Minimum maintenance

Minimum maintenance

Margin accounts increase the normal risks of investing. If an investor purchases shares in a margin account and those shares lose 100% of their value, they lose the overall value of those shares, plus have to pay back borrowed funds. That’s leverage in a nutshell; increased gain and loss potential.

Minimum maintenance helps ensure customer margin accounts don’t spiral out of control if the market moves against them. Additionally, they help protect the broker-dealer offering the margin account from being stuck with unpaid debts or an unwanted short position. In this section, we’ll explore minimum maintenance for long and short accounts.

Minimum maintenance for long accounts

You will find many numbers and calculations in this section. The exam is more likely to test you on the conceptual nature of minimum maintenance. Don’t get bogged down in the math!

To understand minimum maintenance, we need to first establish another form of the equity formula:

$$\text{Equity \%}=\frac{\text{Equity (in \$)}}{\text{LMV\hspace{0.33em}or SMV}}$$

Let’s assume an investor purchases 200 shares of stock at $30 per share and deposits the required initial margin. The regular equity formula would look like this:

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

Now, let’s calculate the equity percentage using the new formula we established above:

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

It shouldn’t be a surprise the account is currently at 50% equity. Remember, equity represents the overall amount the investor owns of the margin account. If the investor owns $3,000 of a $6,000 account, they own 50% of the account. Of course, the equity formula (both of them) will change when market values change. Let’s work through an example together:

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, let’s establish how the account starts:

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

The investor purchases $60,000 of stock (200 shares x $300) in their margin account. The investor must deposit 50% of the overall purchase or $2,000, whichever is greater. 50% of the overall purchase is the greater of the two, so the investor deposits $30,000. The other $30,000 is borrowed from the broker-dealer, which is reflected in the debit.

Next, let’s factor in the decrease in market price to $175 per share:

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

When the market falls, so does the LMV. Now the investor holds 200 shares at $175 per share, resulting in an overall LMV of $35,000. The debit does not change because the investor did not borrow more money or pay any borrowed funds back. This leads to a new equity of $5,000.

Last, let’s calculate the equity percentage:

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

Whether you realize it or not, the investor is in a really bad position. They lost $25,000 of equity when the market fell and is close to their account going “underwater” (owing more than the account is worth). If the market continues to fall, the broker-dealer is at risk of not being repaid the $30,000 they lent to the customer. To avoid something like this happening, FINRA* enforces minimum maintenance rules.

*We discussed how the Federal Reserve sets initial deposit requirements for margin accounts in a previous chapter. FINRA sets minimum maintenance requirements. Be sure to remember which organization sets each requirement!

The minimum maintenance for long accounts is 25% equity. Meaning, the equity percentage cannot fall below 25% without the investor or broker-dealer moving to remedy the situation. To fix the situation, the investor can deposit more funds, securities from other accounts, or sell securities. Don’t worry about the details for this exam (those of you taking the Series 7 will need to know these details).

Minimum maintenance for short accounts

The same philosophy behind minimum maintenance for long accounts applies to short accounts, but there are some differences in approach. The biggest difference is the amount; short accounts must always maintain at least 30% equity (not 25% like long accounts). If equity falls below 30%, the investor or broker-dealer must move to remedy the situation. Let’s work through an example together:

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, the equity formula in dollar form:

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

Next, the equity formula in percent form:

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

This account is well below the 30% minimum maintenance requirement. The account is in danger of going “underwater,” which would occur if the market value went above the credit balance. This results in the value of the stock required to be repurchased being more than the cash in the account. The investor can fix the situation by depositing more funds or closing out some or all of their short position. Don’t worry about the details for this exam.

This video summarizes the important concepts related to minimum maintenance: