Steep Market Selloffs May Uncover Risks in Accounts Such as Adverse Consequences of Margin

crisis-1260919-s.jpgIt was reported by Bloomberg News on Friday January 24, 2014 that there was a “massive selloff” in emerging markets that led to a decline of approximately 2% to the Dow Jones Industrial Average and S&P 500. It is during such fast and sudden selloffs that underlying problems in public investors’ brokerage accounts are typically uncovered.

At Malecki Law, we have seen an increase in claims arising from margin in investors’ accounts. Overwhelmingly, investors were not informed about the risks of buying securities on margin and were only told that they could make more money by leveraging their accounts to buy more securities. However, without fully understanding the risks of products and services such as margin, public investors cannot make a fully informed decision about whether it is suitable for them.

Margin is essentially a loan from the brokerage firm to the investor. The effect of margin is not similar to that of a typical home mortgage, because the securities or cash in the investor’s brokerage account serves as collateral for the loan and large market drops can cause margin calls, request for more money or collateral or a sell-off of positions. Investors may use margin to increase their purchasing power or “buying power,” as some brokers like to say. However, it is very important that the investor is fully informed of all risks associated with the use of margin, including that they can lose more than they borrow.

Like all loans, brokerage firms make money charging interest on the margin. So, as more money is borrowed, the interest payments increase. The Financial Industry Regulatory Authority (FINRA) underlines that in a down market, the securities that are used as collateral also tend to decline in value. The brokerage firm may issue a “margin call” if the value of collateral sinks too low. In these circumstances, the brokerage firm may demand that additional cash be deposited in the account, and if the investor fails to do so, the firm may unilaterally sell securities to satisfy the margin calls. For these margin calls, investors are typically given as little as three days’ notice, and it often comes as a shock that a service that was described as helpful or safe has ended up being very costly (although that is a sign the investor does not understand and should not be in margin).

Margin can be used with many different types of investments, including equity/stock, bonds, mutual funds, etc., but increases in the leverage in a brokerage account increases the risk of the investment, and consequently, also increases the risk to investors of substantial losses. Due the manner in which margin accounts work, investors may lose more than they borrow by making interest payments and satisfying margin calls.

Margin is especially dangerous when purchasing shares of ETFs that already use leverage. By purchasing these shares on margin, the investor is “leveraging their leverage” meaning that they are taking on much more risk. Even relatively small movements in the market can cause crushing losses on such a position. Below are a few leveraged ETFs that incurred serious losses over the past three months.

  • Barclays Short B Lvgd Inv S&P 500 TR ETN – BXDB
  • Direxion Daily Gold Miners Bull 3X Shrs – NUGT
  • Direxion Daily Technology Bear 3X Shares – TECS
  • Direxion Daily Financial Bear 3X Shares – FAZ
  • Direxion Daily Semicondct Bear 3X Shares – SOXS
  • Direxion Daily Small Cap Bear 3X Shares – TZA
  • Direxion Daily Mid Cap Bear 3X Shares – MIDZ
  • ProShares Ultra Silver – AGQ
  • ProShares UltraShort Semiconductors – SSG
  • ProShares UltraShort SmallCap600 – SDD
  • Direxion Daily Brazil Bull 3X Shares – BRZU
  • ProShares UltraShort Nasdaq Biotech – BIS
  • ProShares UltraShort S&P500 – SDS
  • Direxion Daily Nat Gas Rltd Bear 3X Shrs – GASX
  • ProShares Ultra Gold – UGL
  • PowerShares DB Gold Double Long ETN – DGP
  • ProShares UltraShort Russell2000 Value – SJH
  • Direxion Daily Dev Mkts Bear 3X Shrs – DPK
  • Direxion Daily South Korea Bear 3X Shrs – KORZ

Unfortunately, public investors can suffer losses due to their margin account in a stock market that rises or falls. Securities rules require that a broker fully advise the investor of all risks to establishing and using margin in their account. If you believe you were not properly informed of the risks associated with margin, please contact the attorneys at Malecki Law to determine if you have a claim for damages.