We all know how the greediness of the big banks caused the 2008 financial crisis. These banks were unaware of the potential crisis their greed would cause. Just before the 2008 financial crash, these investment banks realized they were going to incur huge losses, which led to panic. The movie “The Margin Call” shows how they handled the situation.
In one of our previous articles, we explained how and why exactly the 2008 crash happened. We recommend that you read that article first. If you liked the movie “The Big Short”, then you must have liked the movie “The Margin Call” as well.
Investment banks make money by offering various services to their clients, which include offering suitable investment products and many other things. You can read this article to learn how exactly an investment bank works.
Contents
What is Margin?
But before we go further, let’s see what a margin call is. These two terms, margin and margin call, sound very similar, which might confuse many people.
In the world of finance, margin means to borrow money.
For example, if your broker offers a 10X margin and if you have only $100, your broker will lend you $900, and you can buy stocks worth $1000.
So without margin, if you want to buy stock whose value is $50. Then with $100 you can buy only 2 stocks. If the stock value of that stock goes up to $75, then you made $50 in profit.
But with 10X margin, you can buy 20, $50 stocks, and when the stock value goes to $75, you make $500 in profit.
Buying stocks on margin means using leverage. When you borrow too much money to buy stocks, you become over-leveraged. As profits with margin are higher, losses with margin are also higher.
If the same stock goes down to $25 from $50 instead of rising to $75, then your loss will be $500. Not only did you lose your own $100, but you also lost $400 from your broker. You will have to pay $400 to the broker.
Margin Call Explained
Now, let’s see what exactly a Margin call is?
You have borrowed money from your broker, and the stock price is going down from $50 to $25. Your broker will notify you that you do not have enough funds to cover your losses, and he will ask you to deposit money in your account to cover those losses. If you do not deposit money, your broker can sell your stocks, close the position, and minimize the losses.
This giving of intimation or asking customers to deposit funds to cover potential losses is known as The Margin Call.
Margin call movie explained.
The movie Margin Call shows a situation in an investment bank when everything goes wrong.
To appeal to a wider audience, the movie does not go into specifics about the numbers and financial terms. This is why, to understand this movie, you really do not need knowledge of finance. But while watching the movie, you know that their bank is in trouble and that something big is going to happen soon. Today we will try to understand the movie with actual numbers.
In the movie, the employee (Peter Sullivan) in the risk management department figures out that the investment bank is going to face huge losses, and it has already started. The company’s higher management realises the seriousness of the situation, and they all end up in a meeting with the CEO. The CEO asks Peter to explain the situation to him and everyone in the meeting.
Then Peter Sullivan starts explaining the real issue. The whole crux of the margin call movie lies in that 10 minute scene of meeting with the CEO. If you understand that scene completely then you understand the whole movie. So, the main problem with their firm is explained by Peter Sullivan in the meeting. We have broken down his speech from the scene in 4 parts so that it is easy to understand for the reader.
Part-1
Peter says, “Well, as you probably know, over the last 36 to 40 months, the firm has begun packaging new MBS products that combine several different tranches of rating classification in one tradable security. This has been enormously profitable, as I imagine you noticed.“
As an investment bank, their bank used to sell financial products to investors. One of the financial products the investment bank used to sell was mortgage-backed security (MBS). To create mortgage-backed securities, the investment bank used to buy home loans from commercial banks.
After buying these loans, the investment bank combined them to make a new tradable product known as mortgage-backed securities. Here is a part from our previous article to learn how the mortgage-backed security product was created.
This MBS product was then sold to investors by these banks.
Part-2
Then Peter Sullivan further says, “Well, the firm is currently doing a considerable amount of this business every day. Now the problem, which is, I guess, why we are here tonight, is that it takes us, the firm, about a month to layer these products correctly, thereby posing a challenge from a risk management standpoint.”
As their firm was buying random home mortgages from commercial banks to create an MBS product. It would take their firm about a month to combine these different loans, according to their ratings, into an MBS product. This process is known as layering.
Part-3
Peter Sullivan further says, “Well, we have to hold these assets on our books longer than we might ideally like to. But the key factor here is that these are essentially just mortgages, so that has allowed us to push the leverage considerably beyond what you might be willing or allowed to do in any other circumstance, thereby pushing the risk profile without raising any red flags.”
When you borrow money on margin, it is known as leverage. To create and sell this mortgage-backed security product, their firm bought lots of these loans from commercial banks.
Before the 2008 financial crash, everybody thought the housing market was stable and wouldn’t crash. So the investment banks bought lots of these home loans to create an MBS product that was backed by home loans.
But as the housing market began crashing, a lot of these home loans the bank bought were losing their value very fast. But it took almost a month to create an MBS product and arrange these home loans according to their ratings.
So if the bank held these loans for a month, they would lose lots of money as the loans were losing their value much faster.
Usually, when these banks buy loans, they calculate the risk of such loans. Since all of these were home loans and considered a safe bet. Investment banks borrowed and invested well above their risk limits. Essentially, the firm became over-leveraged due to the huge borrowing on margin.
Part-4
Peter Sullivan further adds, “If the value of these loans decreases by 25%, then those losses will be more than the current market capitalisation of this company.”
How is this even possible? The reason for such a big loss with just a 25% decline is over-leverage. As explained earlier, if there is a higher profit with high leverage, then there are also higher losses with high leverage.
Example
Let’s see this with an example,
Suppose an investment bank, “XYZ Investments,” wants to buy $100 million worth of home loans to create an MBS product. But the bank has only $20 million of its own capital. The bank then decides to borrow an additional $80 million to create a Mortgage-Backed Security product.
This creates a total investment of $100 million, of which $20 million is their own money and $80 million is borrowed money.
Now, let’s revisit the scenario with a 25% decline in the market value of these loans.
So the new value will be,
$100 million – $25million(25% of $100 million) = $75 million.
As the loans lost 25% of their value,
the actual assets of the bank would be total investment minus borrowed capital minus the Loss of 25% on loans.
So, the new asset value will be,
$100 million – $80 million – $25 million = – $5 million.
In this scenario, despite the $100 million total investment, the investment bank’s capital has decreased to a negative $5 million due to the 25% decline in the value of Mortgage-Backed Securities.
Since the capital becomes negative, the firm’s liabilities or debts are greater than the value of its assets, leading to a situation where the firm is insolvent. The losses have exceeded the entire capital of the firm, which means the value of the company has been wiped out and the firm is effectively worth less than zero.
The bank in the movie realises the potential crisis before everyone else in the market. So, in order to survive, the CEO orders them to sell these loans with no swaps. Which means they only want cash to sell their positions and nothing else. This is how the investment banks were overexposed and were on the brink of collapse just before the 2008 crash.
Bank’s senior management knew
One thing you will notice in the movie is that many of the top executives and management had an idea about the potential loss their bank would suffer years ago. But the bank ignored that and still sold these products with huge borrowings because they sold really well. If investors are ready to buy such a product, then banks would sell it to them. The movie itself says these banks do not lose money no matter what happens.
On top of that, the risk management department was given the least importance. They only focused on the positives and completely ignored the negatives and risks of their investment.
Before the 2008 financial crash, many financial firms used mathematical models to calculate risk, particularly when assessing the risks associated with complex financial products like mortgage-backed securities. One common type of model used for risk assessment was the Value at Risk (VaR) model. The VaR model aimed to estimate the maximum potential loss that an investment or portfolio could suffer within a specified time frame.
These models were based on quantitative techniques and historical data to estimate the likelihood of certain events and potential losses. But no such big loss had happened in history, and the housing market had not collapsed so badly before. So there was no way for these mathematical models to figure out such a huge crisis.
Also, these banks would depend on the ratings given by the credit rating agencies. We already explained in one of our previous articles how the ratings given by the credit rating agencies were a fraud.
Conclusion
Finally, in the end, the bank takes the risk, dumps its huge positions in the market, and saves itself.
This is how most of the firms behaved just before the 2008 crash. During the 2008 crash, everybody lost money, but there were some people who predicted the crash and made huge profits during this crash. One such person was Michael Burry, and we recommend reading this article to know how exactly Michael Burry figured out the crash before anyone else.
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