What Happens When You Get a Margin Call
One of the most unpleasant experiences an investor, trader, or speculator might face in their lifetime is a margin call. Understanding how margin accounts work, and factoring in a little prevention and conservatism, can prevent a lot of potential pain down the line.
How Margin Debt Works
When you open a margin account with your stockbroker, futures broker, or commodities broker, you effectively tell them that, at some point, you may want to borrow money from them. You do this by pledging the cash and securities in your account as collateral for the margin loan. Once you borrow the funds to purchase securities, the broker can then sell off your other assets if needed to satisfy your margin loan, which is a potential disaster waiting to happen.
If your investment account doesn't have enough value to satisfy the margin loan, you are legally bound to come up with the entire remaining debt balance. That is, you can lose much more than the funds you have deposited into your account. There are significant dangers to buying stocks and other securities on margin, even if you believe it's a relatively conservative investment.
Any time you trade on margin, you've introduced the possibility of a margin call. Specifically, a margin call occurs when the required equity relative to the debt in your account has fallen below certain limits, and the broker demands an immediate fix, either by depositing additional funds, liquidating holdings, or a combination of the two.
Triggering Margin Calls
Your account might have fallen below the regulatory requirements governing margin debt due to fluctuations in asset prices or changes by regulators. Federal Reserve Regulation T makes it possible for the nation's central bank to enforce minimum margin debt-to-equity requirements as a way to avoid excessive overleveraging and speculation.
For example, current rules state that when dealing with stocks on the New York Stock Exchange, the borrower must have at least 50% equity at the time of purchase and must maintain 25% equity in their account at all times. If you had $100,000 in an investment account, you could borrow another $100,000 on margin, taking your total assets to $200,000—half debt, half equity. You might not face a margin call until your combined account balance declined by 33.33% to $133,333, at which point the debt would be 75% of the total account balance.
Additional restrictions on margin debt also exist, such as a limit for accounts of less than a certain size (usually $2,000) or when trading so-called penny stocks.
Brokerage Firm Rules
You may also become subject to a margin call if your brokerage firm changes its margin policy for your account. It could be because they no longer consider you a good risk, a specific security you own, the risk exposure warrants it, or any number of other reasons, none of which have to be fair or serve your best interests. For instance, many brokerage firms set margin maintenance requirements much higher than the minimum regulatory rules.
Brokers don't want to be on the hook for borrowed money that you can't repay, so the bigger the equity cushion to absorb losses, the safer it is for them and their owners, shareholders, and lenders. The margin debt exists at the discretion of the brokerage house, and they can demand repayment at any time without giving you notice.
When a situation arises in which your account no longer has the necessary equity-to-debt ratio required by either the broker's own internal house rules for margin maintenance or those set as minimum guidelines by the Federal Reserve, the broker issues a margin call.
Getting a Margin Call
A margin call is most often issued these days by placing a large banner or notification on the website when an investor or speculator logs in to check their account balance. If the broker is not worried about your financial condition, it may give you time to deposit new cash or securities in your account to raise the equity value to a level considered acceptable either by the internal margin debt guidelines or applicable regulations.
Otherwise, brokerage representatives may begin selling off your holdings to raise as much cash as possible. The broker is typically interested in protecting its own financial condition and doesn't want to go after you to collect a debt. As a result, and as spelled out in your account agreement, it is under no obligation to give you additional time to meet a margin call or to consult you before liquidating assets in your account to cover any margin debt.
They don't have to notify you, so you may not get an opportunity to rectify the situation. When you opened your account, you signed the account agreement that spelled out the margin call ramifications clearly, so you must live with the consequences.
Your broker can decide to sell your highly appreciated securities, leaving you with big deferred tax liabilities and triggering major capital gains expenses for you. They can also sell your severely undervalued stocks or bonds at the worst possible moment, permanently locking in your losses.
Not Meeting a Margin Call
The seriousness of a margin call, especially if it leads to debts that you cannot afford to pay, cannot be understated. If you are unable to meet a margin call, and the assets have already been liquidated in your account to repay the debt, you'll find that the remaining balance owed becomes an unsecured debt that is now in default. Among other things, the following are can be potentially affected.
The debt will be reported to credit agencies, making borrowing money difficult as it will affect your credit score. Its presence may cause your other lenders to cut off access to their products—such as a credit card company closing your account—or raise your interest rates to offset the risks.
If you have business loans or other liabilities that permit accelerated maturity in the event of a major change in your financial condition, you may also find the entire balance owed on those debts. Additionally, you may find it harder to land a new job as some states allow companies to consider credit histories as being indicative of responsibility and capability.
A universal default may be triggered, and you may find your insurance rates on your home, cars, or other policies increasing substantially in jurisdictions where it is permitted. Mainly because you would be considered deficient in character.
The broker may launch a lawsuit against you demanding immediate repayment, including legal costs. The remedies available depend on the specific laws of your state, but they may include forcing you to disclose your entire financial situation under oath, including:
Your bank accounts and other personal property may also be garnished or seized, including putting real estate investments up for sale.
In many cases, the best option may be to raise money however you can and wipe out the debt within days, even if it means selling other assets such as cars or furniture. Alternatively, you may choose to consult as quickly as possible with a bankruptcy attorney. If filing is the right call, they might advise you to do it sooner than later.
For example, in some situations, you might opt to accept the pain of bankruptcy and protect the money within your 401(k), 403(b), Roth IRA, or another retirement plan, as they are often beyond the reach of creditors. If you liquidate these accounts to meet a margin call, you'll get hit with ordinary taxes plus an additional 10% penalty tax. If your liquidated retirement accounts weren't sufficient to pay the entire balance, you might still have to result to bankruptcy.
Avoiding Margin Calls
The most effective way to avoid margin calls is to open a cash-only account at your brokerage firm. Aside from being a little more inconvenient, it means you can't create margin debt because securities must be fully paid in cash at the time of acquisition. If you want to employ leverage within a cash account, you can still gamble with investments like stock options that are fully paid or 3x leveraged ETFs.
For instance, instead of shorting a stock, you might buy options on the stock instead. Put options have different risks and trade-offs, but the most you can lose is 100% of the amount you spent on the cost of the puts. You can also decide only to take positions that have a theoretical, maximum loss and keep that amount of money, plus a 10%–20% cushion for interest or other contingencies, in an FDIC-insured bank account or U.S. Treasury bills. That way, you know you can cover the worst-case scenario payment.
Brokers may not give you a chance to meet the margin call if they are sufficiently worried and could liquidate your positions before you've been contacted.
The Bottom Line
You find that you get slightly better treatment from a private bank or full-service broker than you would at a discount brokerage. If you had a margin call that was a tiny percentage of your net worth, they might find a way to avoid having your holdings sold off or inconveniencing you by giving you a courtesy phone call.
Brokers don't have to notify you, so never assume they will, but it's possible they don't want to lose a wealthy client who pays a lot of lucrative fees over a relatively paltry sum. You won't get a courtesy call from a discount broker, operating a do-it-yourself account, so be particularly careful if you're working on your own.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possibility of loss.