Mind if I Borrow Your Shares?

Question: I know that if I carry a margin loan balance on my brokerage account the brokerage firm can borrow my stock and loan it to another customer for a short sale. But can the brokerage firm still do it if there are only long positions and no loan balance in my margin account?

Answer: The idea of someone borrowing your stock shares and selling them may not sit well with readers unfamiliar with margin accounts, but it's commonly done at brokerages for a variety of reasons, including covering other customers' short sales. But before we get to your question, let's first review how margin accounts and short-selling work, along with the brokerage's role.

Margin Account Rules
A margin account allows an investor to buy securities using money borrowed from the brokerage. This is in contrast with a cash account, in which the investor may only invest as much as he or she has deposited. Rather than buying shares outright, an investor with a margin account may choose to put up some of his or her own money and buy the rest on margin. Such a strategy can help a savvy investor boost returns. However, it entails a great deal of added risk and is not advised for those without considerable investing experience.

If borrowing money to invest in securities sounds like an invitation to reckless behavior, keep in mind that there are some rules governing margin accounts, including requirements that a minimum amount of equity be maintained in the account at all times (at least 25% of the account's value, but higher at many firms) and that no more than half of a security's purchase price be borrowed (bought on margin). Securities held in the margin account act as collateral for the loan. But if the balance in the margin account falls below the brokerage firm's stated minimum equity requirement, the brokerage may make what's called a margin call and require that the investor add additional dollars or securities to bring the account up to the minimum level, or the brokerage may sell securities in the account without the investor's permission to bring the account up to that level.

As an example, let's say an investor makes a $10,000 investment in a margin account, with $5,000 coming from his own funds and the other $5,000 loaned by the brokerage. Let's also say that this brokerage requires a 35% minimum equity level. The stock then falls in value so that the position is worth just $7,000. The investor's equity is now worth just $2,000, with the brokerage loan making up the other $5,000 (even though the value of the shares has dropped, the amount of the loan is not affected). That $2,000 in equity represents about 29% of the account's value, so the investor would need to add $450 in dollars or securities to the account to get the level of equity back up to 35% ($2,450 is 35% of $7,000) or face the prospect of the brokerage selling shares from the account to pay down the loan, thus increasing the level of equity.  

As part of the agreement establishing a margin account, the account holder usually must agree to allow his or her shares to be loaned to others--for example, for use in a short sale. (The New York Stock Exchange requires that all its member broker-dealers use standard disclosure language to make this clear, and you can read its rule here).

Short-Selling: Betting on a Stock Taking a Dive
Short-selling, which investors must do through a margin account, is the practice of selling shares of stock that the investor has borrowed (with the brokerage's help) in the hope that the stock's price will decline. If the price goes down he or she can then buy shares in the stock at a reduced price to replace those that were loaned, pocketing the difference in price as a profit. If the stock's price goes up the investor still must purchase replacement shares, but at the higher price, meaning he or she loses money.

SEC rules require that brokerages identify shares available to be delivered to the buyer before a short sale can take place. To make this happen, brokerages will loan the short-seller shares held or obtained by the firm, or shares from other customers' margin accounts. A margin account holder whose shares are borrowed does not see any benefit from this transaction and likely won't even know the shares were loaned. Meanwhile, the brokerage firm earns interest on the loan, not to mention any fees that may apply.

When Shares May Be Loaned Out
Even if you don't do any short-selling from your margin account, shares in it may be subject to loan by the brokerage. According to a spokeswoman for the Financial Industry Regulatory Authority, or FINRA, a brokerage may loan out shares in a margin account worth up to 140% of the value of the outstanding margin loan. If a margin account was established but no margin loan was ever taken, shares in the account may not be loaned out. However, if a margin loan was taken out at some point and fully repaid, the brokerage may still have the right to borrow shares from the account.

Shares held in a conventional account, by contrast, may not be loaned out by the brokerage. Therefore, if you have any concerns about your brokerage loaning out your shares--even if it just doesn't feel right to you--it's best to hold those shares in a cash account. It should also be noted that mutual funds may engage in security lending as well, which we'll look at in an upcoming Short Answer column.

Margin accounts and short-selling are not for novice investors, but even seasoned pros should read the terms of their brokerage agreements closely to understand how they work and to avoid any potential nasty surprises.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.