Fun with Margin

For those of you following my adventures with margin loans let me provide an update. I received a check for $5,000--no questions asked--from TD Ameritrade last Thursday and deposited it on Friday. Was this a withdrawal? Well, the test would probably call it that, but it's actually a loan backed up by the ever-volatile market values of the stocks inside the account. It's a loan against "SMA," and now I have to repay the $5,000 plus interest.

Interestingly, after I requested the check, I got good news from my publisher, First Books, who was kindly sending me a royalty check larger than I anticipated. I also sold 80 shares of NTRS and that check for $4,000 is now on its way, so I'm only partying at this point in the name of helping my customers and blog readers--I no longer even need the five grand. Either way, remember that the $4,000 was a withdrawal of funds after a sale of stock--I made sure they waited until the T + 3 settlement date so they wouldn't think I was taking another hit off that metaphorical crack pipe known as SMA. It's just my cash--please send it to me. And, they did, with no fees, no postage charges, and no questions asked. Remember that cash in a customer's account does earn the broker-dealer interest, but that cash amount is owed to the customer upon request and must be paid out promptly. Of course, with a margin loan against SMA, nobody has to cajole the broker-dealer--they can't wait to start charging me interest on that loan with the same enthusiasm that VISA apparently has for those little pretend "checks" they keep sending me, three to a page.

Remember, I "plan" to sell 90 shares of HSP after they rise at least $10 a share. If so, I'll pay back the $5,000 loan and likely never hit that pipe again. But, how often do a gambler's "plans" pan out? Not very often, so, as they say on the Mythbusters--please do not try this at home.

UGMA accounts

Let's look at a practice question that will look similar to something you'll probably see on your Series 7 exam:

To establish an account under the Uniform Gifts to Minors Act, the custodian must be a:
A. trustee
B. a registered investment adviser
C. an immediate family member of the beneficiary
D. a person who has reached the state's age of majority

EXPLANATION: the custodian simply needs to be an adult (not a minor). He/she does not need to be related to the beneficiary and does not need to be a professional investor. If you open an UGMA account for your niece, you can manage the investments yourself for the benefit of the minor child. And, the beneficiary does not need to be a relative; perhaps the neighbor boy you hire to cut your grass would enjoy a surprise upon his 18th or, perhaps, 21st birthday . . .?
ANSWER: D

Margin and the Real World

A "margin account" is simply an investment account that has been approved for the use of borrowed money. Most people would prefer not to put borrowed money into the stock market, but a margin account allows us to do just that. Of course, nobody's forcing us to use the line of credit that a margin account offers, any more than VISA is forcing us to spend money we don't actually have. As I've written elsewhere, a margin account is no more inherently dangerous than a bottle of Jack Daniels sitting on the shelf. It just depends on who opens it and how they manage things once the cap is off.
When we borrow against "SMA" we pay in the neighborhood of the prime rate, and, believe it or not, margin interest is tax deductible, meaning you can use it to offset/reduce any dividends or bond interest you receive in that account. So, it's a pretty decent line of credit to tap in an emergency. At least that's what I'm telling myself now that I just tapped it for $5,000. Long story short, I split up with a woman a few months ago and badly underestimated all the costs associated with the unwinding of that particular merger. I now sit here with $500 in checking, $251.11 in savings, and no car after buying a house in Texas that she will rent and eventually buy from me. In other words, I have two mortgages starting in July and almost no cash. You're derned tootin' I hit that line of credit called "SMA" yesterday. Took about 30 seconds to send TD Ameritrade an electronic request for $5,000. And, if the stock market cooperates, I should be able to borrow another $5,000 or more in a few months. Like every other gambling junkie who puts it all on number 21, I'm telling myself that Hospira is going to rise $10 a share, and I'll be able to sell 1/2 my shares to pay back the $5,000. Of course, you know how these "plans" tend to pan out, but for right now, I am really looking forward to receiving the $5,000. It might be intersting to track the progress of this potentially bone-headed decision; in fact, let's plan on it.

Stop, Limit, and Market Orders

Let's look at a question on stop, limit, and market orders. Try to use process of elimination until you find a strategy that works for the following pretend customer:

Your customer purchased shares of XYZ for $40 last year. Currently, with the stock trading for $65, your customer is concerned that the stock could drop sharply from its current price, although long-term, she wants to hold this investment if possible. You would recommend that she place
A. a market order to sell
B. a buy-stop order @66
C. a sell-stop order @67
D. a sell-stop order @64

EXPLANATION: the customer does not need to buy any more stock, so you can eliminate choice B. You can eliminate choice A since the customer thinks the stock may be worth holding long-term. A sell-stop order at $67 would be executed as soon as the stock traded at $67 or lower--since the stock is already there, the order would effectively be a market order to sell that might even cost the customer more $ to place than a market order to sell. Choice C, then, can be eliminated, leaving you with the right answer, D.

ANSWER: D

UGMA Accounts and Gift Taxes

For Tax Year 2009 the maximum gift that a donor can make to a non-related minor child in an UGMA account is
A. $11,000
B. $12,000
C. $13,000
D. None of these choices

EXPLANATION: don't jump to conclusions! Sometimes test questions try to mislead you. You're supposed to start thinking about the annual gift tax exclusion amount, which was $12,000 for 2008 and is $13,000 for 2009. That only has to do with gift taxes. If you give someone more than $13,000 this year, you pay gift taxes on the excess above $13,000, which has absolutely nothing to do with this question. There is no such thing as a "maximum gift" for an UGMA account.

ANSWER: D

Practice Question, Bonds

Which of the following corporate debt instruments issued by the same corporation would tend to offer the highest yield?
A. 10-year convertible bond
B. 10-year non-convertible bond
C. 15-year subordinated debenture
D. 15-year collateral trust certificate

EXPLANATION: bonds with longer terms pay higher interest rates to investors, just as you would expect to pay a higher rate on a 30-year vs. a 15-year mortgage. So, you can eliminate choice A and B. Now that you're left with two 15-year bonds, ask yourself which one is more secure? Choice D has collateral behind it (a portfolio of securities). So, eliminate D, and you're left with C. Subordinated debenture holders are the lowest creditors in the pecking order.
ANSWER: C

Berkshire Hathaway annual meeting

I enjoyed listening to Warren Buffett and Charlie Munger mention many concepts and terms used on your Series 7 exam this past Saturday. The very first slide that Mr. Buffett displayed showed a trade ticket, which, right there, is a Series 7 concept. A trade ticket is just a record of a trade--what was bought or sold, how much was bought or sold, at what price the securities were bought or sold, etc. This trade ticket illustrated how panicky the markets became starting last September, and how hard traders had to scramble to post collateral. How? The ticket showed that Berkshire Hathaway was able to sell $5 million par value of T-bills for more than $5 million--$90 more to be exact. It wasn't that Warren was excited about making a risk-free $90; he was showing us that for a while, people were accepting negative yields on Treasuries. In a flight from stocks to Treauries, investors kept pushing up the price of T-bills, pushing their yields so low that the yields went negative for a while. Yes, that means people were willingly losing money on T-bills for a few days, and, yes, the money would have been much better off under their mattresses. Crowds do crazy things when spooked. If the Qwest center had been hosting a heavy metal band as opposed to 35,000 laid-back shareholders, I might have been concerned about a stampede or a melee erupting at any point. Same thing happens in the markets. People freak out on stocks and send a great company like Wells-Fargo below $10 a share while simultaneously snatching up T-bills that give them back less money than they started with.
Wild stuff.
Moody's was brought up in one of the harder-hitting questions posed by shareholders. Somebody wanted to know why Berkshire didn't use its influence over Moody's after purchasing the company. Not sure if the Series 7 cares, but the fact is that Moody's and S & P are paid by the issuers of the bonds to assign credit ratings. Talk about a conflict of interest, right? If you're being paid by GE to assign a credit score that determines GE's cost of borrowing, might you not be just a little bit kind in your ratings? But Buffett said that conflicts didn't cause the housing bubble, and that he and Charlie don't micromanage their investee companies like that. Then Charlie pointed out that Moody's had just downgraded Berkshire Hathaway's Aaa credit rating, so "maybe that shows a little bit of independence" he said, with a shrug of cool sarcasm that got a big laugh from the massive crowd.
When asked about the derivatives markets that seized up, Warren pointed out that unregulated trading markets involving vast sums are dangerous--there is a reason that the Fed mandates 3-day settlements and 50% collateral in margin accounts. See, those funky mortgage-based derivatives that nearly wiped out Wall Street completely were trading in unregulated markets where settlement dates were vague, and the "contra parties" to the contracts could just hem and haw until finally it became apparent that the contracts were no good.
I certainly did not expect to hear about Reg T and 3-day settlements at this meeting, but there were many cool surprises like that. Not to mention, the $15 box of See's candies turned out to be frighteningly good. Warning: don't open a box of See's candy if you're on a strict diet. Good thing I run so many miles a week.