Minimum maintenance

This chapter is long and dense, and it’s usually tested lightly. Although any of this material could appear on the exam, it’s rare to see more than one question focused on margin requirements. Approach this chapter with that in mind, and don’t overinvest time trying to memorize every detail.

Minimum maintenance

Margin accounts increase the normal risks of investing. If you buy shares in a margin account and those shares lose 100% of their value, you lose the value of the shares and you still must repay the borrowed funds. That’s leverage: it increases both potential gains and potential losses.

Minimum maintenance requirements help keep customer margin accounts from deteriorating too far when the market moves against the investor. They also protect the broker-dealer from being left with unpaid debt (or, in a short account, an unwanted short position). This section covers minimum maintenance for both long and short margin accounts.

Minimum maintenance for long accounts

You’ll see several numbers and calculations here. The Series 66 rarely asks you to calculate, but it may test the concepts behind these calculations. Focus on what the numbers mean rather than memorizing the math.

To work with minimum maintenance, it helps to use an equity percentage formula:

$$\text{Equity \%}=\frac{\text{Equity (in \$)}}{\text{LMV or SMV}}$$

Let’s start with a simple setup. An investor buys 200 shares at $30 per share and deposits the required initial margin. The equity formula in dollars is:

$6,000 (LMV) - $3,000 (debit) = $3,000 (equity)

Now calculate equity as a percentage of the account’s market value:

Equity % = $3,000 (equity) / $6,000 (LMV) Equity % = 50%

That 50% makes sense: the investor owns $3,000 of a $6,000 position.

Market value changes will change the equity percentage. Here’s an example.

An investor purchases 200 shares of ABC stock at $300 and deposits the required margin. The market price then falls to $175. What is the equity amount in dollars and percent?

First, establish the starting position:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

• The investor buys $60,000 of stock (200 × $300).
• The investor deposits 50% of the purchase price (or $2,000, whichever is greater). Here, 50% is greater, so the deposit is $30,000.
• The remaining $30,000 is borrowed from the broker-dealer, shown as the debit.

Now apply the price drop to $175:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

• LMV falls to $35,000 (200 × $175).
• The debit stays at $30,000 because no loan repayment or additional borrowing occurred.
• Equity falls to $5,000.

Now compute the equity percentage:

Equity % = $5,000 (equity) / $35,000 (LMV) Equity % = 14.3%

At this point, the investor is close to being “underwater” (owing more than the account is worth). If the market keeps falling, the broker-dealer risks not being repaid. To reduce that risk, FINRA enforces minimum maintenance rules.

The minimum maintenance for long accounts is 25% equity. If equity falls below 25%, the situation must be corrected. There are three ways to fix a long margin account that falls below minimum maintenance:

1. Investor deposits more money
2. Investor deposits “fully paid” stock
3. Securities are sold

If the investor deposits cash, that cash is typically used to reduce the debit balance. Reducing the debit increases equity (in both dollars and percent). Using the prior example:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $10,000?

Can you figure it out?

The investor can also deposit “fully paid” securities to increase equity. In plain terms, this means transferring securities the investor already owns (often from another account) into the margin account. This increases the account’s collateral without changing the loan balance.

Return to the low-equity example:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $15,000 of fully paid stock?

The last remedy is to sell securities. The customer may sell voluntarily, or the broker-dealer may sell proactively. When the investor signed the margin agreement, they gave the broker-dealer the right to sell securities in the account at any time, with or without notice. Firms generally treat this as a last resort, but the right exists to protect the firm’s loan.

Again, start with the low-equity account:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the equity (in $ and % form) if the investor (or the broker-dealer) sold $25,000 of stock?

Now that you’ve seen what minimum maintenance is and how to correct a deficiency, the next question is: how far can the market fall before the account hits minimum maintenance?

Use the original setup:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

To find the market value where the account would be exactly at 25% equity, use:

$$\text{Mkt value at min. maint.}=\frac{\text{Debit}}{\text{0.75}}$$

Apply it:

Mkt value at min. maint. = $30,000 (debit) / 0.75 Mkt value at min. maint. = $40,000

If LMV falls to $40,000, the account is exactly at 25% equity. You can verify that with both equity formulas.

Equity in dollars:

$40,000 (LMV) - $30,000 (debit) = $10,000 (equity)

Equity percentage:

Equity % = $10,000 (equity) / $40,000 (LMV) Equity % = 25%

Sidenote

Restricted accounts

When an account falls below 50% equity, it becomes restricted. Restricted accounts are less severe than the name suggests. When equity is below 50%, half of any sales proceeds must be used to pay down the debit balance.

In the earlier examples, we assumed sales proceeds were used to reduce the debit. In an unrestricted account, an investor could sell securities and withdraw the cash even with an outstanding debit balance. Once equity drops below 50%, that flexibility is limited.

Minimum maintenance for short accounts

The same basic idea applies to short accounts: minimum maintenance helps prevent the account from becoming too risky for the broker-dealer. The key differences are the required percentage and how the account is structured.

Short accounts must maintain at least 30% equity (not 25% like long accounts). If equity falls below 30%, the investor or broker-dealer must correct the deficiency.

Here’s an example.

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000. The account value rises to $45,000. What is the equity amount (in $ and % form)?

First, equity in dollars:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

Next, equity as a percentage:

Equity % = $7,000 (equity) / $45,000 (SMV) Equity % = 15.5%

This is well below the 30% minimum maintenance requirement. The account is approaching “underwater” status, which occurs if the SMV rises above the credit balance. At that point, the cost to repurchase the shares would exceed the cash in the account.

There are two ways to fix a short margin account that falls below minimum maintenance:

1. Investor deposits more money
2. Part or all of the short position is closed (repurchased)

Start with the low-equity account:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

If the investor deposited $18,000 of cash in the account, what would be the changes to equity (in $ and % form)?

The other fix is to repurchase shares to close part or all of the short position. As with long accounts, the investor may do this voluntarily, or the broker-dealer may do it proactively (the [margin agreement gives them the right to do so). Let’s return to the low-equity example:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

What would the equity change to (in $ and % form) if the investor closed $30,000 of the short position?

As with long accounts, you can use a formula to find the market value where the account would be exactly at minimum maintenance.

Start with the original short-account setup:

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000.

Equity in dollars:

$52,000 (credit) - 20,000 (SMV) = $32,000 (equity)

Equity percentage:

Equity % = $32,000 (equity) / $20,000 (SMV) Equity % = 160%

With short accounts, equity can exceed 100% (unlike long accounts). If the investor is concerned about SMV rising, use this formula to find the SMV where equity would be exactly 30%:

$$\text{Mkt value at min. maint.}=\frac{\text{Credit}}{\text{1.3}}$$

Apply it:

Mkt value at min. maint. = $52,000 (credit) / 1.3 Mkt value at min. maint. = $40,000

If SMV rises to $40,000, the account is exactly at 30% equity. Verify it:

Equity in dollars:

$52,000 (credit) - $40,000 (SMV) = $12,000 (equity)

Equity percentage:

Equity % = $12,000 (equity) / $40,000 (SMV) Equity % = 30%

This gives a quick way to see how far a short position can move against the investor before action is required.

This video summarizes the important concepts related to minimum maintenance:

Key points

Minimum maintenance for long accounts

• 25% equity requirement
• If falling below, must:
  • Deposit cash
  • Deposit fully paid securities
  • Sell securities

Restricted accounts

• Below 50% equity
• Half of sales proceeds must pay down the debit balance

Minimum maintenance for short accounts

• 30% equity requirement
• If falling below, must:
  • Deposit cash
  • Close short position