The collapse of the real estate market and difficulties in obtaining bank loans, have made it far more likely that you may suffer losses as a result of getting a loan from your brokerage firm. Firms will often approve lines of credit, even to individuals without a source of income, so long as they have an investment portfolio with sufficient collateral for the loan. You may decide that easy access to a margin account will enable you to win back losses in real estate by over concentrating investments in the stock market. These two scenarios are similar in that they both put your finances at great risk, especially if the underlying collateral declines in value.
Stock brokers have a duty to only recommend the purchase, sale or exchange of a security if they have reasonable grounds to believe that the recommendation is suitable for the customer. In order to know if the recommendation is suitable, the broker must “know their customer” by making reasonable inquiry into their financial status, tax status, investment objectives and any other information that is considered reasonable in making recommendations. Often recommending margin trading or approval of credit lines without adjusting the collateral portfolio can be considered a violation of the suitability rule.
Margin trading is a loan from the brokerage firm that allows the customer to buy more stock than they would normally be able to purchase. The underlying portfolio serves as the collateral for the loan. Brokers will sometimes encourage their customers to open a margin account advising them that it gives the customer “buying power” to fully take advantage of a skyrocketing stock market. As opposed to a trip to Las Vegas, this is held out as a smart way for customers to gain back their real estate losses by investing as heavily as possible in stocks.
Margin trading is exceptionally risky and is only suitable for those who can afford to lose it all and more! Imagine sitting in a casino and being offered a loan by the house to increase your bet. If you win, you can pay back the loan and pocket far greater winnings. But, if you lose, you not only lost the bet, but you still owe the borrowed money to the house.
Margin trading can be even more risky than a loan from the casino because of the risk of the “margin call”. The brokerage firm requires that there be adequate collateral to secure the margin debt. This is referred to as the maintenance margin. If the stock purchased on margin or other stocks in the portfolio decline in value and the maintenance margin is insufficient, the brokerage firm will require the customer to either add cash to the account or liquidate the stock to pay off the margin debt. Usually, if there is a margin call, the broker can sell the stock to pay the debt without consulting the customer and can choose which stock to sell. Trading on margin puts the customer in a position where they could lose far more than they invested. Depending on the customer, a broker should advise their customer to use margin prudently or not at all and only with capital they can afford to lose.
If a customer needs money and cannot borrow from a bank, they may turn to their stock broker for assistance. Brokerage firms will often loan money to a customer using their portfolio as collateral. This is different from a margin account where the money borrowed is used to buy more stock. In credit line accounts, the customer is usually prohibited from using the loan to buy additional stock. Brokers may encourage this type of loan advising the client that increases in the value of the portfolio can be used to pay down the loan. If the customer believes this, he may see the loan as free money that they do not need to pay back. Instead, the money in the portfolio works for them to pay off the loan. In order to do this, the broker may encourage the customer to use the collateral to invest in risky stocks that will surely soar in value.
Sadly, the broker may not fully explain the risks with these credit line accounts. If the collateral declines in value, there may be insufficient value to support to loan. In that scenario, the brokerage firm can require the customer to increase the collateral, pay down the loan, or sell their securities. The firm will usually be able to liquidate the position, without notice, to pay all or some of the loan. In a worst case scenario, if the underlying portfolio nose-dives, the customer could lose their entire portfolio and still owe money to the brokerage firm.
Credit line accounts can be conservative and safe if the underlying collateral is in a secure income producing investment. For example, an A rated ( or higher) bond, CD or money market account will likely not lose principle and will generate some interest that can be applied toward the interest on the loan. A customer who borrows from a brokerage firm credit line should plan to pay the money back and not look to the appreciation of the account to cover the loan principal.