Ending My Margin Adventure

So my margin account adventure ended with a wimper, not a bang. I just logged into my TD Ameritrade account and saw that the "margin balance," or what the exam calls the "debit register" or "debit balance," is at zero. After selling the 90 shares of HSP (Hospira) for $4,723 on March 1, the "DR" or "margin balance" sat stubbornly at eight or nine dollars, increasing gradually with the margin interest charges. Too lazy to deposit money into the account, I just waited for the next dividend payment to come in, and on April 1 and April 7 three little dividends came in--$5.60, $5.50, and $7.60--from Northern Trust, Bancorp South, and Merck, respectively. They're all marked "qualified dividends," which means that--until and unless Congress and the President (fiscal policy) take the kinder, gentler tax rate of 15% away--those little payments are darned tax efficient, even if this is just a taxable brokerage account. Your exam calls this type of investment account a "margin account," but that just means it's approved for margin. IF I want or need to, I can purchase securities on margin or borrow money against the value of my stock and bond assets. However, I have never bought securities "on margin," and I have only taken one margin loan against "SMA."
So, what did I learn from my 10-month adventure in margin?

1. Being forced to sell stock to pay the margin loan is really stupid. Those 90 shares of Hospira that I sold to pay off the loan would have generated $1,000 in dividends over my holding period and possibly increased in value by 50-100%.
2. The real world uses different terminology than the Series 7, but the concepts are exactly the same as what you study for your exam. My account doesn't use the term "SMA," or "debit balance," but you quickly get used to the terms "available funds for trading" and "margin balance."
3. I will never use margin again.

My adventure was highly educational, and the $4,000 loan was totally necessary when I took it. But, if you see me blogging about another adventure in margin, please remind me that I no longer engage in that sort of foolishness.

I could borrow $4,790.72 from "SMA" right now with just a few clicks of the mouse, but I won't do it. Just like I won't walk down to the liquor store at the end of the block this evening. Nothing illegal about either activity, but as someone who has experienced both destructive pursuits, I can say with confidence that I'm better off without it.

Holy Hypothecation Mishap, Batman!

You could easily see a Series 7 question like this one at the testing center:

Broker-dealers may lawfully hypothecate which of the following?
A. customers' fully paid securities
B. customers' excess margin securities
C. customers' securities held in safekeeping
D. customers' securities upon which the firm holds a proper lien

EXPLANATION: one of my pet peeves with all these license exams is that it eventually becomes a guessing game rather than an opportunity to teach new hires some very important information. This question here appears to mean absolutely nothing, but, in fact, a failure to understand its meaning can cost you a big fine by FINRA and a suspension or revocation of your license. A broker-dealer called a "clearing member" or a "custodial broker-dealer" routinely holds customer assets on its books. When I cut a check to my SIMPLE IRA each month, TD Ameritrade puts it on their books--do they wrap up $875 with my name on it? No--like a bank, they play with my cash and merely put it down as what is owed to me. Similarly, I've never seen any of the stock certificates that I've purchased because my broker-dealer holds them in street name, on my behalf. In other words, I put a lot of trust in my broker-dealer. I assume they're good for that cash balance in my account and that all of those shares of stock are actually still under their control/possession. If FINRA found out that a broker-dealer was going around pledging customer assets as collateral for a loan to the firm, that could be a problem. It would be similar to having your neighbor take out a home equity loan but actually pledge your house as collateral. Wouldn't that be awkward if your neighbor couldn't pay off the loan, and the bank foreclosed on your house. To prevent that, FINRA, the SEC, and the state regulators will only allow broker-dealers to pledge customer securities required to secure the margin loan in a margin account. Fully paid securities belong to customers, even if the firm holds them in street name or in the customer's name in "safekeeping." When the customer signs the margin agreement, including the hypothecation agreement, then the firm can pledge the customer's securities as collateral. But if a firm accidentally pledges securities it has no business pledging, bad things can happen. Just a few weeks ago, we saw an instance where a principal got in trouble for hypothecating securities the firm had no right to hypothecate. To read about it yourself, go to www.finra.org, click on "industry professionals" then under Enforcement click on "disciplinary actions" then find the January 2010 summary. On page 11, you'll see that a principal accidentally hypothecated customer securities worth about $106 million dollars, earning him a suspension and a small fine. You'll also see that it takes about 10 clicks to find anything on the FINRA website, but that's another matter.

Oh yeah, and the answer to the question is . . . D.

Margin Update

Well, things on the margin front are looking very positive lately. My 90 shares of Hospira (HSP) are now worth about $4,000, with the debit balance at about $4,500. When I went into this, I was not planning on purchasing 100 shares FMBI on credit, but I did, and that added about $1,000 to the debit balance. Which is why HSP now has to pull more weight.

Luckily, it appears to be in a cooperative mood.

If it advances another $5-6 a share, I'll place a sell-stop slightly below the then-current market price. That means if the stock sits still or rises, I hold. But, if it drops, I fold.

Wish me luck. And, if I ever take another margin loan, somebody please shoot me.

More from the Margin Front

Well, things in the old margin account have certainly gotten interesting. Hospira, which I plan to sell in order to pay down the "debit balance," is doing okay--in fact, it's worth about $3,600, which is enough to pay down the initial loan. But, well, things got a little complicated. I had inherited 200 shares of FMBI, which is a bank holding company. Why did my 70-year-old mother hold shares of a bank holding company headquartered in Itasca, IL? Apparently, her father--my Grandpa Olson--was a founder of the Farmer's Bank of Wyanet, which was purchased by FMBI along with about a dozen other small Illinois banks. Why Mom had never mentioned any of this--who knows. In any case, the stock had been devastated, along with all other financial/bank stocks, and I was not willing to watch it drop to zero. So, I placed a sell-stop at $5.99. As you know, that meant that if the stock dropped to $5.99 or lower, it would be sold.
It did, and it was.
Well, I suffered the usual seller's remorse and started to worry that the stock would eventually rise without me. So, I placed a buy-stop on 100 FMBI at $10. As you know, that meant that if the stock rose to $10 or higher, it would be purchased.
It did, and it was.
This being a margin account, $1,000 of stock (plus a $9.99 commission) was purchased and placed on my tab, a tab which is now $4,557.78.
Hmm. I should probably place a sell-stop on HSP right now. That way if it plummets, I won't lose my best chance to pay off most of this silly margin loan.
I don't know. Every sell-stop I enter seems to be sold a few days later, at--by definition--a lower market price.
Oh well. Nobody forced me into this loan, and it isn't like I owe Tony Soprano. The interest rate is right around prime, and is tax deductible, unlike the juice I would have to pay to Mr. Soprano. I'll survive. I just want to win this one, even though I know how quickly I could end up losing.

On the Margin Trail

Hospira has advanced since I last reported, but is still down 11% from my purchase point. If the stock rises $3 a share, I'll be tempted to sell it, pay off the margin loan, and be done with it. But, if that happens, I would probably instead just place a sell-stop order slightly below the market price. In other words, if it rises to $40, I'll place a sell-stop at $38.50. That way if the stock stays above $38.50, I hold it; if it drops, it's liquidated. What I won't do is let the stock go up to $40 and then plummet with me still holding it like a total loser.
On the other hand, what if Hospira (HSP) drops from here? Then, I move on to Plan B, which is to take a loss, throw some cash money on the table and walk away from this crazy idea of borrowing money backed up with stock as "collateral."

On another note, the 200 shares of FMBI that I inherited a few years ago were triggered and sold at $5.99 when my sell-stop was activated. But, now that the big banks are reporting positive earnings, little bank holding companies like this one are starting to rise again. Unwilling to jump in just now, I placed a buy-stop-limit order for 100 shares FMBI, with an activation price of $10 and a limit price of $10.50. What if the stock drops from here? I'll be glad I never bought it. But if it rises to $10 or more, I'll end up with 100 shares.

Again, the idea that "this Series 7 stuff has nothing to do with the real world" is crazy. I'm using sell-stops, buy-stop-limits, and margin loans in my daily life. And pretty soon so will many of you.

Careful out there.

Margin Update

Just logged into my margin account and saw some interesting developments. I had inherited 200 shares FMBI when my mother passed away 5 years ago. They were worth $33.50 (fair market value), and after watching them fall farther and farther along with the financial sector, I decided to pick a pain threshold of $5.99. So, I placed a sell-stop order on 200 FMBI with a trigger price of $5.99. As fate would have it, the stock dropped and was sold automatically at $5.99 which, after the $9.99 commission, turned the stock into $1,198 cash money.

Except, since I owe the broker-dealer for the money I borrowed, guess how that "cash" was applied? Yep--they used it to pay down my debit balance, which is now $3,528.76.

My 90 shares of Hospira (HSP) are worth $3,425.40, so maybe it's time to think about selling them and paying off the margin balance?

Should I place a sell-limit a few dollars above the current price? Or, should I try to set a floor below the current price with a sell-stop order, selling only if the stock drops from here?
Or, should I just watch the market every day and place a market order if I have to? Who knows? The Series 7 doesn't tackle important questions like that--they just expect you to know the basic terminology and be able to follow a blog post like this one.

Margin Update

Logged into my TD Ameritrade account this morning and found that Hospira (HSP) is still trading in the same range. My "SMA" is still about $2,000 and I'm still not going to tap that line of credit, let alone use my buying power to purchase up to $5,700 worth of stock. Good thing I took the $5,000 loan against SMA for educational purposes only, because this is a losing proposition as a so-called "investment." See, Hospira isn't paying any dividends, and even if they were, it's pretty unlikely that any stock's dividend yield is going to outweigh the margin interest that the "investor" is paying, even after-tax. As at the casino, the margin investor needs really fast movement on the stock, preferably in the correct direction. I'm lucky I have the $5,000 in checking because if HSP announces bankruptcy or that one of their I.V. systems accidentally killed 27 patients nationwide, the stock could drop to $2, or zero even. Probably not going to happen, but it's always a possibility when you're dealing with a stock. Investing in the stock market always involves market risk in general and non-systematic risk specific to the particular company. To then buy that stock on credit is to take an already dangerous animal and pump it up with steroids, which probably explains why I'm having so darned much fun with this. I'm a guy. I take stupid risks. What can I tell you?

Margin Question

Not much to report on my adventures with margin loans. Hospira (HSP) is still about where it was, and unless it rises sharply, I'm going to have to dip into savings to pay back the loan I took from "SMA." Oh well. I'll keep you posted on that.

For now, let's do a question on margin accounts:

An investor purchased 1,000 shares of XYZ @50 in a new margin account, making the required Reg T deposit. If XYZ rises to $75 per share, the investor's buying power will be equal to:
A. $12,500
B. $25,000
C. $50,000
D. $75,000

EXPLANATION: the investor has a Debit Balance of $25,000 after putting down $25,000 cash money. When the stock value rises to $75,000, the equity rises to $50,000. Now--carefully--what is the Reg T requirement on $75,000? Only $37,500. So, there is $12,500 of excess equity or SMA. The customer can borrow $12,500; his buying power is twice that amount, or $25,000.

ANSWER: B

What's a Hospira?

I've mentioned that the exit strategy for my little foray into margin loans is the inevitable rise of Hospira common stock. If Hospira rises to $55, I can sell my 90 shares, pay back the margin loan and continue to hold the other shares I currently hold in an IRA. But, what is this "Hospira" I keep referring to? It's a former unit of Abbott Labs, which is another stock I own (and love). Hospira was spun off from the parent comany, which is where I got my initial dose of the stock. Later, when I became the executor of my mother's estate, I purchased 270 shares, or 90 for me and each of my two sisters. Hospira is a very simple, straightforward company--basically, they make injectables and I.V. systems for use in hospitals, clinics, and in-home care. In the past five fiscal years, their sales/revenue came in at about $2.64 billion, $2.62 billion, $2.68 billion, $3.43 billion, and $3.63 billion. Their net income (profit) has been anywhere from $107 million to $321 million most recently. The stock is not trading expensively--like most stocks these days--at only 13 times earnings. It earns $2.61 per share but--like many companies--pays no dividends. How do you make money on a stock that pays no dividends? You wait for it to rise in value, at which point you can sell for a capital gain or, perhaps, the company eventually does start paying dividends, making it both a growth and an income investment. From a technical standpoint, the short interest is very low in the stock; only about 2.5% of the shares have been sold short. The 52-week high is about $42; the 52-week low is about $21. Lately, it's on an uptrend: +7% last 5 days, +8% last 30 days, +15% last 60 days. What does this all mean for my chances of Hospira rising to $55 or higher, allowing me to sell and pay back the $5,000 I borrowed from my margin account?
No idea. Luckily, the exam doesn't expect you to know something like that. The exam just wants you to have an idea what earnings and P/E ratios might be, which stocks are generally more volatile and which are generally more stable, that sort of thing. Being able to relate some of this exam material to the real world will give you a big edge when studying, so I encourage you to look up some of your favorite companies and look for testable points. Glance at the income statement, click on the "overview," and have yourself as much fun as I'm currently having at 4:55 AM on a cold, dreary morning in early June.

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.

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.

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.