Major global banks could be hit with billions of dollars in losses after US investment firm Archegos Capital was forced to dump shares last week when it got into financial trouble.
It all starts with borrowed money. If people only risked their own money then margin calls would not exist.
Here’s the scenario. When the investor borrows money to invest in something or other it thinks will give it a better return than it is paying to the lender, then it will all unravel if the investment falls in value. If that happens then the lender’s loan is at risk and the lender will act to protect it.
A margin is the amount of liquid assets (cash) that the investor must hold in relation to the value of its investments. And the margin is agreed between the lender and the investor when the loan is set up.
A margin call is when the lender tells the investor to honour the agreement when the value of the investment has fallen and the lender doesn’t like the increased risk of the investor never being able to repay the loan. The investor then has to either put more of their own money in or sell some of the assets.
The lender doesn’t have to wait for the investor to sell the assets. The lender can take matters into its own hands and sell them.
The very fact that the investments are falling in value means it is not a good time to be selling them. Selling them accelerates the fall and make the margin more difficult to maintain.
I read about this stuff after reading the Big Short and I read it again after I saw the film Margin Call on TV. I should watch Margin Call again.
The plot of Margin Call concerns an investment bank where a junior analyst discovers that the assumptions underpinning the firm’s risk profile are wrong and that the firm could go bankrupt because its mortgage backed securities were likely to fail. The firm wriggles out of it by giving big commission bonuses to its traders to sit and sell the bad assets to their unsuspecting clients. The bosses don’t spell out the problems to the traders, but the traders are not stupid and they must know they are selling junk to their clients.
The film is supposed to represent the way some firms avoided the fallout of the 2007-08 crash.
You may remember that Merrill Lynch was wiped out in the crash, and was bought by Bank of America.
The Big Short is the story of Steve, Eisman, Mike Burry, and a trio of others, who each separately saw the crash coming. It’s the story of how they shorted those who they thought would be left holding the bag when the crash came. The author describes how when asked why he had shorted Merrill Lynch, Steve Eisman said he had a simple thesis. It’s rude, demeaning, and not flattering, but he said that Goldman Sachs was the big kid who ran the games in the neighbourhood. Merrill Lynch was the little fat kid assigned to take the less pleasant roles, just happy to be part of things.
Steve Eisman and Mike Burry were worried that the firms that crashed would not have the means to complete on the shorted deals, so they bought guarantees from banks. In the end the banks paid them out and Merrill Lynch was swallowed up.
Shorting is a funny beast. It is borrowing stock and not paying for it yet, and selling it on with the sale to be completed at a future date. You bet that the value of the stock is going to fall so that when you get to the date when the deal is to be completed you will be able to complete the purchase of the borrowed stock at a cheaper price, and complete the sale at the previously agreed higher price – and pocket the difference.
It all goes wrong if the stock rises and you have to make up the difference.
Property In The UK
I think it is human nature to be less careful with other people’s money than with one’s own. And that goes all the way from the homeowner with a 100% mortgage, and up to the chain.
The problem in the UK is that properties are so expensive that young purchasers trying to get a foot on the ladder are hard pressed to save enough for even a five or ten percent deposit. I have thought about this issue several times and I don’t see a way for the situation to wind down. Banks have their asset value based upon the values of the properties on their books. So how can prices go down against the resistance of all the institutions who are pushing in the opposite direction? With each passing year the numbers tie everyone in more rigidly. All it does is drive more people into mortgages that cripple their lives, or tie them to jobs they don’t want or lifestyles they don’t want. There has got to be a better way.