Parents of teenagers who frequent parties will always confess that their worst fear is to get a call at 3am when their children are out, as this rarely ever result in the continuation of a good night’s sleep.

The same theory applies to individuals and institutions who invest in securities on borrowed cash. Buying on margin involves taking out a partial loan from one’s broker in order to cover a larger investment than one’s capital could directly cover. A margin call most often occurs when the amount of actual capital the investor has drops below a set percent of the total investment. A margin call may also be triggered if the broker changes their minimum margin requirement because of an internal decision of a perceived risk. This is the absolute minimum percentage that one must have in direct equity of the total investment amount.

Let us assume that you wish to purchase a bloc of Government of Jamaica 2039 US denominated Securities as the present yields seems attractive. You have US$50,000 available at your disposal. There is the option to purchase US$100,000 worth of the instrument by borrowing $50,000 from our broker on margin to purchase the stocks. If, after a particularly poor week of performance, the bond you initially invested in is now worth only $75,000. This leaves your equity at $25,000, which we can determine by taking the current value of $75,000 and deducting the loan value of $50,000. If our broker’s minimum margin requirement is 30 per cent, we will still be fine, as the minimum margin requirement in our case would be 30 per cent of $75,000, or $22,500.

If, however, the value of the bond drops again the next day to $60,000, then our equity will be left at a mere $10,000. At this point, our broker will put out a margin call, and you will be forced to raise at least an additional $8,000. You might raise the money to meet the margin call by various options: either by selling off a portion of the bond you have invested in, or by taking out an additional loan from another source (depending on liquidity and loan rate in the market), or by replenishing your equity pool with your own assets (ie Out of pocket).

Why do it? Well apart from the fact that your interest (coupon) payment will be calculated on the larger face value, if the anticipated capital appreciation occurs, there could be large windfall gain to be had after netting out the interest cost for the margin.

A margin call in and of itself is not a crisis in the financial world, and it does not reflect poorly on an investor to be subject to one. Margin calls are simply a part of buying on margin, and while some people choose to keep their invested equity well above the minimum margin requirements to avoid a margin call, others keep themselves continuously invested at exactly the minimum, prompting a margin call every time the market takes a downturn.

When it becomes an issue is when the global market liquidity becomes tight and firms being increasingly cautious of the veracity of rating agencies. They then begin to increase their minimum margin requirement. If the individual has the capacity to fund the margin call then there is no problem. The trouble occurs where the individual or institution cannot find the liquidity to top up the facility and the global markets have no appetite for the Bond if it is hocked for sale.

This has prompted calls in some quarters for the regulators to reign in local broker/dealers who have proprietary interest in other Sovereign and Corporate Debt while using margin to fund these purchases. When the global liquidity crisis occurred many got the dreaded call and had to find the US liquidity to top up their account as there weren’t many takers (at any price) to purchase the securities held. This exposure created some exchange rate pressure in the market causing the Central Bank to provide alternative support/assistance for those affected.

Hopefully there will be a full discussion between the broker dealers and regulators if drastic changes are to be made in the trading of assets on Margin.

Whatever changes are made, there could be interesting times ahead for our local bond traders.

David Weir is a Manager – Investment and Client Services with Sterling Asset Management Limited. Sterling provides medium to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.

You can now follow our investment updates on Facebook.com and Twitter.com!