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The CFPB would do well to enforce usury and fraud laws in the broker margin arena. This realm, a major consumer borrowing area that is largely ignored by regulators, involves the credit extended to clients of retail brokerage firms. The Securities and Exchange Commission’s Regulation T provides that when a client buys a stock the broker is allowed to loan the buyer up to 50% of the purchase price.The NYSE stipulates that if a client’s equity value sinks (i.e. the stock drops after the client bought it or rises after he shorted it) the broker must reduce the loan such that the equity remains at least 25% of the asset value. Save that, there is little direction or regulation as to the terms of this loan and as such is ripe for abuse. But what constitutes abuse?
Delaware, California and other states set their usury rates at 5% above government rates, and as such that would seem a reasonable starting point. However, broker margin is different from most loans in that the collateral held by the lender is highly liquid. In fact it is virtually cash, as equity holdings are considered the same as cash on most balance sheets.
When the borrower’s equity sinks to a dangerous level the lender is able to easily reduce the loan by instantly liquidating collateral. As such the lender is in no genuine risk of losing his principal. For example, if a client buys IBM at a price of $100, and uses Reg T margin, he posts $50, while his broker posts the other $50. The buyer’s equity is $50 (the asset value minus the loan amount, or $100 minus $50). If the price of IBM shrinks to $70, the buyer’s equity is now $70-$50=$20.
Though the NYSE requires the client maintain equity of at least 25% of the asset value, typically each broker sets a requirement above that. For instance Scottrade sets 35% as its lower limit for its clients. Given the liquidity of the collateral and the margin cushion the lender has essentially zero risk. In fact most banks have zero reserves for broker margin losses, which is consistent with their actual risk, but inconsistent with the rates they charge—rates right up against the 5% usury thresholds, as we will see.
According to Charles Schwab and E-Trade 2010 regulatory filings, the firms received an average rate of 4.8% and 4.4% respectively on margin loans made in 2010, while paying 0.01% on client balances. The latter number, rates paid to customers on cash balances, rings legitimate as the Fed Funds target range in 2010 was 0-0.25%. However, given the rates brokers received on margin balances, the two brokers effectively lent money on average at 4.5% more than the government rate. The question remains if some states prohibit charging more than 5% excess on even risky unsecured loans, why are brokers allowed to charge 4.8% premium on risk less loans?
In addition to excessive rates, there is another area of broker margin that bears scrutiny: the broker’s discretion at which price to liquidate a borrower who falls below equity thresholds, and the broker’s option to take the other side of clients’ trades. This situation creates an inherent conflict of interest between broker and client. For example, consider a case where if IBM falls to $72 the client’s equity is reduced to 34% of assets, and the terms of the margin loan stipulate that the borrowers equity must remain above 35%. If IBM hits $72 at, say, noon, and then subsequently goes to $71, the broker can sell some of the client’s IBM shares at $71, and still come away without a loss of principal.
However if the shares fall to $72 at noon then quickly rebound to $74, the broker can still claim a liquidation at $72 and further claim that they were the buyer at that price. In other words, when prices get near a liquidation point, the client has given the broker an option for free. This option has value and is a very real cost to the margin borrower over and above the interest cost. More worrisome still, the broker has incentive to move the equity to a price that is on the cusp of its equity percentage threshold such that the option realises its value.
There will be resistance in the brokerage community to any changes as margin interest is no small matter to the brokers. In 2010 Schwab’s net margin interest was $435mm (and another $60mm in ‘principal transactions’, aka taking the other side of client trades such as forced margin liquidations), while total net profits were $454mm.
Likewise in 2010 E-trade made $180mm in net margin interest, and $100mm in principal transactions while
posting a $28mm loss. If the arriviste CFPB is to show that it can make a dent for the consumer against entrenched business interests, it would do well to begin enforcing usury and fraud statutes when it comes to broker margin.