About “The Big Short” Movie#

“The Big Short” is kind of unique for a big Hollywood movie. It’s got an all-star cast, but it actually takes the time to show how finance really worked behind the scenes. Instead of just focusing on typical movie stuff like wild parties, fancy cars, and attractive people, it uses the financial events themselves to drive the story. That’s a different approach from some other movies about the financial world, which might be equally entertaining but tell the story differently.

Now, you might wonder: was all this stuff legal? Absolutely [explicit language from original text] not.

Similar to the movie “The Wolf of Wall Street”, “The Big Short” is based on a book.

• “The Wolf of Wall Street” came from an autobiography written by Jordan Belfort himself.
• “The Big Short” is based on a standard non-fiction book called “The Big Short: Inside the Doomsday Machine”. This book went into detail about the various people involved in setting up the credit default swap market, essentially betting against the American housing market.

The book “The Big Short: Inside the Doomsday Machine” was written by Michael Lewis, who’s a veteran financial journalist. The book reads a lot like a very long (320-page) financial article. It’s packed with information, but it’s also extremely well-researched and double-checked.

For this explanation, we’re just focusing on the folks who were in the movie. The book, however, goes into more detail about some people who were either completely cut from the film or blended into other characters to make the movie flow better for a wider audience.

Sadly, in trying to make the movie as appealing as possible to moviegoers, some important details were cut and, honestly, some things were just straight-up wrong. A big challenge was figuring out how to explain the complicated financial instruments involved. As one person quoted says, “The biggest disadvantage we had was about the financial instruments and how to explain them, that was really the problem I saw.” (They thought the characters were great though!).

So, let’s try to understand a bit about how the money stuff worked.

The Key Players Who Bet Against the Market#

The movie follows three main groups who decided to take a short position – meaning they bet that the value of something would go down – against the American housing market and the financial system built around it back in the early 2000s.

1. Michael J. Burry:

   • He’s the first group we meet and is now pretty famous (or infamous).
   • He was originally a physician (a medical doctor) but gave that up to start his own hedge fund called Scion Capital in the year 2000.
   • Burry had a lot of success early on by shorting overvalued tech stocks.
   • He delivered an average return of 25% to his investors over the first four years, which is amazing performance.
   • By 2004, he was managing a massive 600 million dollars for investors.
   • With those kinds of returns and a typical hedge fund fee structure (which is usually 2% of assets under management PLUS 20% of the profits made over a certain benchmark), he was making a huge amount for himself.
     • 2% of $600 million** is **$12 million.
     • Conservatively, the 20% of the excess returns he generated at that time would have added another $18 million.
     • So, he was likely making around $30 million a year for himself by 2004.
   • His fund was so successful that by 2004, he actually stopped accepting new investors. This was because his trading strategies relied on being able to buy and sell assets without his large orders affecting the market price itself.
   • The movie shows Burry as a bit of an eccentric guy, which is true, but it maybe didn’t quite capture how extremely wealthy he already was by the time he made his big bet against housing.

2. Mark Baum (Steve Eisman) and FrontPoint Partners:

   • This group is led by the character Mark Baum, played by Steve Carell.
   • The character is based on a real person named Steve Eisman, who also managed a hedge fund called FrontPoint Partners. The name was changed for the movie.
   • Eisman and his team also worked with Greg Lipmann, a trader at Deutsche Bank who was also betting against the housing market. Lipmann is portrayed in the film by Ryan Gosling, and his name was changed to Jared Vennett.

3. Brownfield Capital (Cornwall Capital):

   • This group was renamed Brownfield Capital in the movie.
   • They had a much smaller amount of money to work with compared to the other two.
   • However, they ended up generating the highest returns because of a smart strategy they used (we’ll get to that later).

So, you’ve got Burry (Scion Capital), Baum’s group (FrontPoint Partners), and Brownfield Capital (Cornwall Capital). They all had the same goal: they wanted to short the housing market.

How Shorting the Housing Market Worked (It’s Not Straightforward)#

Normally, shorting something works like this: you borrow an asset (like a stock), sell it right away at the current price, hoping the price will drop. If the price does fall, you buy it back at the lower price, give the borrowed asset back, and you pocket the difference.

But you can’t exactly do that with houses! Nobody’s going to let you borrow their house just so you can sell it.

This is why all these parties ended up using something called credit default swaps.

Understanding Credit Default Swaps (CDs)#

Credit default swaps sound fancy, but they’re really just like regular insurance contracts you have for your car or house.

• Car insurance: A contract between you and an insurance company. If your car gets into an accident, the insurance company pays out.
• Credit Default Swap (CDS): An insurance contract between an insurance company (or an investment bank) and someone who owns an asset that pays interest, like bonds or mortgage-backed securities.

Mortgage-backed securities (MBS) are supposed to pay a steady income to the people who own them. If those payments stop coming (meaning the mortgages default), the company that sold the CDS (the “insurer”) promises to pay the owner of the MBS to cover those losses.

What Michael Burry was doing in the movie was basically buying insurance on a car he didn’t own. If that “car” (the MBS) crashed (defaulted), he could collect the insurance payout even though he never owned the MBS in the first place. Replace the car with mortgage-backed securities, and you get the idea.

The catch for Burry was that he bought a LOT of these credit default swaps. Just like buying a lot of car insurance policies, he had to keep paying quarterly premiums to keep the coverage active. If the mortgage-backed securities never went bad, he’d never get a payout and would have just spent all his investors’ money on these “insurance payments.”

A Movie Detail About CDS That Wasn’t Quite Right#

One detail the movie doesn’t get totally right: Burry later tells his investors that he had several Wall Street banks create these credit default swaps for him. This sort of suggests that buying insurance on mortgage-backed securities was a brand new thing that Burry came up with.

In reality, credit default swaps (these insurance contracts) had actually been used since the 1990s. And they were used for a really interesting reason related to how mortgage-backed securities were made.

How Mortgage-Backed Securities (MBS) Were Created#

Mortgage-backed securities were basically a big pool of thousands of individual mortgages bundled together and sold off as an investment, often considered low-risk at first.

• Banks loved selling these mortgages to other investors because it gave them more cash.
• More cash meant they could give out more mortgages.
• Washington liked this because it meant more people could become homeowners.

But turning thousands of mortgage contracts into a new mortgage-backed security is a slow and complicated process. Lawyers and bankers had to make sure everything was accounted for properly. Most smaller lenders outsourced this tedious work to bigger investment banks.

This meant the investment banks had to buy mortgages from the smaller banks and hold onto them for two or three months while they packaged them up into new financial products. During that time, the bank risked those mortgages defaulting, which would cost them money.

Normally, this wouldn’t be a huge deal. But the sheer size of the mortgage-backed security business meant some of these banks were holding trillions of dollars worth of mortgages at any given time. This was a risk far beyond what they were comfortable with.

The investment banks didn’t actually expect things to go wrong, especially when they first started making MBS. But it’s like getting car insurance – you don’t expect a crash, but you get it because a crash could cost you more than you could afford.

So, credit default swaps let these investment banks hold trillions of dollars in assets while packaging them up, collecting their fees for the work, without taking on the risk of those mortgages defaulting. The only real risk they saw was if the company selling the insurance (like AIG, which wrote a lot of these contracts) went broke. Nobody thought that was likely.

These private insurance contracts were indeed called credit default swaps. And eventually, when the housing bubble burst, this exposed a huge company like AIG to a potential 64 billion dollars in losses related to subprime mortgages. AIG simply didn’t have enough money to pay out when the time came.

Burry’s Big Bet Timing#

Back to Michael Burry: He started buying these credit default swaps in 2005. That was three years before he finally cashed them out for a huge profit, which ended up being over 800 million dollars.

He specifically bought insurance on some of the riskiest types of mortgage-backed securities. And this brings up the next mistake the movie made: it heavily implied that these risky financial products never failed before 2008.

That’s not true. They did fail, especially the riskier ones. That’s exactly why the insurance contracts (the CDS) existed in the first place! As the quote in the text says, “In other words, we lose millions until something that’s never happened before happens. Correct.” This was about betting on the riskiest parts failing.

Riskier assets naturally commanded higher premiums for the insurance (the CDS). Burry was quoted saying the premiums were roughly 80 to 90 million dollars each year. It’s like how a young driver with a bad record pays way more to insure an older, fast car than an older driver with a perfect record insuring a newer, standard car. It’s all about the chance the insurance company will have to pay out.

Mortgage-Backed Securities (MBS) vs. Collateralized Debt Obligations (CDOs) and Tranches#

Mortgage-backed securities could become safer or riskier in a couple of ways:

1. Quality of underlying mortgages: If they were full of mortgages from people with high incomes, good credit scores, and low loan amounts compared to the home value, they were safer. By the early 2000s, these “good” borrowers were often mixed together with “bad” borrowers. The text quotes someone saying, “I think it’s was in fact in retrospect a great big National and not just National Global Ponzi scheme.”
2. Layering into Tranches: Banks made their products safer or riskier by dividing them into layers, called tranches. Imagine three buckets lined up. All the cash coming from people paying their mortgages goes into the top bucket first. Once that bucket is full, the extra cash overflows into the second bucket. Then, if that fills, it overflows into the third bucket, and so on.
   • The final bucket gets paid last, so it’s the cheapest to buy.
   • Buying this last bucket could offer a really good return if everyone pays their mortgages and all the buckets fill up.
   • But, if some people don’t pay, the last bucket might get nothing. That’s the higher risk investors take for the chance of higher returns.

Structuring mortgage bonds this way created different levels of risk and potential return:

• The first (top) bucket was much safer than any single mortgage on its own.
• The last (bottom) bucket offered potentially higher returns than the interest rates on the original loans. This created a market where both risk-seeking investors and more cautious investors could find something they liked within the same basic asset class.

The idea was that mixing thousands of mortgages together made the overall returns more predictable. This gave some Wall Street folks another idea: if you can mix lots of mortgages into one MBS, maybe you could mix lots of MBS together!

This led to the Collateralized Debt Obligation (CDO). The theory here was also safety through diversification – getting returns from lots of potentially risky mortgage buckets. They expected some of the underlying buckets to fail, but figured the income from the thousands of other buckets would cover those losses.

Many CDOs were also layered into their own tranches! And you can probably see where this is heading. Some firms took the lowest (riskiest) tranches from these CDOs and mixed them together to make brand new CDOs. These became known as CDO squared (CDO²).

While mixing mortgages into MBS helped protect against a single mortgage defaulting, or even defaults in one small area, no amount of diversification could protect the entire system when the flow of cash feeding everything got cut off, like it did in 2008.

Fortunately (for the shorters, anyway), you could buy insurance (credit default swaps) on any of these buckets or tranches you wanted.

Another Movie Detail: MBS vs. CDOs#

Now that you know the difference between Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) and how they were structured with tranches, we can point out another small detail the movie got slightly wrong.

In the scene where Michael Burry goes around to investment banks trying to get them to sell him insurance contracts, he’s shown handing them information sheets (prospectuses) about mortgage bonds (MBS) he wants to short.

• Movie dialogue: “on six mortgage-backed securities” “I’m not sure Dr. Barry, these should be fine.” “yeah, we’re prepared to sell you five million in credit default swaps on these mortgage funds” “Can we make it 100 million?” “Absolutely, we can make it 100 million.”

However, the real Michael Burry actually bought credit default swaps on Collateralized Debt Obligations (CDOs), which were the products made from mixing lots of other buckets together.

• Real quote from someone involved: “right we bought basically short 8.4 billion of credit default swaps related to mortgages or financial companies” “You must have been pretty confident that this thing was going to blow?” “we had a giant bet for us and and I was extremely confident in the outcome” “Were your investors as confident?”

It’s not a huge deal in the grand scheme of the story, but it’s something you can point out to friends next time you watch the movie if you want to sound annoying!

The Payoff#

The end of “The Big Short” shows the events of 2008 starting to unfold, and the incredibly complicated financial products that these three groups bet against starting to lose value.

At this point, Brownfield, Scion (Burry), and FrontPoint (Baum) had two ways to cash in their bets (their short positions):

1. Wait for the assets they bet against to completely collapse and collect the payout from their insurance contracts (the credit default swaps).
2. Sell their insurance contracts back to the banks who were now desperate to get rid of them.

They all chose option two. As Michael Burry worried earlier in the movie, there was a real possibility that the banks or insurance companies who sold them the CDS (like AIG) could collapse themselves, and then they’d never get their payout.

• Movie dialogue: “You wouldn’t bet against the housing market and you’re worried we won’t pay you?” “Yes.”

It would be like crashing your car only to find out your insurance company went out of business before you could claim your money!

Why Brownfield Made More Money#

Remember how Brownfield Capital (the group with less money) ended up getting the highest returns? This is why:

They bought insurance contracts (CDS) on assets that were considered much safer – specifically the A and Double-A (AA) rated buckets/tranches. The larger hedge funds like Scion and FrontPoint were buying CDS on the riskier Triple-B (BBB) rated stuff.

Because the A and AA assets were safer, the premiums for the insurance contracts were lower. This meant Brownfield could buy more of these contracts with their limited amount of investor money.

This is the clever play they made that the others missed: “This is what we did that no one else thought of. Not even Baum or Burry thought [to] short the Double-A’s, but we did.”

One Final Movie Detail#

The final thing the movie could have done a better job of explaining is that almost all of the Triple-A (AAA) rated mortgage-backed securities, and over 90% of the A and Double-A (AA) rated securities, ultimately failed. These were the “safe” investments!

Okay, let’s get this information sorted out so it’s easy to read and understand, just like talking about it over a cup of coffee. We’ll keep all the details in there, no worries.