Margin Accounts Dangerous For Voyagers

MP900387264In reading the headline of this post, you could be forgiven for thinking that I have completely lost my mind and decided to leave the nautical arena to become an investment blogger. Not so. Almost everyone out there voyaging is relying on their savings, to at least some extent, and most of you who are planning to go cruising are saving to do so. Here at AAC we warn you about poor anchors and other nautical dangers, this post is just an extension of that.

The Danger

Here’s the danger: If you have an investment account that allows you to use margin it is possible, maybe even likely, that your broker is using your securities to gamble for their benefit.

I’m no finance expert, but as I understand it, what the broker does is rent your securities out to people shorting the market and/or uses your securities as collateral to back their own bets. And if one of those shorts goes bust, or your broker does, you lose—maybe everything. Think MF-Global.

Worse

It gets worse: this may be true whether or not you actually use the margin facility.

Worse Still

And worse: your broker may be able to gamble with all of the securities in your account, even the ones that are not margined.

Don’t Assume

You may have a margin account, even if you never consciously asked for one since some brokers will set your new account up that way by default.

It’s International

Apparently this is happening in the UK, Europe, the USA and Canada, at least, and probably in many or even most other places.

They Take The Profit, You Take The Risk

What makes this so heinous is that the broker is reaping all of the benefits of this activity and you are taking all of the risk. It’s just like being a taxpayer: the finance industry reaps all the profits and you get stuck with the losses—oops, who said that?

It’s Not Paranoia If…

Of course, when you tackle your broker about this, they will, as mine and several other people’s did, pat you on the head and tell you not to worry your little old yachty head about such things. They would never do such a thing. Yea, right, and I’m still waiting for the fat guy in the red suit to deliver presents.

Don’t ever forget that many, perhaps most, of the people in the “wealth management business” are really in the wealth transfer business…from you to them. One of the reasons that Phyllis and I are still voyaging is because we remind ourselves of this fundamental truth before any dealings with the finance industry.

My Source

How do I know about this? By pure luck. One of my oldest and best friends is a risk management and securities custody expert with thirty years of experience in keeping money and securities safe.

But I Need Margin

Some of you may say that you need margin to support your trading activities and so that you don’t have to leave a large cash balance in your account to fund your next investment. Fine, if you want to take this risk, that’s up to you. But for me, the benefit of making a tiny amount of interest, by the improvement in cash management that a margin account allows, is not worth the risk of losing everything in a crash.

How Can You Check?

I urge all of you to immediately check your broker statements and contracts (you may have to ask for the latter) and make sure that you do not have a margin (type 2) account.

The Smoking Guns

Look for the following:

  • Any indication on your statement that the funds available to you are more than the actual cash balance.
  • Any use of the word “margin”.
  • Any use of the words “hypothecate” or “re-hypothecate”.

Further Reading

For more, from an industry insider, on this danger, I urge you to read this blog post. Also, Wikipedia has a good definition of hypothecation here.

Disclaimer

I have no qualifications whatsoever in the finance or investment industries. This post is not investment advice, but purely a warning about a danger that I believe to be real, but could, of course, be wrong about.

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Meet the Author

John

John was born and brought up in Bermuda and started sailing as a child, racing locally and offshore before turning to cruising. He has sailed over 100,000 miles, most of it on his McCurdy & Rhodes 56, Morgan's Cloud, including eight ocean races to Bermuda, culminating in winning his class twice in the Newport Bermuda Race. He has skippered a series of voyages in the North Atlantic, the majority of which have been to the high latitudes. John has been helping others go voyaging by sharing his experience for twenty years, first in yachting magazines and, for the last 12 years, as co-editor/publisher of AAC.

21 comments… add one
  • Scott Kuhner Jan 14, 2012, 1:51 pm

    If I am not mistaken, even if you securities are not in a margin account and the brokerage firm goes under, you will not be able to sell your securities even if you want to, until the bankruptcy is complete and then they only owe you the shares you owned, not the value of the account at the time of the bankruptcy.

    • John Jan 14, 2012, 2:31 pm

      Hi Scott,

      I think that’s right, although you would know better than me.

      But in that case (securities not on margin) you would at least get them back eventually. Whereas, as I understand it, with a margin account, if the broker has used your securities for their own activities, as many margin agreements allow, you would lose everything, for ever. Just like MF Global.

      • Scott Kuhner Jan 14, 2012, 11:32 pm

        John, Yes you would get your securities back; but, in the meantime you may think that the company is overpriced and want to sell; but, you can’t. That happened to a friend in the 69-70 crash and by the time he got the stocks back the stock had declined by 80%.

  • Jerry Levy Jan 14, 2012, 2:36 pm

    You can develop effective strategies in advance for navigational hazards and storms at sea, but there is no sure way of navigating financial seas. What you say is true, but there are also dangers with all other ways you can invest your savings. For instance, you can speculate (on silver, gold, pork futures, baseball cards, you name it) in which case you can win big or lose big. It’s just a legal form of gambling. Or, you can buy bonds – in which case they can be downgraded. Or, you could put your money in a savings bank where the rate of interest is likely to be less than the rate of inflation in which case your real savings (savings adjusted for inflation) will decline.

    There was a time, not so long ago, when cruisers projected a growth of savings by a rate that allowed for – with a simple, small boat and thrift – replinishment of their cruising kitty out of savings. This was the strategy of Annie Hill, as explained in _Voyaging on a Small Income_, who anticipated a 10% interest rate on savings. Those days are long past. My suspicion (as an economist) is that it will be a long time – if ever – before it returns.

    This has big implications for cruisers and would-be cruisers – likely it will cause many to put off cruising until after they retire. But, people are waiting longer now anyway before they retire because of financial uncertainties, etc. It is a sad reality that many of these people will die before they retire. At a minimum, I suspect that these financial realities will cause many sailors who DO go to downsize their boats and their spending. This would lead to a reversal of the trend (bigger size boats on average) we’ve seen in recent years.

    Unless you’re part of “the 1%” these realities will force cruisers and would-be cruisers to make some very difficult choices.

    • Scott Kuhner Jan 14, 2012, 11:42 pm

      Jerry, the only risk free investment is TIPS, Treasury Inflation Protection Securities. However the last auction of a 10 year TIP had an interest rate of 0.625%. In case you are not aware the principal goes up every year by the amount of inflation and the interest rate is applied to the new principal amount. However, you have to pay income taxes on the amount of principal increase so you must own them in an IRA or other tax free account.

  • John Jan 14, 2012, 2:45 pm

    Hi Jerry,

    Great comment and so very true. We feel truly fortunate to have been able to make our rather modest nest egg in a much easier time to do so. I also wonder if we will be able to hold on to that nest egg in the coming years—it will not, as you say, be easy.

    Having said that, I think that the risk from re-hypothecation, as described in this post, is much worse than the risks of reduced income or value of investments since re-hypothecation can, as I understand it, potentially take everything you have—a complete wipe out, even if you have invested wisely.

  • Jerry Levy Jan 14, 2012, 6:08 pm

    Yes, that’s true: there are different levels of risk associated with different types of financial investments. But, the logic of that is that IF you are out cruising and IF you can’t conduct financial transactions from afar then the least risky options are the best. There are some types of investments that you have to follow on a daily basis and be prepared to sell or buy FAST. If you can’t do that, then you shouldn’t make those investments.

    OTOH, cruisers are more ‘connected’ nowadays and often can readily get online and conduct transactions online. IF you can do that, then you’re in a better position to play the more risky financial games.

  • Colin Farrar Jan 14, 2012, 11:09 pm

    John,

    This is sound advice. My non-professional opinion is that we could go one step further, leaving our savings with custodian banks or brokers whose business is serving account holders, not engaging in proprietary trading (to the extent we can determine this). Another option is direct registration for equities. After all, SIPC is a promise, not a guarantee, and the last thing we want to worry about as we set sail is whether our bank or broker has made foolish bets that place our accounts at risk. It’s enough to worry about our own individual investments.

    Colin

  • RDE Jan 15, 2012, 12:00 am

    What you have to keep in mind is that the rule of law has been completely forfeited in the USA, almost without a whimper by the public. John Corzine STOLE 1.3 billion dollars of his customers money and transferred it thru his London subsidiary and partner in crime JP Morgan. That money included Montana wheat farmers hedging (pre-selling) their crops to insure against price fluctuations and buy next years fertilizer and seed, and it also included physical gold and silver identified by individual bar stamps supposedly being stored on behalf of the customers by MF Global. The Obama department of Injustice clearly has no intention of prosecuting anybody for this crime. Of course not, after all Corzine is one of the largest fund raisers for Obama’s re-election campaign.

    At a much larger scale, the housing market is saddled with a near universal level of bank criminal fraud that the administration not only is not prosecuting but is actively working to cover up and incorporate into the national debt. Of all the real estate loans issued in the past decade only a small percentage have marketable chain of title because of the MERS Ponzi scheme banks invented to allow mortgages to be repackaged as securities and sold to pension funds and other suckers. So if you are thinking about buying a cheap repossessed rental apartment to support your cruising lifestyle, you should be aware that title to your property will likely be fraudulent at its origin. And not a single high level prosecution has been brought in what has been the single largest theft in the history of the world. Bill Black, author of (“The Best Way to Rob a Bank is to Own One” ) (http://www.youtube.com/watch?v=Rz1b__MdtHY), was lead prosecutor in the savings and loan scandal 20 years ago. His small staff sent over 1000 perps to prison. That scandal was a mere pimple on the present pillage.

    So what is a cruiser to do? If you are going to have a bank account it should be in Canada. Better yet, cut your needs down to what is really important, build in a very hidden compartment in your boat, and stock it with Maple Leafs.

    ps. I cashed out my futures account one week before the MS Global bankruptcy became public knowledge. As it turns out my broker was using MS as a clearing agent. Better to be lucky than smart!

  • RDE Jan 15, 2012, 12:37 am

    Perhaps I should have underlined in red ink the fact that the gold bars stolen in the MS Global fraud have nothing to do with whether there was a margin account or futures account. They were physical assets supposedly being held in a warehouse by MS, each individually identified by a warehouse receipt. Far more concrete an asset than a stock certificate or a digital notation from your broker saying that you own 1000 shares of Apple stock. And they were stolen in broad daylight while the department of justice looks the other way.

    So the problem is not whether margin accounts can be hypothecated, but rather whether there are any remaining legal protections to prevent banksters stealing customer funds at will.

    ps. If you think this state of affairs has anything to do with Elephants and Asses, consider that it has been interbreeding through at least two Democrat and three Republican administrations.

  • John Jan 15, 2012, 11:13 am

    Hi All,

    Thanks for the good and interesting comments.

    However, one thing that I would not like to see lost in all this justifiable anger against the finance industry or concern about security value is that if you were to lose everything due to your broker re-hypothecating your securities, as discussed in my post, it would not, in fact, be fraud because you would have agreed to let them gamble with your money when you signed their margin agreement!

    For example both of the broker accounts that we hold with major Canadian banks specifically allow them to re-hypothecating all of our securities the minute we convert our account from Type 1 (cash) to Type 2 (margin). You have to read through 10 pages of fine print and know what you are looking for (search on hypothecate) but it’s there, bold as brass.

    And that is why Phyllis and I will never have a Type 2 (margin) account.

  • richard Jan 15, 2012, 3:35 pm

    to my relatively unitiated mind all this sounds like a can of not just worms but of nasty worms that my financial professionals will no doubt sugar coat when i ask for their views on it and then give me great-sounding reasons why these concerns are will-o-the-wisps leaving me with confusing alternatives from which to choose…i don’t doubt any of these posts, it’s just that financial matters seem more and more like rabbit trails often leading nowhere…i saw corzine’s testimony before that senate committee recently…he was cool as a cucumber when responding to every question including the big ones like where do you think that money went to which his answer was not only that he didn’t know but he implied nobody should expect him to know…i know enough to realize that is bald-faced lieing…yet the senate committee had no alternative but to listen to that tripe and ostensibly accept it…sorry and pathetic in a mounting history of sorry and pathetic where the world of macro-finances is concerned if you ask me…richard in tampa bay (m/v cavu’s skipper, formerly s/v sidra’s skipper)

  • Peter Hollings Jan 16, 2012, 4:39 pm

    Another part of the problem is the likely inadequate resources of the SIPC. (I say this based on something I learned in the mid ’80s that I assume is still true today.) The SIPC is not a government entity like the FDIC. It is a creature of the securities industry. Moreover, it does not have reserves as an insurer would. Instead, it holds letters of credit from the banks. So, in this post Glass Steagall era, if we were to have a systemic crisis, e.g., triggered by Euro defaults, this contemplates that the financially-distressed firms would loan themselves the money to cover their losses. (Recognizing that these were bad loans, I suppose that Bernanke would buy them up and the process would continue so long as China, etc., wanted to continue holding Treasuries. 🙂 )

  • richard Jan 16, 2012, 4:58 pm

    adding more definition to the overall sorry state of u.s. macro finance, we hear constantly about the federal budget deficit ($15 trillion and growing) but there’s more federal debt: the social security trust fund holds about the same amount of debt bringing us up to $30 trillion…what about medicare ? that’s in the red too by probably another trillion and growing…we better start turning this around now or else our nest eggs will soon be worthless in whatever form they take including cash…richard in tampa bay (m/v cavu’s skipper, formerly s/v sidra’s skipper)

  • Steve James Jan 22, 2012, 10:06 am

    John, and gentlemen, thanks for the enlightening discussion which has contributed to more loss of sleep. I feel as if I am on night anchor watch in a building gale with a rocky lee shore; and rather than a Spade I am hanging on a single, ancient and bent CQR.
    May I add one more aspect of money management to be cautious of? That would be the very popular money market funds the brokerages use roll our “cash” into for a slightly higher yield. During the ’08 financial breakdown there were a number of them that had difficulty maintaining their $1 nav. Today many of these funds have invested heavily in European bank paper. I had to ask my broker ( as i could not get to the information easily on the Internet) what the top ten holding were in my money fund. Eight of the top ten holdings were European bank issuances of various, indecipherable notes, guarantees, and “paper”. It will be these banks that will be the first to go down. I made sure that these funds were tranfered to a US treasury mmfund. Now it seems that I must make another change and find a pocket to stick some Maple Leafs into.

    • John Jan 23, 2012, 6:36 pm

      A really good point. It amazes me that anyone would put cash into MM funds. In doing so, all you are doing is: taking substantial risk over and above treasuries for little or no increased return, and enriching the broker and fund manager.

  • Geoff Jan 25, 2012, 3:39 pm

    In the investment business there is as much misinformation published by non-specialists as there is in boating!

    In Canada the rules which apply to all investment dealers provide that all securities which have been paid for must be segregated. This means that only the amount of securities which are required to margin your indebtedness to the brokerage firm are available to be lent out or pledged by the broker to secure loans. For example if you have $500,000 of market value of shares in major corporations in your margin account and you owe the broker $100,000, the broker would have to place in segregation approximately $358,000 of your shares and he could lend or pledge the remaining $142,000 (this assumes a typical margin rate of 30%).
    There are logical and sound reasons for the broker to have the ability to lend or pledge the securities which are required to fully margin your account. If you are borrowing $100,000 to buy stocks, your broker may have to borrow the money to fund your purchase, in which case he will pledge the collateral securities which you bought.

    The Investment Industry Regulatory Organization of Canada requires audit testing of investment dealers compliance with the rules requiring segregation of securities.

    There are also very valid reasons why one may prefer a margin account over cash account. These include the ability to buy a security without selling another one first, withdrawing cash without first settling a sale of securities, having the ability to write options or to hedge an investment by short selling.

    I would urge anyone who is concerned about a brokerage firm’s ability to lend out their securities to get further information on the rules governing segregation before rushing to possibly impede their investment options. In Canada the regulator of investment dealers is “IIROC” which has a comprehensive web site. The Canadian Investor Protection Fund (“CIPF”) also has much information on its website which explains how its insurance coverage protects investors in the event of the failure of a dealer.

    • John Jan 25, 2012, 6:14 pm

      Hi Geoff,

      You are obviously an expert, and may easily be right. However, my reading of both of my Canadian broker agreements indicates that they can in fact lend all of the securities in a margin account.

      Also, apparently, according to Ms. Park, see the links at the bottom of the post, several brokers have found a way around Canadian government securities regulations.

      And while I am no expert, as you so rightly point out, as I said in the post, I consulted with in custody expert with 30 years of experience.

      One other thing that everyone should be aware of. CIPF is not a government guaranteed protection fund and there is no guarantee that it would have the funds to make all investors whole in the event of a really bad crash.

  • Geoff Jan 27, 2012, 2:50 pm

    Hi John,
    You are correct that CIPF is funded by the securities industry participants and is not government guaranteed. The good news is that the number of incidents requiring CIPF involvement has been very few — from its inception in 1971 it has only had to cover a total of $33 million in losses and has never not covered an insured client loss. The last dealer that collapsed requiring CIPF coverage was in 2002. It’s ironic that it is safer to hold your assets with a small to mid size investment dealer instead of the largest ones from the point of view of CIPF having sufficient resources to fund a collapse.

    Regarding your margin agreement, regardless of the wording, in Canada the segregation rules apply to all investment dealers. The dealer is not permitted to lend out your fully paid securities unless you enter into a specific security lending agreement in a form prescribed by IIROC. In this case the dealer would have to place collateral in segregation to secure the borrowing of your securities.

    Clients should be able to see from their monthly statements which of their securities are held in segregation. At my firm the monthly statement has a column which says “asset location” and for every security held the word “segregated” will be reported if the security is held segregated from the firm’s assets. This is an area that most clients do not understand but it is one of the most important safeguards to allow cruising Canadians to know their assets are safe.

  • Paul Mills Jan 28, 2012, 12:07 am

    Hello all,

    It seems to me that we live in crazy financial times, where it’s very challenging to make inteligent decisions without very specialist knowledge, and that even then risk is hard to asess clearly. If there is one thing harder than making some money – it’s keeping it and growing it! – or using its growth to fund living the life you want.

    A few years ago, after the sale of my largest investment I made the mistake of temporarily putting more than half in an Icelandic bank, having carefully read all the recoomendations etc. Three weeks later the Iclenadic crash happened and I thought my dream of Ovni ownership was dead, leaving me feeling very,very sick,. Luckily the UK government came to the rescue. I then stepped back and realised just how little control I had over large banks etc all driven by maximising staff bonuses and trying to maintain ecenomic growth.

    Since then, and with due regard to the turmoil I have kept to simple options. My funds are nearly all invested directly by me in areas that I know, some in commercial property, some in domestic property (though none in ‘sub prime’)- here though yields may be lower I know that whatever happens the risk is spread and I will be left on a par with many millions of other uk citizens.

    I also invested in shareholdings in buisnesses that I know, and offer value added to them as part of my holding. At the same time I have two ‘start ups’ with low initial outlay and again high potential or my input to enhance progress, each run day to day by others who are hungry for success, and in whom I have solid professional trust. Exclusing ths start ups, overall last year this gave over 10% direct yield and little risk to the bulk of my capital. The start ups are both doing fine, and one looks set to really fly and has already created a paper return of 5 multiples .

    Using this combination I have maintained the cashflow we need for a modest life of cruising and being at home in about equal measures and work about 2 days a week when at home, and am managing 65% of the financial growth I got whilst working flat out and slowly killing myself!

    For me – the key is involvement and feeling that I can use my skills to significantly influence positive outcomes, and most of it via technology from wherever I am.

    • John Jan 29, 2012, 11:54 am

      Hi Paul,

      A really interesting comment and approach, thank you. Your approach is probably not for everyone, but for those with specialized knowledge and a business start-up background, you make a convincing argument that it is simply safer to stay away from the entire finance industry.

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