Lesson 7 of 7
Leverage and forced selling
See how borrowed money turns a price fall into a forced sale, and where a margin call comes from.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Borrowing to buy stock turns a price fall into a larger fall in your own money, because the loan stays fixed while the stock's value does not.
- Regulation T caps the loan at half the purchase price. FINRA's rule then sets the price fall that triggers a call for more cash.
- A company's own debt works the same way one level down: when earnings fall, a broken loan covenant or a maturity it cannot refinance can force it to sell assets or issue shares at a bad price.
Buying stock with borrowed money means a price fall lands entirely on your own equity, since the loan itself does not shrink. Past a certain fall, a lender can demand cash you do not have, forcing a sale at whatever price is on offer.
What it takes to trigger a call on a position bought half with borrowed money
- Your equity at purchase · 50% of the position$10,000
- Your equity after a 33.3% fall · 25%, the maintenance floor$3,333
How the loan amplifies the fall
$20,000 of stock bought with $10,000 of your own money and $10,000 borrowed means every dollar the stock loses comes entirely out of your $10,000. A 33.3 percent fall in the stock, from $20,000 to $13,333, cuts the position's value by $6,667. That $6,667 comes out of $10,000 of equity, not $20,000 of stock, a fall of 66.7 percent in your own money for a 33.3 percent fall in the price.
Initial margin and the maintenance call
Regulation T sets the initial margin at 50 percent: a broker can lend up to half of a stock's purchase price. FINRA's Rule 4210 then sets a maintenance floor of 25 percent of the securities' market value, and many brokers set a higher house minimum, below which the broker issues a call for more cash or securities.
Equity ratio equals Position value minus the loan divided by Position value.
Example($13,333 minus $10,000) divided by $13,333 = 25%
The forced sale
A call not met in the time the broker allows is not a request. The broker sells enough of the position to bring the account back above the maintenance minimum, at whatever price the market offers that day, converting a paper loss into a realized one at what is often the worst possible moment to sell. A broker does not have to call first. It can sell without notice, choose what to sell, and you still owe any shortfall.
Lowenstein's When Genius Failed tells the story at scale. Long-Term Capital Management, a hedge fund run on heavy borrowing, lost most of its capital within weeks in 1998. Its positions were ones few buyers wanted, so a group of its lenders, brought together by the Federal Reserve Bank of New York, took the fund over rather than let it be sold off into falling markets.
The same leverage on a company's own books
A company that borrows against its assets faces a related squeeze, one level down. Break a covenant in the loan agreement, or fail to refinance a maturity, and lenders can demand repayment, forcing asset sales or new shares at a bad price.
Check yourself
In the example, a 33.3 percent fall in the stock's price produced what fall in the investor's own equity?
- 33.3%
- 50.0%
- 66.7%
Show the answer
Answer: C.
Equity fell from $10,000 to $3,333, a fall of 66.7 percent, because the fixed $10,000 loan absorbed none of the loss.What does Regulation T set?
- The maintenance minimum for an existing account
- The initial margin, the most a broker can lend when a stock is first bought on margin
- The broker's commission on the trade
Show the answer
Answer: B.
Regulation T caps the initial loan at 50 percent of the purchase price. FINRA's Rule 4210, a separate rule, sets the maintenance minimum afterward.What happens when a maintenance call is not met?
- The loan is forgiven
- Nothing, the account continues as before
- The broker sells part of the position, often at whatever price is available that day
Show the answer
Answer: C.
An unmet call leads to a forced sale, at the market's price rather than one the investor chose, which is how a paper loss becomes a realized one.Sources
- Regulation T and FINRA Rule 4210, on initial and maintenance margin requirements.
- Lowenstein, When Genius Failed, 2000, on the 1998 collapse and rescue of Long-Term Capital Management.
What this leaves out
- The $20,000 position is illustrative. 25 percent is FINRA's floor; many brokers set a higher house minimum.
- This does not cover options, short positions or portfolio margin, which follow different rules.
- The company balance sheet comparison is a mechanic, not a matching legal process: shareholders and lenders sit in a different order and under different rules than a margin account.
- Nothing here is advice about borrowing to invest in any security.