What is a Five Hundred Dollar Rule
BREAKING DOWN Five Hundred Dollar Rule
The five hundred dollar rule was established by the Federal Reserve to prevent margin requirements from causing the potential to liquidate a client account. Margin calls may occur quickly and require immediate attention; this prevents brokerages from making changes to existing accounts over smaller demands.
Prior to the five hundred dollar rule, brokers could make liquidation orders on margin calls as low as a fraction of a percent. With the new rule in place, an investor’s assets are protected from the smaller price fluctuations.
Margin calls occur when a security held in a margin account has experienced a value drop below a certain point. The investor either needs to deposit money into the account to cover the deficit or sell off assets held in the account to cover the shortage. This happen on assets that have been purchased on margin, or with borrowed money. Maintenance margins exist, which vary among brokers, but a minimum margin is 25 percent per federal law.
Margin Calls in the News
One of the most famous margin calls in recent times was one that occurred during the subprime lending crash in the early 2000’s. Many mortgage-backed securities experienced a rapid price adjustment as the subprime mortgages they were secured against began to fail. Numerous borrowers found themselves overextended in properties they could not afford thanks to adjustable rate mortgages that made significant upward adjustments. When these margin calls went out, many investors were unprepared, as the housing bubble had been a successful investment source for so long.
Several investment firms suffered great losses, as was depicted in multiple movies made about the time such as "Margin Call" and "Too Big To Fail." A significant number of large, well established lenders found themselves having to close their doors for good during the crash. Some mortgage companies were unable to meet their own obligations when borrowers stopped making their monthly payments, others still were no longer able to secure funds to make further lending offers.
While much has changed about how mortgage-backed securities are invested in since then, margin calls can still happen on any investments that are purchased with borrowed funds. The very act of purchasing an asset with borrowed funds is called purchasing on margin and it is a strategy still widely practiced today.