Monday, November 7, 2011

What does "Margin Call" teach us about the morality of markets?

Review of Margin Call, starring Kevin Spacey.

An analyst at an investment bank (think Goldman Sachs) builds a model suggesting that their portfolio of securities is essentially worthless. The firm ends up selling the assets to other sophisticated firms whose models place different valuations on them.

For some reason, however, the protagonist wrestles with his conscience before deciding to fulfill his fiduciary responsibility to shareholders.  And this takes up the bulk of the movie.

When they sell the assets, price drops by about 35% as other firms realize that their models must be wrong.

The happy ending is predictable: price adjusts to reflect the real value of the assets.  Future investors are protected from losses that would have been incurred had they purchased over-priced securities. And the firm survives because they were the first to realize that their securities were mis-priced. Other firms presumably failed.  Performance is rewarded:  the analyst who built the model makes a lot of money, while the other analysts are fired.

All my friends who voted for President Obama are raving about the movie. I suspect they see it as an expose of the inherent corruption of Wall Street and a cause for the rebels who are occupying it.

Here is a question for my economically challenged friends. Would the ethical issues raised by the movie have been any different if the firm had been buying rather than selling securities, i.e., how is searching for under-valued securities to buy any different from searching for over-valued securities to sell?

The movie is playing at the Belcourt in Nashville and On-Demand on Comcast.


  1. It's not quite as simple as what you say. When other firms bought those assets at 65 cents on the dollar, everyone across Wall Street then had to mark similar assets on their books to 65 cents, according to the FASB-157 guidelines then in place ("mark to market").

    If another firm had levered up 30-1 like Bear Stearns did (they actually achieved 50-1 leverage mid quarter), then suddenly they're insolvent with a 35% drop. They get hammered by margin calls because everyone knows they're insolvent, and cash flows out of their building in torrents. Then hedge funds start pulling out of their prime brokerage accounts -- further putting a strain on the bank's cash -- and shorting the bank's stock to boot, so that the bank can't even go to the equity markets to raise the funds. So that 30-1 investment bank, who wasn't _first_, goes bust.

    But then a money-market fund is holding the bonds of that now-bust-firm, which are suddenly worthless, and they break the buck. Money-market funds don't exactly look like deposit accounts any longer (they're not FDIC insured), so there is an epic run on them as everyone realizes how exposed they are, all in the name of an extra 1% yield. Now that money-market funds have collapsed, suddenly huge industrial firms like GE, P&G, Verizon, etc. can't roll their short-term commercial paper, since no one is available to buy it (money-market funds were huge purchasers of the stuff). Now those firms, in turn can't meet payroll. What happens then? Workers get laid off by the thousands and thousands. Those workers still need cash to meet their bills, so they withdraw some money from their deposit accounts, without putting any more in, and suddenly the commercial banks are under a ton of pressure. How much longer do ATMs keep working in a situation like that? What happens then?

    No one, and I mean no one, wanted to find out in September of 2008. That's where TARP, Maiden Lanes II and III, the Fed loaning out $14T, etc. all came in. That's not exactly economics at work -- that's fear of a systemic collapse.

    And I do think that there are a lot of ethical questions raised in that scenario, which is more or less exactly what happened that fateful year. The lack of ethics shown just prior to the collapse, and revealed by the Levin and FCIC hearings, is the root of movies like this.

    But there were also ethical questions that came into play in terms of relaxing the rules when times were good, such as getting the repeal of Glass-Steagall through so that commercial banks like Citi could also play in the MBS space, like getting the CFMA passed so that CDS weren't regulated, and like pushing FASB-157 in a rising market because "mark-to-market" then meant big bonuses.

    The relaxation of rules on the way up, the lack of ethics shown at the height of the market, the subsequent need for mega bailouts so that society didn't collapse once the party ended, and the utter lack of accountability from all involved (both on Wall Street and in Washington), is the root of the whole Occupy Wall Street Movement, in my opinion.

  2. Anonymous' post makes a lot of sense. How do you respond, Luke?