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Big money managers often borrow money to make more investments. This practice is called "using leverage" and it can dramatically increase profits. But did you know that you can do the same thing with a margin account through your broker?
There are, however, limits on how much you can borrow, and these and other requirements are set forth in the Federal Reserve Board's Regulation U. Basically, Regulation U governs transactions by banks and other lenders that extend credit for the purpose of purchasing or carrying margin stock, when the credit is to be secured by margin stock.
Here's the part that you need to know about: Regulation U specifies the amount a bank or other lender can loan to its customers for the purchase or carrying of listed equity stocks, most mutual funds, over-the-counter securities, and convertible debt securities, such as convertible bonds, rights, and warrants. Specifically, banks cannot extend more credit than the "maximum loan value" of the collateral. Regulation U currently provides that the "maximum loan value" for margin stock is 50 percent of the stock's current market value. (Note that, while the margin requirement can be changed, it hasn't been changed in the last ten years.)
So, if you want to borrow $50,000 for the purchase of margin stock and secure the loan with margin stock, then the market value of the margin stock at the time of the loan must be at least $100,000. What happens if the market value changes? Nothing. Once the loan is made in compliance with Regulation U, the loan will not be affected by a subsequent change in the margin stock's value. (Note that different requirements can apply to lines of credit secured by margin stock.)
So, what's the point of a margin requirement? While the use of leverage is a common investment practice that can be important to maximizing profits, it can also backfire. You may have heard of large money managers who "blew up" the funds under their management by using leverage recklessly - and these people are the professionals! The government does not want this to happen to less experienced individual investors. In addition, the potential impact on the market could be devastating. For these reasons, Regulation U keeps the practice in check.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.