Margin Accounts

Anyone who bought a house back before the bubble burst has a pretty good model for how margin accounts work. Let's say there was this house going for $300,000 that you simply had to buy. Of course, like most home buyers, you had very little actual money to use toward the purchase, so you found a financial firm interested in spotting you, say, 90% of the property's value. You filled out some credit information to get the loan, and pretty soon you were putting down $30,000, with the lender cutting a check to the seller for the other $270,000.
Believe it or not, you were using what the exam calls "leverage." Leverage involves borrowing money in order to increase your potential returns. So, at the outset, your property was worth $300,000 and you owed $270,000. The difference between what you own and owe is your equity, which at the beginning was $30,000.
$300,000 market value
$270,000 balance owed
$ 30,000 equity

At the beginning, your equity is just the cash you put down to buy the property. Let's say that one year later, you get an appraisal stating that the home is now worth $350,000. You've paid down some of the principal balance by overpaying the monthly mortgage payment, so the balance owed is now just $250,000. If we run the numbers again, we see some good news:
$350,000 market value
$250,000 balance owed
$100,000 equity

On paper, you're up $70,000. Talk about leverage, huh? You risked only $30,000 and, at least on paper, you're sitting on a capital gain of over 200%! You could either try to sell the house for a fast capital gain, or you could borrow against this $100,000 of "equity" in order to re-do the kitchen and bathroom. What happens if you borrow $70,000 of your equity, and then home values start to fall in your area? You're in trouble, as we see from the numbers:
$300,000 market value
$320,000 balance owed
$ -20,000 equity

Talk about being "underwater," huh? So, using leverage to speculate on house prices was a lot of fun while it lasted. As soon as the market turns against you, though, the pain sets in.

In a margin account, customers buy stocks and bonds with borrowed money, as well. With the Federal Reserve Board's Reg T requirement at 50%, customers put down 1/2 the current value, with the broker-dealer financing the other half. The broker-dealer will earn interest on the margin loan, and--just like a mortgage lender--they will foreclose, so to speak, on your property if its value begins to plummet. Let's say you wanted to buy 10,000 shares of LMNO, a company developing a new glow-in-the-dark alphabet soup for kids. The stock trades for $30 a share, so you put down $150,000, and the broker-dealer spots you the other $150,000. You start out like this:
$300,000 market value
$150,000 balance owed
$150,000 equity

As with the house, the equity at the beginning is just the cash you put down. Luckily, LMNO gets mentioned by a raving, spitting, lunatic stock jockey on CNBC the next day, sending it up to $47 a share. Check out your increased equity suddenly:
$470,000 market value
$150,000 balance owed
$320,000 equity

Imagine making $170,000 that fast on $150,000! Leverage is awesome, as long as the lever swings in your favor. You could sell and walk away with a fast profit, or you could do what you did when the house value rose--you could borrow against your equity. On a $470,000 stock position, Reg T is $235,000. Any equity above that can be played with. So, you have $320,000 in equity, which is "excess equity" of $85,000. Believe it or not, you could tell the broker-dealer to cut you a check for $85,000 right now, and they will simply tack it onto the debit balance that you owe them. Or--and I swear this is true--you could buy $170,000 worth of stock. Remember that "SMA" is the $85,000 you can borrow cash-money; your buying power is exactly twice that amount, or $170,000. Let's say you use your buying power just like a homeowner putting a big, unnecessary addition onto a 4,000 square-foot home. You buy the $170,000 of stock and your account looks like this now:
$640,000 market value
$320,000 debit balance owed
$320,000 equity

As you can see, clearly you are now rich. You should probably start looking at properties in Florida, Texas, Arizona, or whichever sunny paradise you will be retiring to in just a few short months. You might even want to start drafting the snarky letter of resignation in which you call your supervisor an inferior, bald-headed, suck-up. But then--no, this can't be right--suddenly LMNO is in the news because of a product re-call. Apparently, the factory in Georgia that supplied the glow-in-the-dark coloring agent was infested with rats and roaches, forcing over 300 kids to become violently ill all across the country. Will the company be able to avoid bankruptcy? Maybe. But the stock is now trading for $11. But, but, you owe a lot more than what the stock is worth! Yes, you do. And that means you can either send in a bunch of cash to pay down the debit balance, or the broker-dealer can sell the stock (just like a foreclosure) and use the proceeds to pay some of what you owe.
So, margin accounts are not so different from mortgages. You put down a percentage of the property's value and pay interest on the loan that finances the rest of the purchase. As long as the property's value is rising, your equity is increasing, and you can borrow against that equity. But, if you max out all your borrowing power, and then the property starts dropping in value, well, that's when the creditor starts leaning on you for cash. Pay up now, or we'll have to sell the property.