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.
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Finance: What Does It Mean to "Buy on Ma...20 Views
Finance, a la shmoop. What does it mean to buy on margin? Whoa, okay enough of that
yeah. That was buying on margarine but okay yeah that was a stretch, buying on [Guy sliding around with blocks of margarine on his feet]
margin is something totally different. Well margin just means debt or a loan or [Guy in a hospital bed]
credit and this buying on margin usually refers to an investor buying stocks,
pledging their portfolio as collateral in making that purchase. (Illustrative example time).
Grete Greedmonger has a hundred million dollar portfolio filled with very conservative [Greta stood next to a list of her holdings]
stocks comprising ninety percent of it or ninety million bucks and she has 10
million in cash. Well Greta, tired of flying in her measly small jet wants to [Greta's jet in the sky]
be able to afford a really big jet like the kind of the truly wealthy fly like [Warren Buffet and Bill Gates walking up to the bigger jet]
you know those guys. She wants to be in the billionaire's Club and your [Greta sat in the Billionare's club bar]
membership card gets you a great discount on private planes, so you know
like why not. Well anyway she's impatient to just let her stocks compound away and
get there quote naturally unquote at the 8% a year or so compound growth rate [The value of Greta's investment shown after each 5 years]
that they kind of have shown last a few decades. Well she wants to add gasoline
to the relatively slow burning embers of her portfolio and speed up her compound [Pouring gasoline over a fire]
rate to get to billionaire status from her current hundred millionaire status [The value is shown to be almost 2 billion in 10 years]
you know and by a G6 and that plan can't possibly backfire right.. So she bets big [Greta's big jet falls out the sky]
on a few stocks believing that she has a solid understanding of the stock market. [Greta buying amazon stock]
Specifically she wants to invest 40 million dollars in Amazon, currently
trading at 2000 bucks a share well she only has 10 million in cash. Well how can
she buy 40 million dollars when she only has 10. Well she could sell 30 million [Greta holding a big sack of stocks]
dollars worth of her stock unfortunately though those stocks were acquired years [The broker has a big sack of money]
ago at a very low price, so if she sold them she would pay massive tax bills and in [The money the broker pays is taxed]
fact to generate 30 million dollars of net after-tax cash she'd probably have [The tax calculation is shown]
to sell something north of 50 million dollars of stock to pay for
it and that's way too high a price in taxes to pay to be worth making the sale [Greta runs away with her stocks]
at all. So instead she borrows money to invest that 40 million bucks, only she [Greta getting the borrowed money and buying Amazon stock with it]
borrows it on margin, meaning she is borrowing that money from herself she
has 90 million dollars in stocks and 10 million in cash and needs another 30
million beyond the cash she already has to buy that 40 million of Amazon right. Well her
account at Schwab is already set up as a margin account or margin style account, [Definition of a margin account shown on a 100 dollar bill]
meaning that she has already signed a bunch papers stating that she understands the
margin rules the brokerage and the biggest rule is that the maximum margin [The rule is highlighted on the contract]
she's allowed to take in her account is 50 percent, five zero. So with her account
value at 100 million the most she could borrow would be 50 million bucks and [Margin limit calculation is shown]
there's that little dangerous voice whispering in her ear and well there [Devil version of Greta in her ear]
might be another voice telling her to just spend a few bucks on jet skis and [Angel version of Greta in her other ear]
vacations instead of that big jet and she just ignores that one and that's [Greta flicks the angel away]
good because otherwise we wouldn't have this video for you. So if she needs 40
million bucks to invest in Amazon she'll use up her ten millio in cash
and then take out a margin loan of thirty million dollars against herself.
Her account will have a hundred thirty million dollars in equities in it and 30 [Greta's holdings are shown]
million dollars of debt and no cash and that cash that she's borrowed carries
interest charges that is in return for borrowing money from herself she will [Greta paying Schwab]
pay Schwab a few percent a year in interests. That's nice high margin business for
Schwab because the money to them is almost free so all is good until she
decides she wants to put 20 million into Netflix as well all on margin so now she [Greta is watching Netflix on her TV]
has fifty million dollars in margin in an account with a hundred fifty million
in equities and 50 million in debt so note that her base hundred million
dollars in value and equity has not changed since the beginning of this [The value of the portfolio is shown]
awesome story only now she has a hundred fifty million in investments in that
account and fifty million of debt so if the portfolio goes up 10 percent she'll
show gains of 15 million versus a situation where if she hadn't done any
with margin while that gain of 10% would have given her just 10 million in gains [The with and without margin gain calculations]
right, 10 percent of 100 million invested vs. 10 percent of 150 million invested.
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 from herself it's really
Schwab kind of fronting the cash for her using her portfolio as collateral. So all [Schwab demanding that she pay back the loan]
is great she's thinking about the upholstery color in her g5 and then a
bomb goes off in North Korea and well all bets are off the stock market freaks [Explosion]
out printing down 20% in a short period with the high octane names like Amazon
and Netflix trading down even more and all the sudden 150 million dollars in
value in her portfolio is cut 40% such that the 150 million dollars is now [The loss on Greta's holings is shown]
worth only 90 million and that's a really big problem. Why? Because she still
has 50 million bucks in margin loans on the account and the brokerage has a max
50% limit that is, clients cannot borrow more than half of their portfolio.
Because it's just too risky for Schwab to have to potentially bear the burden [Guy holding sacks full of I.O.U.s falls over]
of making the margin whole on that account like if the market then really
tanks like if it went down another 30 or 40 percent you can imagine it would be [Stock chart showing price going even lower]
worth less than 50 million dollars which is the debt that they have [Combined stock value going down]
outstanding and then it's really bad and Schwab could go bankrupt really fast. So [Money disappearing from Schwab vault]
Schwab sends her a kindly loving nasty gram requiring her within 24 hours to [Schwab sending an email telling her to pay or never see you precious portfolio again]
inject 10 million dollars of capital into that margin account to quote true
it up unquote to be at least a hundred million dollars in value like she could
wire in 10 million bucks that says sitting around in her BofA account [Greta using an ATM]
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 just gone from 90 million to [Greta's holdings are shown]
a hundred million dollars and she'd be just fine. So that's 40 million bucks of
margin on a hundred million dollars of an account value and it's ten points
below the red line threshold of that 50% maximum [Greta's margin level is calculated]
margin limit. Only problem, she doesn't have 10 million dollars in her BofA
account just sitting around. So what else can she do well she'll have to sell
stock in her Schwab account to meet her margin requirements and you can see what [Greta at her stock for sale stand]
a vicious spiral this is gonna become and if she won't proactively call in the
orders herself well 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 [Schwab guy selling Greta's stock at any price]
smart sales or not they just need the margin minimums met right away and oh by
the way she'll pay taxes on those Schwab sales if there were gains on them and [The stock sale being taxed]
then the IRS is coming after her for dough later so it gets really ugly and [IRS taking money from Greta]
yes you can imagine that if a whole lot of people were caught in the margin [The word margin being squeezed by two hands]
squeeze like this in a bad market where they got more greedy than fearful and a [Guy in a suit running around]
whole lot of brokerages put in sell mortimer, sell, at market orders well that [Guy in a suit waving his arms around]
the whole system would cave in on itself with massive supplies of stock for [The broker collapses]
relatively little demand and well that's how stock markets crash and that's why [Big sack of stock and only 1 person left to buy]
brokerages have you know typically 50 ish percent margin kind of limits at
least for retail investors. And the general goal of the G-man here is to you
know, avoid such a slippery set of circumstances and maybe she should just [Guy wants to use a block of margarine as a sled]
get used to flying commercial. [Greta looks unhappy on a commercial flight]