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Lessons From Margin Call

Spending a couple of days at home recovering from a minor operation, I had an opportunity to watch Margin Call on DVD. Starring Kevin Spacey, Jeremy Irons and Demi Moore, the movie was a fascinating recap of one of Wall Street's least auspicious moments. It's a worthwhile two hours for anyone involved with investments. A warning, however, to those squeamish about crude language - such language is a Wall Street staple. You should, though, be ready to give these characters a pass, because they are, after all, masters of the universe - intelligent, aggressive, competitive, rich and filled with an exaggerated sense of entitlement. Why should they bend their language to society's civility conventions?

The movie focused on the unraveling of the subprime mortgage market. Knowledge of that arcane segment of the fixed income market, however, is not necessary to appreciate the key messages of the movie. Most memorable are how rapidly the price of a basically flawed asset type can plummet and how vulnerable a major firm can be when overleveraged. Once the profiled firm's senior executives recognized the severity of their overexposure to subprime assets, they quickly determined that they needed to sell their entire position in a single day before the rest of the street fully understood the implications of the fire sale. Bids in the low-90s on the opening bell had eroded to the low-60s by that day's close. In the current crisis, only Greek debt has so far demonstrated such vulnerability, but there are definitely more candidates.

In the prior crisis, precipitated by subprime mortgages, Bear Stearns and Lehman Brothers were the most public failures, yet uncounted others were at the edge of the cliff but for history's greatest-ever government bailout. AIG, with a longstanding reputation for sound business practices, bet the ranch on not having to pay off on widespread business failures. As in Margin Call, the egregious misjudgments of one of that company's divisions sunk an otherwise successful firm. And if the government hadn't bailed out AIG and its clients, would Goldman Sachs and others be alive today? Obviously, a great many people still question the propriety of using taxpayer money to rescue firms which made tremendously flawed business judgments. We could soon again face the uncertainty of whether or not some firms have badly miscalculated, this time regarding the prospect of Greek rescue efforts triggering an unknown, but still potentially dangerous amount of credit default swaps.

Judging from the frantic recent expansion of its balance sheet, the European Central Bank believes there is serious danger of both bank and sovereign failures throughout the Eurozone. So far that rescue effort has buoyed the spirits of equity investors who have faith that central bank efforts will succeed, at least for a while.

Realistically, there are only three alternatives for dealing with excessive sovereign debt: 1) repudiate it (with central banks so far trying to avoid that option at all cost); 2) grow fast enough to pay it down (not realistic for most developed countries); or 3) inflate it away. Thus far the major central banks have set themselves on the path of the third alternative, although they're adamant about their commitment ultimately to withdraw all the newly created liquidity and about their ability to do it successfully. History casts serious doubt on central banks' ability to accomplish that task, however, now that debt levels have reached current heights. In This Time is Different, authors Reinhart and Rogoff spell out in copious detail how inflating away the debt has been the method of choice for centuries.

Notwithstanding the already massive levels of debt, central banks around the world appear willing to lend even more if economic growth remains sluggish. How long will investors let governments and central banks play the game of inflating away excessive debt by printing new money? If currency is methodically being devalued by the printing press, investors will logically begin to demand higher interest rates to compensate for the anticipated diminished value of the currency at maturity. So far that has not happened except in countries in which creditworthiness is suspect. The situation could change quickly, however. Once again, Margin Call can provide insight. When the firm's most senior executive foresaw the potential calamity in the subprime mortgage arena, he counseled others that while it might become a huge problem for the industry, it would not be as bad for the first one out the door. So far there has been no apparent move toward the door with respect to most central bank supported debt. Given the underlying insolvency of some of the guaranteed banks and countries, however, it is not farfetched to expect worried investors to consider being the first out the door. Investors have to evaluate whether or not Margin Call may be prophetic on a broader level.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.