her stocks compound away at the 8 percent a year growth zone.

She wants to add gasoline to the relatively slow burning embers and speed up her compound rate to get to billionaire status and a G5. That can't possibly, uh, backfire.

So she wants to bet big on a few stocks, believing that she has a solid understanding of the stock market. Specifically, she wants to invest $40M in Amazon, currently trading at 2,000 dollars a share.

But she only has 10 million in cash so...how can she do that?

Well, she could sell 30 million dollars worth of stock. Unfortunately, those stocks were acquired ages ago at very low prices, so if she sold them, she would pay massive tax bills…and, in fact, to generate 30 million of net after tax cash, she’d have to sell something closer to 50 million dollars worth of stock. Way too high a price to pay.

So instead, she borrows money...but she borrows it on margin, meaning that she is borrowing money from...herself.

She has 90 million in stocks. And 10 million in cash. And needs another 30 million beyond the cash she already has to buy that 40 million worth of amazon. Her account at Schwab is already set up as a margin account, meaning that she has already signed a bunch of papers stating that she understands the margin rules of the brokerage...and the biggest rule is that the maximum margin she is allowed to take in her account is 50 percent.

So with her account value at 100 million, the most she could borrow would be 50 million bucks. And there might be another voice telling her to spend it all on jetskis and vacations, but…she just ignores that one. For now.

So if she needs 40 million to invest into Amazon, she’ll use up her 10 million in cash and then take out a margin loan of 30 million bucks. Her account will have 130 million of equities in it, and 30 million of debt and no cash. And that cash carries interest charges. That is, in return for borrowing money from herself, she will pay Schwab a few percent a year in interest. Nice high margin business for Schwab.

So all is good until she decide she wants to put 20 million into Netflix, all on margin. Now she has 50 million in margin in an account with 150 million in equities...and 50 million in debt. Note that her base 100 million in value or equity hasn’t changed since the beginning...only now she has 150 million in investments in that account.

If the portfolio now goes up 10%, she’ll show gains of 15 million...versus the situation where she hadn’t done anything with margin, that gain of 10% would have given her just 10 million in gain. And yes, she’ll be paying, say, 4 percent interest now on the 50 million she borrowed, or about 2 million a year to rent that money.

So all is great…and then a bomb goes off in North Korea and, well, all bets are off. The stock market freaks out, printing down 20 percent in a short period with the high octane names like Amazon and Netflix trading down even more…and all of a sudden, the 150 million in value in her portfolio is cut 40 percent, such that the 150 million is now worth only 90 million.

And that’s a really big problem.

Why? Because she still has 50 million in margin loans on the account and the brokerage has a max 50 percent limit. That is, clients can’t borrow more than half of their portfolio, because it's just too risky for Schwab to have to potentially bear the burden of making the margin whole on that account…if the market then really tanks.

So Schwab sends her a nastygram requiring her, within 24 hours, to inject 10 million of capital into that account to ‘true it up’ to be at least 100 million in value. Like...she could wire in 10 million sitting around in her Bank of America account to make it whole, and in that case, her margin account would go down from 50 million to 40 million on an account that would have gone from 90 million to 100 million, and she’d be just fine.

40 million of margin on 100 million of value is 10 points below the 50 percent max margin limit. But if she doesn't have money in her B of A account just sitting around, then she has to sell stock in her Schwab account to meet her margin requirements...and if she won't proactively call in the orders herself, then Schwab has the right to step in and sell them for her. And Schwab won’t care a whole lot about whether they’re making smart sales or not. They just need the margin minimums met.

So you can imagine that, if a whole lot of people were caught in a margin squeeze like this, and a whole lot of brokerages put in ‘sell, mortimer, sell at market’ orders, the whole system could cave in on itself with massive supply of stock for relatively little demand. And, well...that’s how crashes happen.