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‘Margin Call’: Deciphering disaster on Wall Street

Insight

An interesting, if disheartening, film coming to your neighborhood theater is “Margin Call,” written and directed by J.C. Chandor, starring Kevin Spacey, Paul Bettany and Jeremy Irons. (See review in this week’s Compass.)

The film tells you what happens when the numbers at a Wall Street investment firm, analogous to Lehman Brothers, “go South”: a cascade of financial disaster. It’s a cruel story told with a human face.

One thing missing from the film, however, is a good explanation or a clear example of what a margin call actually is. Let’s remedy that.

Margin buying is buying securities using money borrowed from someone else, typically from a financial firm, broker or exchange. The borrower may be an individual or a wealthy institution. To help secure the borrowing, the investor/borrower is required to deposit some share of the borrowed amount, using other securities he may own, in a margin account held by the lender as collateral for the loan.

Usually there is a minimum margin requirement, a percentage value determined by law and/or by rules of the lender. In an up-market margin, buying tends to go well and the investor makes hay on this form of leveraged financial investment, because he is able to invest and risk more than he actually owns. In good times he earns more, pays back the loan and pockets the profit. It’s win-win for buyer and lender.

In a down-market, however, the value of the securities deposited in the margin account may decline and no longer meet the minimum margin value requirement. The investor/borrower has lost book value not only in the margin account, but also in the additional securities he purchased on margin. It’s lose-lose for the borrower, and the lender begins to worry.

In that unfortunate situation, the lender has the right to make a margin call requiring the investor/borrower to ante up more collateral in the margin account. If the investor/borrower can’t do it, he’s forced to sell off his other securities, even at a loss, to repay the borrowing, and the lender has the right to seize the collateral assets in the margin account to cover any remaining debt.

This could happen to you personally. Suppose you have some GE stock in a private account with, say, Fidelity or T. Rowe Price. You will undoubtedly have received on your statement a notice of how much more you could borrow to make further investments on margin, if you choose to do so. So, if you make that choice and the market rises, good luck for you.

If, however, the value of your collateral GE stock falls by say 35 percent, then you may receive a margin call from your favorite broker. Your devalued GE stock no longer meets the minimum margin requirement. You have to put more in your margin account. One way to do that is to sell off some or all of the investments you bought on margin. You may then be able to repay your lender. If not, your broker has the right to seize your GE stock, and then some. You have to put up, or bail out. That can spell personal disaster.

Margin calls on Wall Street, between large institutions, have a domino effect of selling which leads to a cascade of margin calls and massive selling of investment instruments. This may begin with especially risky, opaque instruments such as derivatives, bundled mortgages, credit default swaps and junk bonds whose inherent risks are notoriously difficult to assess. This contagion eventually spreads to panic selling in the more reputable equities market. The result: disaster on Wall Street, with fallout on Main Street and around the world.

What the film “Margin Call” captures and conveys so well is the inhumanity, folly and utter uselessness of it all. There was a day when commercial banks dutifully made commercial loans and investment banks exclusively facilitated investment in new American enterprise. This is no longer much the case. Today, firms like Goldman Sachs have reduced the investment side of their operations, while their trading departments have mushroomed to dominate their overall business. Their principal occupation is trading in paper.

As “Margin Call” demonstrates, Wall Street speculative paper trading creates no jobs (other than their own), no services (other than their own), no products of value, no roads and bridges, or anything of social utility. Only profiteering for middlemen, risks for us taxpayers and real investors, and potential for local, national and global economic disaster. It isn’t even capitalism; it’s a parasite on the back of capitalism.

Nothing in the U.S. Constitution or in the concept of democracy remotely suggests that corporate paper trading is supposed to be part of peoples’ welfare, human rights or the American dream. True, thousands of smart people are engaged in the Wall Street paper trading game, but as the film “Margin Call” ruefully concludes, these smart people would better serve America by building bridges to somewhere.

Sharon resident Anthony Piel is a former Citibanker and legal counsel of the World Health Organization.