Disclaimer: All the details mentioned here are from the movie and not independently researched to be accurate by the author. Any opinions expressed here are my own and do not reflect the opinions of my employer.
As part of my curriculum for Machine Learning for Trading (CS 7646) in my OMSCS course, we were asked to watch the movie “The Big Short” to learn how the market crash in 2008 happened, the sequence of events leading up to it and some of the key financial aspects and terms which are key to its plot.
CS 7646: Machine Learning for Trading | OMSCS | Georgia Institute of Technology | Atlanta, GA
Course Creator and Instructor Overview This course introduces students to the real world challenges of implementing…
The movie itself was released in 2015 and had a heavy weight cast including Steve Carrell, Christian Bale, Ryan Gosling and Brad Pitt. Steve Carell was brilliant in his portrayal of Mark Baum (the book’s character based on real life investor Steve Eisman).
The Big Short (2015)
Directed by Adam McKay. With Christian Bale, Steve Carell, Ryan Gosling, Brad Pitt. In 2006-7 a group of investors bet…
Needless to say, this post will be full of spoilers (no pun intended) and would highly encourage anyone interested to watch the movie first before continuing on.
This is neither a narrative or a review of the movie. Rather a set of “student’s” notes who anticipates an exam on the nuances of trading concepts portrayed in the movie.
The movie begins with the introduction of Lewis Ranieri from Salomon Brothers who invents the concept of “Mortgage Backed Securities” (Private Labelled MBS) in 1970s and how it transformed banking and stock market into a lucrative employment. Read more here
Lewis Ranieri - Wikipedia
Lewis S. Ranieri (; born 1947) is a former bond trader, founding partner and current chairman of Ranieri Partners, a…
MBS were supposed to be iron-clad and the bonds backed by these securities are always rated AAA. Many of the loans in these securities were mostly privately held mortgage with a Fixed rate of either 20 or 30 years. The common consensus was yield is up with same risk as everyone pays mortgages.
So what happened?
Banks got greedy. There are only limited number of AAA rated good loans and since mortgages always had a sense of “infallibility”, they started sub-prime mortgage loans with Adjustable Rate Primes. These are loans which are given at a higher risk to the lender and ARM rates tend to go up as time progresses in comparison to fixed rate mortgages.
Watch Margot Robbie explain this.
So these toxic loans that were given with little to low verification starts building up in these securities waiting for these bonds to blow up.
This is where the movie starts following three protagonists who either figure it out like Dr. Michael Burry (an actual ex-doctor) who is a mathematical genius or find it by accident like Jared Vennett (Deutsche Bank) and Mark Baum when they come across Dr.Burry’s research. There are some minor deviations from reality like how Jamie Mai and Charlie Ledley (Garage fund managers) found about the research.
Hero’s battle for truth
Like any movie, the plot starts with the hero Dr. Michael (played by Christian Bale) uncovering the risks around these MBS and that they are filled with extremely risky sub-prime mortgages. He decides to take a huge risk to short the bonds. But he is met with heavy resistance from his primary investor who makes this great remark.
“Bubbles are regional and defaults are rare”
The second protagonist Mark Baum is a Fund Manager who managed FrontPoint Partners LLC a unit under Morgan Stanley. They hear about the upcoming crisis from Jared Vennett who has read the Dr. Burry’s report. Jared Vennett then sells them the credit default swaps for these bonds which Mark Baum uses to short the market.
So what are these Credit Default swaps?
We hear this term first in the discussion that Dr. Burry has with Goldman Sachs executives on how to short these mortgage bonds, essentially “Betting against the housing market”
The executives were skeptical at first and even mention that “This is Wall street, and if you give us free money, we will take it”.
So they created these instruments “Credit Default Swap” which insures the bonds against failure and the insurer will pay the claim if the underlying bonds fails.
They insure these bonds without knowing the structure of these underlying bonds and basing it on the theory “Bonds will fail only if Millions of House owners in those bonds, don’t pay their mortgages and that has “Never” happened in history, basing their financial strategy on other banks, market sentiment and populist culture.
Dr. Burry seeing a kill, raises concerns about payments when bonds fail, due to solvency issues and Goldman Sachs even creates a “Pay as we go” structure if the mortgage bonds go down. However if value of mortgage bonds go up, Dr. Burry has to pay a monthly premium as he is insuring against the mortgage bonds with the bank. Since such an instrument never existed they created it for him and called it “Credit Swaps for Mortgage bonds”.