Berko: Making money on margin a double-edged sword

Dear Mr. Berko: I got a $10,000 bonus from my employer in January and put it with a broker in early February. He has made four trades, including a biotech stock with a funny name I’ve never heard of. My account is now worth $12,200. He said if he had my account on margin, then he could have made twice as much money. Is that true?

I asked how it works, and he said I won’t have to put up more money but I just have to sign a broker’s form and I can buy twice as much stock immediately. Because he doesn’t explain things well, and I don’t want to offend him, could you please explain how margin works? And is it true that I could have made twice as much money as he claims? Also, I’d like to buy stock in the fantastic Chinese market. Do you think Chinese stocks will move way up? What Chinese stocks would you recommend?

— LD, Portland

Dear LD: That broker’s right on the money! If you had signed his margin agreement upon opening the account and followed his advice, you’d have made twice as much money. That margin agreement would give you an extra $10,000 credit so you could buy $20,000 worth of stock. The flip side of that agreement is that you could also lose twice as much.

Here’s a very simple explanation of how it works. Margin accounts, offered by most brokers, enable clients to borrow money to purchase stocks or bonds. Assume you wish to buy 100 shares of the fictional company LSMFT (LSMFT-$100), which would cost you $10,000. You can write the broker a check for $10,000 and own LSMFT free and clear. Or you can sign a margin agreement and buy 100 shares of LSMFT for $10,000, putting down 50 percent of the price ($5,000) and borrowing the remaining $5,000 from your broker. The broker charges interest (today’s rate of 8 percent is turnpike thievery because the collateral is good as gold) on the borrowed $5,000 and he holds your 100 shares of LSMFT for collateral. If the brokerage charges 8 percent simple interest, then $33.33 will be deducted from your account each month. And if 10 months later you sell LSMFT at $110, you’ll have a credit in your account of $11,000, from which you repay the broker the borrowed $5,000. Now you have $6,000 remaining and a gross profit of ($6,000 less $5,000) $1,000. So, after subtracting buying and selling commissions of $150 and 10 months of interest of $33.33 from the $1,000 gross profit you have a net profit of $516.67.

The important thing investors must understand about margin is that it’s a double-edged sword. If you had invested $10,000 in cash, your 10-month return would’ve been 5.16 percent. But you leveraged LSMFT with just $5,000 so your 10-month return is 10.32 percent. When stocks rise in value, your gains are amplified and that’s wonderful. However, in a down market, margin really hurts because the borrowed money exposes you to higher risks. Now, if you can get this in your head, you’ll have it in a nutshell.

The extreme use of leverage is one of the reasons banks like Lehman, Bear Stearns, Merrill, JPMorgan, etc., collectively lost hundreds of billions of dollars nine years ago. Goldman, Citigroup, Bank of America, etc., traded bonds using 1 percent margin, investing only $1,000 for every $100,000 of market value. If the bonds fall 5 percent or $5,000 (many did and more), the $1,000 is wiped out and they’re $4,000 on the wrong side of the eight ball. Multiply this number by billions (remember those subprime mortgages) and you may understand how the great financial crisis occurred.

Individual Chinese stocks scare the bejabbers out of me. I don’t trust China’s banking/financial system or its corporate and government executives.

Corporate income statements are bloated, balance sheets are fudged, and I can’t read Pinyin so Chinese corporate reports are Greek to me. But the China market can be hot and I’d own the iShares MSCI China ETF (MCHI-$69) — that’s a Chinese imitation of the S&P 500 Index. MCHI was plus 12.5 percent last year.

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