Margin Account Abuse

A "margin" account is a brokerage account in which the brokerage firm loans money to the investor. For example, if $100,000 is deposited into a "cash" account it can be used to buy $100,000 worth of stock. If deposited into margin account, $200,000 worth of stock can be bought, because half the cost can be loaned to purchase stock.

While margin investing can double the gains on an investment, it also doubles the risk. In fact, because interest immediately begins to be charged to the account and a temporary drop in the stock value can cause liquidation, the danger is even greater than many investors realize.

Margin accounts are very profitable for brokerage firms. Just as Sears and other retailers earn more on financing than selling goods, many brokerage firms earn more on margin interest than on commissions. Brokers sometimes get a bonus on interest charged to their clients accounts, but their goal is usually to double commissions. When management fees are charged instead of commissions, these fees are charged on the portfolio size rather than the client's "equity" in the account. Thus, in addition to interest costs, commissions and fees double in margin accounts.

Brokers often dispell a clients' fear of investing on margin by reminding them they borrow 90% or more on a house, so borrowing 50% on stock is conservative. Yet, this is a false logic, because a house has no "internal debt." Almost all companys have debt and most are highly leveraged. Buying stock in a company on margin thus adds leverage on top of leverage.

Using margin is a high risk method of investing and is only appropriate for sophisitcated investors who fully understand the risk. The most egregious cases law firms handle are for investors who have been decimated through margin accounts.