What Is a Margin Call?
A margin call is one of the worst pieces of news an investor can receive. Not only does it mean the value of his assets has declined, it could mean he has to deposit more money in his trading account. Margin calls are issued by brokers according to the terms of a margin agreement, which specifies the terms by which the broker lends funds to an account holder. The Federal Reserve regulates margin accounts and the terms of a specific margin agreement.
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Function
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The purpose of a margin call is to inform an account holder that the equity in her stock positions has dropped below the minimum required maintenance level, and to activate certain provisions of the margin agreement. The Federal Reserve mandates a maintenance level of at least 25 percent, though some brokers set a much higher bar. In response to a margin call, investors must liquidate assets in their account to raise cash or deposit additional funds in their account.
Considerations
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The important values that trigger a margin call, the margin equity, can change quickly. Assets in the amount of $10,000 purchased with a 50 percent margin loan have a margin equity of $5,000. A maintenance requirement of 25 percent represents a cash value of $2,500. If the value of the assets declines to $8,000, the outstanding loan is still $5,000, so the margin equity becomes $3,000, and the maintenance level of 25 percent represents $2,000. At a total asset value of $6,000, the equity is only $1,000 but the maintenance level (25 percent of $6,000) is $1,500. A margin call would be issued to generate the difference. A precipitous decline could cause investors to lose more than their initial investment.
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Warning
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Not only can the margin equity in an account fluctuate, but the maintenance level is usually subject to change at any time. If the maintenance level is raised to 35 percent in the same example ($10,000 of assets with an initial $5,000 in margin equity), a decline to $7,500, producing equity of $2,500, would trigger a margin call because the maintenance level would be $2,625. In addition to changes in the maintenance level, over time, interest on the loan will also eat into margin equity. This decreases the size of the decline in asset value that is necessary to trigger a margin call.
Time Frame
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Upon issuing a margin call, a broker usually expects account holders to bring their equity in line with the maintenance level immediately or at least by the end of the trading day. Though a margin call alerts the account holder to the situation, it doesn't necessarily provide much opportunity to be proactive and prioritize stocks for liquidation. Concurrent with the issuance of a margin call and without warning, the broker can begin to sell assets in the account.
Potential
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Leverage is truly the proverbial double-edged sword. In fact, over-leveraged investment banks and financial firms precipitated the 2008 credit crisis. Whereas small investors can double their buying power with margin borrowing, some firms had leveraged up by a factor of 30 times or more. Consequently, only a small decline in the value of their assets triggered the equivalent of a margin call they could not meet. Whenever credit contracts, one response by brokers is to increase the maintenance level, both to protect themselves and discourage wild borrowing.
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