Margin rates are LOW. Any opinions on the following idea?

[Guest kawikaho]

Hello folks,

 

I'm pretty new to this board, and hope to have my investment ideas challenged.  Ok, so, the other day I was looking at the margin rates at my brokerage and found them to be VERY low: for any amount I borrow below $100,000, the interest rate is 1.73%.  From $100,000 to one million dollars, the interest rate is a 1.23%.  Above one million dollars, the interest rate drops to 0.73%.  I don't know if these rates are secured for the life of the loan, which in my case would be forever Wink  But if they are, then what do you guys think of the following idea?  I'm allowed to lever up 4x my portfolio to over 1 million dollars.  The cost to borrow drops to 0.73% a year.  I take that amount and invest into a fixed income vehicle yielding around 4% (thinking maybe a long term CD?).  My total returns would a little over 13%.  That's guaranteed.

 

What do you guys think?  I think it sounds too good to be true, and the hitch might be that the interest rate isn't fixed like a 15 or 30 year loan.  I don't have any experience using leverage to invest in fixed income securities, so any help or advice would be much appreciated.

[StubbleJumper]

Where are you getting such attractive margin rates? 

[Guest kawikaho]

Trading Direct.  I know of a few others too.  I'm inquiring about the rates, but i'm almost positive the rates are floatable.  It just sounds too good to be true.

 

I guess that's a positive in this low rate environment: interest rates on CD's, MMA's, and high yield accounts are bad, but the corollary is the rates on borrowing money is GOOD. 

[Uccmal]

Hi Kawikaho,  Those rates dont sound right.  The rates I can get with TD Waterhouse for over 100,000 are 3.75% in the US.  Margin rates rise and fall with the prevailing interest rates based on some spread from the rate for short term treasuries.  So, that part is too good to be true.  In an inflationary environment you could find yourself with interest rates at greater than 10%, very quickly.  The other too good to be true is the leverage you think you are getting.  That can be changed on a dime by the broker.

 

 

I use leverage but in a discretionary manner.  I work out a rough worst case scenario for use of borrowed money.  Having experienced a couple of margin calls in my time I am suitably humbled as to what can happen when you dont have enough margin left to actually execute the trade ($7.00) - that doen't mean I had lost everything just that I had no margin available (leaves you in a position of promising your broker that you will clean house at a loss of course).  This was one of the causes of the panic selling we saw in the fall.  Major and minor investors getting hit with margin calls.

 

Finally, until you get a good handle on the ins and outs of trading, margin, and stock behaviour you may want to stay to cash investing.  Losing 50% on an investment that's in cash leaves you with a 50% cheaper investment.  Losing 50% on a 75% levered investment leaves you owing the brokerage alot of cash and filing for bankruptcy.  Some professional value investors with 30 years experience thought Citi, and other large financials couldn't go down 98%.  

 

[Guest kawikaho]

Well, I would definitely not trade volatile instruments on margin.  That is suicidal to me.  But a fixed income vehicle like a CD?  I dunno.  I think that's what most hedge funds did: use the low interest yen and carried it over to invest in high yielding fixed income securities here.

[benhacker]

Interactive Brokers base their lending rates off Fed Funds (not LIBOR) so I think that is the broker.

 

The main statement of the OP was that the rate is fixed... it is not.  So you are trading a fixed long rate for a short term variable.  Could work, could not.

 

It's not risk free though.

 

Ben

[Guest kawikaho]

Ah, well, there you go.  That would not be good.

[Smazz]

I agree with Ben.

You have been most likely quoted a fluctuating margin rate perhaps even with a teaser rate for the first XXX months.

 

Read the fine print, and remember if you do this with any kind of fixed income - you will get the double whammy. When rates starts to rise - so will your payments inversely to your capital.  BAM! MArgin call - good night Irene.

 

sorry, Im a bit of joker too. ;D

[oec2000]

Brokers lending at 0.73% in these credit-challenged times?! And, I thought the days of easy money were over - I guess we have not hit bottom yet.

 

Can someone explain how these brokers can get funding so cheap when even banks are having to pay up for money? The 0.73% includes their margin so their cost would have to be virtually zero!

 

If it sounds too good to be true,. .............. Bernie Madoff must have escaped from his penthouse and gone to Interactive. ;)

[benhacker]

IB is legit (and public).

 

http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=ibkr&sid=0&o_symb=ibkr

 

Rates are Benchmark + 0.5% on $3m+ balances.  FF is the benchmark.  All their fees are cost plus, and they are razor thin margin on their broker biz... their primary money comes from option market making.

 

I'd be interested to know the logistics of their margin biz and how that works.  Any shareholders out there?  Is it internal netting with cash balances / margin?

 

Ben

[oec2000]

Ben, I know IB is legit. Just being facetious with the Madoff remark - after all, the safest time to kick a man is when he's down. :)

 

However, I am serious about wanting to know how they can fund these margin loans. There should be some legal impediment to them using clients' cash balances to fund other clients' margin debt. If not, I would be very wary about keeping cash balances with them. What happens if there is a rash of margin debt defaults? Will client balances be impaired?

 

Just doesn't smell right to me.

[Guest kawikaho]

I agree with Ben.

You have been most likely quoted a fluctuating margin rate perhaps even with a teaser rate for the first XXX months.

 

Read the fine print, and remember if you do this with any kind of fixed income - you will get the double whammy. When rates starts to rise - so will your payments inversely to your capital.  BAM! MArgin call - good night Irene.

 

sorry, Im a bit of joker too. ;D

 

I wouldn't say these are "teaser" rates.  Besides, I think the margin call, in this case, would be when the total net asset value of the margined portfolio drops 25%.  I find that kind of hard to see unless interest rates sky rocket from 0.5% to over the interest rate of the fixed income.  In the case of a 3% CD, that would mean rates would have to be quadrupled in a short period. 

[Partner24]

I'll close my margin account soon enough. I always have maintained a quite low margin to equity ratio, but the volatility is not my concern. My concern are the brokers here in Canada, and especially with margin accounts.

 

First, there is their supposed garantee by the CIPF, but in 2007 they were only 500 millions in assets (they don't provide updated numbers for 2008...) to protect over 1 trillion in assets (based on what one of their employee told me in a phone call 2 weeks ago). When I said that this was not very high, he basicaly told me 2 things:

 

- historical bankruptcy data since the 60's suggest that this is enough

- they will first liquidate the brokers first and then use the funds available to provide capital if needed

 

When I asked to see the balance sheets of the main brokers available here in Quebec, no one said yes. When I asked to IIROC to provide me with data, he also said no.

 

Furthermore, when I took a look at my broker agreement for a margin account, what I what they can do with my assets that are used to protect the margin, I didn't like what I red.

 

I may sound overconservative, but I don't like that.

[SharperDingaan]

 

Good post.

 

- This combo is attractive because it offers a positive spread, over a long period, at supposedly minimal risk; different spin, & different mechanics - but isn't this pretty much the same message that Alt-A mortgagees heard when they rushed to sign up ?

- As pointed out this is a variable spread & for now its strongly positive. But look forward; doesn't the P(x1) of the spread widening seem pretty low, & the P(x2) of it narrowing, or even going negative P(x3)seem much bigger ? If we have inflation, wouldn't this spread also get very negative, very quickly ?

- To unwind you need to sell the CD for at least what you paid it, & any realized loss will be multiplied by 4. But if you only unwound when the spread was negative, at that time wouldn't the YTM on the CD be higher than when you bought it ? - almost guanteeing a realized loss on this long term CD

- To make money on the combo you really need (1) the spread to widen & (2) the CD YTM to fall, plus the sooner it occurrs the better. In effect you need the fed to run out of rabbits, & the stimulus package to fail. Who is more likely to win here ? the buyer of this combo, or the folks who sold you the CD & margin debt ?

 

Lessons ?

* Dont be afraid to ask

* Look critically. Why is it good today, will it do better/worse going forward, what happens on exit

* Who benefits. Is it mostly you, or the guy who sold it to you ?

     

Next time you go past a soup kettle throw some change in.

You just saved a fortune

 

SD

[SharperDingaan]

 

Quick note on margin funding.

 

In the US the fed is the backstop. Mechanically XYZ coy is seized, & the fed makes the legal entity an unsecured short-term loan to keep the accounts on side. Account holders are then given a letter, asked to verify their bonafides, & transfer their accounts elsewhere within X days. Once the days are up accounts that aren't transferred go to the fed for safekeeping, & the loan repaid. Any losses incurred are repaid from the industries 'insurance' account, recoveries, & writeoff. Minor differences in Canada.

 

Suspicious accounts are not unusual, & there are often ties to money laundering/drug proceeds/home country tax evasion/slush funds, etc. Where proof of ownership is problematic, the funds are seized. Discussion between the former beneficaries & the fed, are by neccessity - somewhat delicate.   

     

[StubbleJumper]

Partner,

 

A potential option that you could consider is to hold a margin account with one of the big banks.  For example, in all reasonable likelihood, RBC falls under the "too big to fail" category in Canada.  Given the size of its domestic operations, I simply cannot fathom the possibility of the federal government allowing RBC to go under.  It would be complete chaos in our financial system.  For that reason, my working hypothesis is that RBC would be bailed out of any serious trouble that it encounters in any of its domestic divisions, be it retail banking, investment banking, wealth management, brokerage or insurance.  IMO, the feds simply cannot accept the risk of a run on the Royal due to rumours of trouble somewhere in its operations. 

 

The same might be said of the other 4 big banks, but perhaps to a lesser degree.  They might all be "too big to fail."  CIPF is only a theoretical backstop for them if they are considered too big to fail, and the CIPF reserves are only $500m.  In reality, the only value that one might reasonably ascribe to CIPF is to provide some semblance of protection to account holders of the smaller, more obscure brokerages.

 

On a personal note, until recently I had significant (for me) holdings with E*Trade Canada.  When the US parent company ran into some grief about two years ago, I had a small bit of angst about the status of my accounts.  I was a very happy guy when ScotiaBank announced that they were purchasing E*Trade Canada!  Going forward, I have no intention of maintaining any significant assets with a second-tier Canadian brokerage!  Dealing with the brokerage arm of a big-bank can seriously suck, but when the caca hits the fan, it's probably a good place to be!

 

SJ

[Partner24]

StubbleJumper,

 

That's interesting comments. I had this reflexion about that "too big to fail" scenario in Canada. However:

 

- We have a Conservative party in Canada that don't like to do these kind of bailout things;

- Who knows what could happen if it's brokerage division was in trouble? Maybe that in the end every client would get a % percentage of their assets below XXXXXXX$ or something like that and the government would only garantee that.

 

And even then, I don't like to rely on good faith of politicians to keep my arch above water. There is also the option to get your stock certificate and keep them on the brokerage vaults. In that case, as far as I know, the stock fully belong to you and the broker cannot put it in their own assets as a trustee. So if he does stupid things with the assets and liabilities of it's clients, creditors cannot claim your stocks if there is a bankruptcy. I don't know if this is fully accurate. I'm still studying about these safer alternatives to the traditional trustee format.

 

[StubbleJumper]

Conservative, liberal, NDP, it doesn't much matter.  RBC is such a large organization that any government would have to come to the rescue if it runs into any serious trouble.  What percentage of Canadians hold their primary account at the Royal?  Maybe 10-15% of us?  There would be all supreme hell to pay for any government that sat on its hands while the chequing accounts for 10-15% of the population were frozen.

 

The interesting thing is that the government is also not really in a position to let just a portion of RBC fail.  If I hear about trouble at RBC securities, the first thing that I'll do is move my money from my RBC chequing account as fast as possible.  Same with RBC insurance -- if I hear about imminent financial failure on the part of RBC Insurance, I'll also move my chequing account as fast as possible.  ANY plausible rumour of financial difficulty in one part of a big bank would trigger a run in the retail banking operations as people like me will act quickly to protect our money.  In effect, the gov't has no real choice but to support the brokerage arm of the big banks.

 

That being said, requesting the certificates for long-term holdings might be extra insurance at a reasonable cost....Will you store the certificates in your bank safe deposit box?!!!  ;D ;D ;D

 

SJ

 

SJ

[Uccmal]

I carry my brokerage business with TD.  IMHO, there is no chance in hell they would be allowed to fail to the point where the brokerage accounts would be compomised.  That would end confidence in the system for generations.  No government would want that on their hands.

 

RE: British, European, and US banks, all of whom are further along in the process. 

 

Maybe I am naive or missing something but have any of the bank based brokerages being compromised to the extent of freezing their margin accounts.  Not that I am aware of.  Citigroup has been a counterparty to billions of CDS and I have not heard of contracts not being honoured.  Same with RBS - they are just being nationalized.  I am not referring to the ABCP market in Canada which was frozen over inability to value and move the assets. 

 

It looks to me like the end result of all of this kerfluffle will see the nationalization of the biggest Zombies such as Citigroup, and some European, and UK banks. 

 

The Canadian banks seemed to have side stepped alot of this unlike past debacles.  I would think they would be easily nationalized with alot less hoopla than in the US. 

 

RE: The conservative government.  After Harper's miss-steps in November they no longer have any significant power in Canada.  The are being allowed to govern totally at the grace of the Liberals right now. 

[oec2000]

Partner,

 

Would appreciate some clarification. If one had a cash trading account (as opposed to a margin account), would the assets would be more secure? Or, are you saying that the only secure way would be to have the stock actually registered in your name?

 

As for the Conservatives and bailouts, I doubt that any political party that wants to stay in power would let a major bank fail without doing anything. Besides, even if you are right that the Tories are ideologically opposed to bailouts, it does not mean that they cannot save a failing institution. They could do it by letting equity and debt holders take the first loss before recapitalising the institution. In order to preserve confidence in the entire financial system, depositors will have to be protected in any case and the best way to do it is to keep the institution as a going concern by recapitalising it. This way, govt can recover their money from future profits.

 

 

[Partner24]

"Would appreciate some clarification. If one had a cash trading account (as opposed to a margin account), would the assets would be more secure?"

 

Well, I'm not an expert on that field, but based on what I've red so far and the discussions that I've had so far with the representatives of my broker tell me that they can't do the same things with the securities that are not used to secure the margin and the securities that are in a cash account. They are more limited with what they can do with a stock that is not used to secure your margin.

 

But in both cases, the stocks are not in your name. They are registered on the broker's name as a trustee. Let's say you have 1 share of ABC inc. In aggregate, the clients of your broker have 100 shares of ABC inc. So, your broker will have 100 shares registered in his name, but as a trustee, 1 share will belong to you. If your broker goes bankrupt, the 100 shares are on it's balance sheet, but as a trustee.

 

If you have the stock in your own name (paper stock certificate), the situation is different. The trustee link with your broker is broken and the stock is not on it's balance sheet. If he goes bankrupt, you can say "Sorry, but these stocks are in my own name and cannot be used to pay your creditors".

 

And when you say that to them, they all say "Yes, but you have a garantee with the CIPF". Further studies of CIPF assets tell me that they have not built a very solid ark, and the numbers that are available are for 2007. They don't provide anything for the end of 2008. http://www.cipf.ca/c_learn_fund.htm . And these assets and contracts are used to garantee more than 1 trillion of assets (based on a discussion I had with a CIPF's representative).

 

But frankly that's just my own humble assessment of the CIPF situation. I might be totally wrong.

 

Again, I'm not an expert in that field. If anybody would want to add or correct something, please don't hesitate to do it. Your comments, facts and corrections are more than welcomed.

[SharperDingaan]

 

The mechanics run on beneficial ownership. Give your certificate of 100 shares to the broker; he will re-register it with the transfer agent in his name, & give you a paper statement showing you beneficially own 100 shares.

 

If its a cash account the broker is required to deposit (101% to 105%) of the cash equivalent of the days closing market value with the regulator/BOC, & can use your shares however he wants. If the broker goes under you get reimbursed the cash value of your shares, the day before the broker crashed. As the broker is required to put up more than 100% (in Canada), he has incentive to push you towards other account.

 

If its a non-cash account the broker still has to deposit with the regulator/BOC but can offset (100 +X%) of the margin loan he's made to you. X varies with the security. If the broker goes under the 'shortfall' is essentially the margin difference before & after the collapse, plus all unrecoverable margin balances net the sale of the underlying. The bigger the broker the greater the margin delta, the sleazier the broker the bigger the unrecoverable balance.

 

The brokers deposits are typically made at a Sched-A bank, & flow up to the BOC that night. Different mechanics in the US, but same general idea.

 

* Cash & margin accounts are backed by BOC deposits. How much you get depends on your account.

* Headlines will cause disruption, but while it happens there is relatively little risk.

* Recoverables are a 3 step process. Sell the underlying, int'l cooperation in funds tracking/recovery, tell your less savoury friends - Europe typically being a little more aggressive [Roberto Calvi, Banco Immobilari] 

 

 

[Uccmal]

Thanks Sharper, That was very valuable.  Al the noob

[oec2000]

Thanks, Partner and Sharper for the clarifications.

 

oec

[Junto]

Interactive Brokers base their lending rates off Fed Funds (not LIBOR) so I think that is the broker.

 

The main statement of the OP was that the rate is fixed... it is not.  So you are trading a fixed long rate for a short term variable.  Could work, could not.

 

It's not risk free though.

 

Ben

 

I think that is what you call a bank...trading fixed long rate with a short-term variable...