Margin debt at all-time highs is one factor propelling a long-in-the-tooth bull market, now more than five years old.
But while securities lending is a profit center for brokerage firms, it will inevitably pave a primrose path to arbitration and a potentially adverse settlement for brokers involved in the practice.
In a speech last week, Dallas Federal Reserve President Richard Fisher cited record-high margin debt as one indicator of today's "irrational exuberance," purposely echoing the phrase made famous by former Fed chairman Alan Greenspan.
Margin lending refers to the loans a brokerage firm will make available to its clients in order to increase the amount of securities they can purchase; the loans are secured by the securities held in the customer's brokerage account.
Investors accepting such loans are hoping to earn a return on their investments in excess of the margin interest rate they pay the brokerage firm for the loan.
Such transactions can be quite profitable in a bull market like today's, but in many situations margin loans risk violating FINRA suitability standards obligating brokers to limit transactions only to those in the client's best interest.
To learn how brokers can protect themselves — and their clients — from future arbitration headaches, ThinkAdvisor reached out to Chicago-based securities attorney Andrew Stoltmann, who represents investors with arbitration claims against their brokers.
Stoltmann has a unique perspective — not only because he has represented some 1,000 claims against brokers since 1999, but because he himself worked as a broker at Merrill Lynch for two years before he went to law school.
"I hated the cold calling, the prospecting," he says. "I saw a lot of bad things even at a Merrill Lynch that were absolutely incredible. I said to myself I'd rather sue these guys than continue to be one of them."
ThinkAdvisor: What do you see in the market today that should be of concern to financial advisors?
Stoltmann: I feel like I'm living in the movie "Groundhog Day." It seems that every 10 years we see a massive surge in margin. The last time it really got this bad was the late '90s before the 2000 market crash.
Brokers just salivate on taking out margin loans for clients in part because the brokerage firms get part of that interest. But it also allows for additional purchases for generating commission and fees.
And for me, as a plaintiff's lawyer, it's like shooting fish in a barrel when these brokers recommend margin to many of their clients.
Which brokers do you have in your sights?
If the client's over the age of 50; if the client's retired; if the client has a relatively significant amount of their net worth with that broker, it's simply going to be an easy suitability claim for me to make when the market tanks 20%.
Would brokers catering to wealthy clients be less vulnerable?
If you have a 47-year-old cardiologist making $700,000 a year and his portfolio has $300,000 worth of margin and he sustains significant losses, I'm not going to take that case, and he's not going to win the FINRA arbitration.
But if you have a 57-year-old blue-collar factory worker who loses $2,000 in his $5,000 account, it's going to be very difficult for a broker to explain to an arbitration panel why that's suitable.
