Margin Call
In my ethics course, I have stopped using the movie The Big Short because as entertaining as it is, it simply is not a particularly realistic version of whaat really goes on when the shit hits the fan on Wall Street. Don’t get me wrong, Adam McKay, made a very good movie and there are many many truths imbedded in the story McKay tells about the first six months of 2007. No one knows that better than me since I ran the first bungalow on the beach to get hit by the subprime tsunami that landed on our shores in 2007. I spent the better part of two years after that giving testimony to the United States Attorneys about exactly what happened. Imagine going over every email you wrote and received as the CEO of a large and active money manager for a full four years. And that was all done with several assistant U.S. Attorneys and an FBI agent in the room on Tillary Street in Brooklyn (the home of the Eastern District of the U.S. Attorneys Office). Want to know why there’s an FBI agent in the room when this goes on, given that he generally doesn’t understand any of it? Because if I lied to a U.S. Attorney its not good, but if I lie to an FBI agent its a felony and I end up like Michael Flynn only without a Presidential pardon to fall back onto.
I actually have a hard time watching The Big Short, not because I don’t like reliving that awful six month period, the following six months was actually much worse, but what I really cannot stomach is seeing McKay use my two guys, Ralph and Matt, who got perp walked in Brooklyn, as the poster children of Wall Street excess. They didn’t deserve to be immortalized forever that way, given that they were resoundingly acquitted of all charges in record time and helped a snick by my own direct testimony. But the movie that truly captures what it is like at the moment of truth in the upper echelons of Wall Street when that shit starts hitting that fan, is Margin Call, with Jeremy Irons, Kevin Spacey, Paul Bettany, Stanley Tucci and Demi Moore. It takes place over 24 hours and it is so realistic that its almost painful for those of us who lived that life several times over. In my 45-year career, I can say that I lived it five times to varying degrees and with varying amounts of personal pain. None was more dramatic than the last time, which was what gets depicted in Margin Call. Strangely enough, that time was no where near as bad for me personally as one of the first times in 1989, which rattled me to my core. I guess you get used to these things if you stay on Wall Street long enough.
The course that I’m teaching is called Law, Policy and Ethics and it is a required course for all MBA students. It is specifically NOT a finance course and there are few students in the class that plan to concentrate in Finance. Therefore, it is not fair and not even appropriate for me to try to teach law, policy or ethics lessons about financial markets per se. I really need to keep the lessons focused on general business issues that any of the students can equally relate to. I take that charge quite seriously, which is why I felt I needed to choose either The Big Short or Margin Call to use for one of our debates, but could not use both, especially since they covered the same market period and really depict the same fundamental crisis. I chose Margin Call for the reasons I mentioned and because it is a far more serious movie that ends on a somber note and not a big pay day and feeling of relief the way Adam McKay’s film does. But there was another reason as well. The story of Margin Call may be about a financial markets crisis and how a firm managed through the turmoil, but what it is really about is reputation and reputation is a fine general topic for a law, policy and ethics course in the current environment we are living through.
Strangely enough, there are no margin calls enacted or even discussed in Margin Call. A margin call occurs when a financial position is leveraged and it moves against the owner in a way that requires the intermediary (broker) to demand additional collateral or a money true-up by the person who has chosen to take on this leveraged risk. A margin call is not an extraneous event, but an expression of risk and reward when the investor has bet badly on the market. In fact, the subtle message of the movie has little to do with investor leverage, but rather extreme leverage by the intermediary itself in carrying a large inventory position to facilitate market-making as a lucrative business enterprise. It isn’t really about voluntary risk-taking since those intermediaries would like to keep their inventories as low as possible while still having enough inventory to do business.
The real story is about trust, which factors in very little to actual margin calls. Trust is what is absent and needs to be covered financially by the very calling for margin. But what happens if a margin call is not met is really the topic of the movie, because that is when the firm sells out the position with little or no regard for what it costs the presumably cash-strapped owner of the asset. In this case, the firm decides it can no longer stomach the risk of its own inventory and it chooses to dump those securities (all Mortgage Backed Securities in this case) in what can be called a fire-sale manner. The self-inflicted harm to the broker is a foregone conclusion and one that is of little consequence to the firm, who sees it as a necessary for survival. The real harm of the fire-sale is perpetrated on the trusting clients and counterparties that do business with the firm and who trust their market-maker to not drop a falling knife into their midst. It’s called a falling knife because to try to catch it will inevitably lead to harm since gravity makes the knife far more dangerous than it might otherwise be. Few can catch a falling knife and not end up with scars to show for the trouble.
We are living in a very strange moment. It used to be that reputation, particularly in areas requiring great trust, such a being a Wall Street broker/dealer, was a sine qua non of being in business. There is a reason why banks build stone pillars and facades to show great strength to the public. The inherent leverage of banking is such that a bank cannot exist without trust and trust comes from a strong reputation. Much ado is made of reputation and since banking quickly and ubiquitously extends from the firm to the leaders and professionals that man the firm, this reputation must, by necessity, be equally strong for the firm and its senior managers. It is an unwritten rule that if a banker’s reputation is marred, he is immediately distanced from the firm and if a firm’s reputation suffers, its best people will separate from it quickly. the two are inextricably linked.
It has recently been suggested based on a number of questionable incidents that reputation is less relevant to success in business than it used to be. The view is that perhaps clients can be “sacrificed” more inexpensively than the cost of reacquiring new clients. The quid pro quo of relationship banking or relationship business in general may be passé. This is the topic that we will be discussing in class tomorrow and I wish there was a clear and easy answer to the question, but the real purpose of the course is to teach students that most often there are no easy answers, only difficult choices with indeterminant outcomes.
Is reputation dead? Probably not. Does it matter the way it used to at the moment? Probably not. Does the world only move linearly on reputation? Probably not. Is it likely that reputation will matter more again in the future? Probably so. Does the bridge burning that takes place in Margin Call make sense? In the long run, probably not, but in the short run, survival may be the only course that makes sense due to its finite nature. Interesting lesson for life, even if not a particularly pleasant one.