What ‘The Big Short’ Taught Us About Stress Testing

by Sari Nahmad

The Big Short, a box office hit, details how Dr. Michael Burry (and a select few) predicted the credit and housing bubble collapse and made millions while the entire economy went down the drain. How did Burry end up on top? The key to his success was that he analyzed the fine details: loan data at the individual loan level. While it may seem this is a commonplace practice, at the time, no one seemed to notice the sub-prime (poor quality) loans that were fraudulently being packaged as quality loans. The consequences of these practices were revealed when the adjustable mortgage rates associated with these loans took effect: mortgage rates sky-rocketed leaving many home owners unable to pay.

This movie highlights the importance of detailed and stringent analysis and the creation of the Dodd-Frank Stress Test, a new requirement regulated by the Federal government. Simply put, this test requires Financial Institutions (currently the top grossing banks) to project their financial losses over the next two years given multiple scenarios, each with varying economic factors and severity levels. This forces banks to take a closer look at their assets. Based on historical data, banks predict the probability of default and the loss given a default for every single loan. How these institutions will use this information is still unclear, however, this approach is a great start to enhance awareness and provide tools to understand possible future outcomes.

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