Margin accounts, borrowing, and the rules on leverage are essential topics not just for any financial professional, but for people at the very top. Leverage, specifically overextending one’s position, has caused many fund blowups in the past. Most recently the famous Archegos trial is based on whether the fund fraudulently overextended their bet on equities that, ultimately, caused the underlying equities to balloon and crash, causing the fund to lose pretty much all its value at the same time.
While the focus on this case is on the bad actions of the hedge fund principal, the real story underneath is the rules that that fund ignored or circumvented. Those rules aren’t supposed to be avoidable, at least not legally, and many market structures exist to ensure that the rules aren’t broken during normal trading. Archegos’s strategy was far from normal.
But for the rest of us, knowing these rules is important. We first need to establish some ground rules: cash accounts cannot borrow money to extend investments in stocks and bonds, while margin accounts can. Those accounts allow the investor to borrow money from their broker to buy more than the current market value (CMV) of their initial deposit.
Let’s say I want to buy $10,000 worth of stock but only have $5,000. Margin rules make this possible, since the initial margin requirement determined by the Federal Reserve Board’s Regulation T says that an initial investment requires 50% collateral. In the terms brokerages us, initial margin is the purchase price times the initial margin requirement, or half the purchase price at current RegT = 0.5.
5,000 = 10,000 * 0.5.
This is the basic formula for calculating initial margin, and it’s quite simple.
After the purchase, however, investors must maintain a minimum amount of equity that is 25% of the CMV of the purchase. Therefore, a $10,000 investment initially made with $5,000 in cash requires just $2,500 in market value before a margin call is issued.
We can express this with the simple formula: Maintenance requirement = CMV * 0.25. Still easy.
What if the stock falls by 20%? Then our CMV is $8,000, and our maintenance requirement has fallen to $2,000. That may sound like a good thing by itself, but it isn’t. Let me explain why.
Calculating the maintenance requirement of a falling stock price requires calculating the Special Memorandum Account, or SMA. This is a line of credit tied to the account’s total excess equity in the account, here excess simply means more than the minimum required 25%.
So, going back to our calculation we can say that we have the following at the start of our transaction:
CMV = $10,000
Debt = $5,000
Equity = $5,000
Where CMV – D = E or CMV = E + D.
We have $5,000 in credit and $5,000 in debt with a rolling requirement to keep our account’s equity equal to at least 25% of CMV. When we make this purchase, therefore, we have $2,500 in excess equity:
CMV = $10,000
Debt = $5,000
Equity = $5,000
Minimum Equity Requirement = $2,500
Excess Equity = $2,500
Now, if the stock has fallen to $8,000 from $10k, we can simply modify the data from the list above
CMV = $8,000
Debt = $5,000
Equity = …
Obviously at this point our equity is not $5,000. Our debt hasn’t changed since we didn’t pay any debt back or borrow more, and CMV = E+D, so therefore our equity must be $3,000. Our minimum equity requirement has changed too, which then makes excess equity really easy to calculate.
CMV = $8,000
Debt = $5,000
Equity = $3,000
Minimum Equity Requirement = $2,000
Excess Equity = $1,000
We now have $1,000 in excess equity.
Furthermore, we can now easily see when we will hit a margin call. If the stock falls to $6,666, we get:
CMV = $6,666
Debt = $5,000
Equity = $1,666
Minimum Equity Requirement = $1,666
Excess Equity = $0
In other words, our investment needs to fall by 33.3% for our 50% levered bet to face a margin call.
This is the basic way to approach long margin accounts—a slightly different approach is necessary for short accounts, and that is something we’ll tackle next week.