First, cash accounts will be addressed, and then margin accounts. A cash account, is one in which the customer agrees to pay the full amount of his purchase price within three (3) days of the trade date. Basically, it's cash and carry. You bought it and now have to pay for it in cash.

Regulation T (known as Reg. T.) mandates that the brokerage firm cancel the trade if it is not paid for on time. If the customer has made a partial payment, but owes more than $500, by the end of the 3rd day, the unpaid portion will be sold off. However, if less than $500 is owed, the broker has a little discretion. He may permit the customer a little more time to pay up his account. If a customer feels that his reasons for not paying are 

exceptional, he can appeal for more time. This appeal for an extension can only be approved by a national securities exchange, the National Association of Securities Dealers (NASD), or a Federal Reserve Bank. Perhaps the worst part of not paying your account in full is that after the brokerage firm takes its actions with respect to the unpaid portion, your account will be frozen for 90 calendar days. This means that the customer can only purchase securities during that time if they are paid for in full in advance.

Regulation T also covers margin accounts. A margin account is one in which credit is used to purchase securities. Reg. T calls for the Federal Reserve to establish the standards under which margin transactions may occur, which securities may be purchased with margin, and the required down payment the customer must make when financing this type of transaction. Presently, 50% is the required down payment.

Hypothecation is a component of margin. It is the pledge of collateral against the loan. When you buy stock on margin, you hypothecate the stock. You pledge the stock as collateral. The law requires that the transaction be secured or collateralized.

Re-hypothecation is the pledging of the clients securities to secure loans from banks. This way, the securities firm can afford to carry margin accounts for their customers. Securities worth 140% of the client’s debits is the legal maximum which may be re-hypothecated.

All securities purchased with margin must be held in 'Street Name'. That is, the securities are registered in the name of the securities firm. This is so that the securities firm can liquidate the collateral in a hurry if they need to.

The client is in actuality, the 'Beneficial Owner'. The client remains the actual owner of the securities held in street name. The client receives all the benefits of ownership including: dividends, interest, capital appreciation, voting rights, preemptive rights, and the right to liquidate the position in whole or in part.

It is illegal for the securities firm to commingle the securities that it owns with the customer securities in an effort to obtain loans and benefits which go beyond that allowed by law.

The debit balance is the amount of the loan from the brokerage firm to the customer who has financed the securities he purchased with margin.

Let's say that a customer has a margin account set up. He wants to purchase 1,000 shares of a $30 stock. The purchase price is $30,000. The initial margin call at 50% is $15,000. This is the amount that must be present in the account to purchase the securities. This leaves a debit balance of $15,000. It also leaves the customer with an equity balance of $15,000. The Current Market Value (CMV) is $30,000. The debit balance percentage and the equity balance percentage always add up to 100%.

In lieu of cash, a customer can deposit securities that he owns outright to meet the margin call. If the customer in our example owned securities outright, he could deposit these securities in his account and use 50% of the value of them to meet the margin call assuming 50% of these securities added up to $15,000. If the value of the stock rises to $40 from $30, the current market value of the customers account will rise by $10,000.

This is called 'Excess Equity'. The current market value of the customer's account is now $40,000.  Previously, the customer only borrowed $15,000. This was 50% of the original current market value of $30,000. However, now his account is worth $40,000. 50% of $40,000 is $20,000. This means that the customer now has the ability to borrow an additional $5,000.  This excess equity in the margin account is referred to as SMA. SMA stands for 'Special Memorandum Account'. The Special Memorandum Account is where brokerage firms record excess equity. With respect to excess equity, the customer can do one of three things. He may withdraw it in cash; he may use it to buy more stock; or he may do nothing now and reserve the right to do either one of the first two choices in the future. By the way, with the additional Excess Equity of $5,000, the customer could purchase an additional $10,000 worth of stock without putting up any additional capital.

Conversely, let's say that the stock the customer bought for $30 declines to $20. The current market value drops from $30,000 to $20,000. The debit value remains the same at $15,000. Except now the equity in the account has dropped to $5,000. This means that the account doesn't have enough of your money in it to meet the Reg. T margin requirement of 50%.

The way this is determined is to multiple 50% or .50 times the new current market value of $20,000, which gives us $10,000. Then subtract the equity of $5,000, which gives us an answer of $5,000. Therefore, the account would be 'Restricted' until another $5,000 is deposited in the account.

What happens with a restricted account? A customer may purchase additional securities in a restricted account as long as he deposits enough funds to meet the Reg. T requirements for the new transaction. However, if a customer wants to sell some or all of the securities in the restricted account, he will find out that the Federal Reserve has a rule called the 'Retention Rule'. This means that the brokerage firm is required to retain 50% of the proceeds of the sale to reduce the customers debit balance. The other 50% goes to the customer to do with as he desires.

There is a minimum maintenance requirement for a margin account. There must be equity of at least 25% of the market value of the securities in the margin account. This way, the value of the securities can never fall below the amount of the original loan. Additionally, NYSE and NASD rules state that accounts must have at least $2,000 in them to qualify for credit in a margin account. In short sale situations, the minimum maintenance requirement is 30% of the current market value.

Regulation T really applies to broker-dealers and all national securities exchange members. The only way they can extend credit to their clients is through the use of margin securities. By the way, the brokerage firm is not permitted to arrange for you to borrow money at terms that are better than the brokerage firm can provide you.

The Federal Reserve defines a margin security to include:

1) Any equity security listed on or having unlisted trading privileges on a national securities exchange

2) Mutual Funds, after 30 days

3) OTC margin bonds, meeting criteria specified by the Board

4) Any OTC stock designated by the Securities and Exchange Commission as qualified for trading in the national market system

5) Any security included on the Board's List of Marginable OTC Stocks which is published four times annually and available at the Board or from any Federal Reserve Bank.

The regulation permits any registered self-regulatory organization or registered broker-dealer to establish more stringent rules than those required by the regulation. So that if the brokerage firm believes that there might be a significant increase in defaults, they could make the margin requirements more stringent.

B. R. Bowers & Company

122 East Maumee St.
Adrian, MI  49221
Phone: (517) 265-7683
Toll Free:  800-392-6230
Fax:  (517) 264-5095

3225 Walker Avenue NW
Suite 200
Grand Rapids, MI  49544
Phone:  (616) 784-0652
Fax:  (616) 784-0674

Email:  bryan@brbowerscompany.com

http://www.brbowerscompany.com