The Podcast of the Lotus Eaters - PREVIEW： Brokenomics ｜ The Big Short

00:00:00.000 Hello and welcome to Brokonomics. Now in this episode I have been asked many many times to,

00:00:06.260 because I did the review of Margin Call, my favourite financial movie, I've been asked

00:00:10.100 many many times to cover The Big Short and well if it is demanded then so I shall provide. This

00:00:17.280 is going to be my review of The Big Short and a little, well actually it's mostly an explanation

00:00:22.180 of what went on using the movie as a prop but you know gets us to the same place.

00:00:27.680 Right, now before we go into the movie itself, which you can buy on YouTube or

00:00:34.700 presumably a whole bunch of other places, Prime and whatever, before we get into that

00:00:39.800 I thought let's give a few minutes just on the background of what led up to it because it was

00:00:45.320 a kind of perfect storm of factors that led into it. I want to start the story, you could start the

00:00:50.740 story in a number of places but I want to start it in 1997-1998, the Asian financial crisis,

00:00:57.680 this was basically a whole bunch of Asian economies and Russia racking up far too much debt, a bit like the 0.86

00:01:06.700 Western world is today and the Western world doesn't seem to have any problem with it because

00:01:10.700 it seems to think, you know, debt crisis is what happens to other countries, not us. But anyway,

00:01:16.300 the Asians got there first, that blew up rather nastily and emerging economies, Asian economies, 1.00

00:01:25.100 they started thinking, okay, well let's keep our money in the US because that would obviously be

00:01:32.540 better and it basically started to channel a whole load of money towards the US, that sloshes around and

00:01:40.800 ultimately ends up in houses, in mortgages because it's got to go somewhere, that's the route that it

00:01:46.300 went, it was a path of least resistance for a whole bunch of reasons, regulatory reasons, cultural reasons

00:01:50.740 and so on. So massive glut of capital comes into the US, starts to push houses higher from about, you know,

00:02:01.300 99, 2000 onwards. I remember this is just when I was getting into, getting in, out of university and

00:02:07.400 starting to look for a house and just every year houses just went up and up and up, same in the US,

00:02:12.900 same across the Western world. The next prelude point would have to be the dot-com crisis,

00:02:18.580 which was, actually that was the thing that was crashing just as I came into finance.

00:02:24.560 NASDAQ lost 78% of its value in a very short order and the key thing from our point of view

00:02:30.900 is that Alan Greenspan, who was the Treasury Secretary at the time, he decided, okay, the solution to this

00:02:38.060 problem is if we make money really, really cheap and so he slashed interest rates down to 1%,

00:02:45.700 did a whole bunch of things that gave rise to a, just a cheap money environment

00:02:51.680 where if you've got cheap money, people leverage up, they take on more debt, they don't worry about

00:02:57.660 the interest cost of all of this stuff. Again, sounds very familiar to the crisis that is brewing

00:03:02.260 right now in the Western world. And the Fed basically decided, yeah, rather than deal fundamentally

00:03:08.940 with the dot-com crisis, rather than, you know, have a genuine clear out and a reset of the system,

00:03:15.200 we're just going to paper over the cracks and we're just going to get the party started again.

00:03:19.920 Probably a bad idea. The next prelude to it is going to have to be a whole bunch of policies,

00:03:25.740 largely in the Clinton era. What did they have? They had an affordable housing markets bill or 0.80

00:03:33.140 something like agenda, whatever. And they set these, what do they call them, GSE standards,

00:03:38.480 which basically led to a race to the bottom in who was eligible to get money for a house. 0.89

00:03:44.520 It had always been the case that banks were incentivized to lend money to people who could

00:03:52.040 actually pay it back. Now, for the younger members of my audience, that might seem a bizarre concept,

00:03:57.580 only lending money to people who could actually pay it back. But that is genuinely how the financial

00:04:02.340 world used to work at one time. So Clinton came along and he was like, no, no, we want immigrants

00:04:08.700 and people from disadvantaged backgrounds, however that is defined, to be able to buy a house, even if

00:04:13.940 they can't afford it. Don't let a little thing, like them not being able to afford it, stop them

00:04:18.940 from buying a house. So they did, was it CRA enforcements, the other thing they did. There

00:04:25.700 was loads of pressure to reduce racial inequality in who was getting a house, because of course the

00:04:31.760 only reason why people with different levels of melanin might not own a house is nothing to do with

00:04:37.160 their propensity to pay what they owe. It must be racism on behalf of the banks. So that was all,

00:04:45.380 well, with social engineering through the markets, effectively. I'll also flag securitization rule

00:04:52.580 changes. So the Fed and the SEC basically changed how quickly a financial institution could basically

00:05:03.000 shift something off their books. Why does this matter? It's because if you, if you make a loan

00:05:07.880 and you have to sit with it for a number of years, you're going to be careful about that loan

00:05:16.160 not being shit. But if you can ship it on to somebody else, somebody who looked less closely

00:05:24.840 at it, the ability of the underlying to pay than you did, well, you don't care. And actually,

00:05:32.400 if you can make a turn by doing that, suddenly you're thinking, what I can do is I can just go

00:05:38.900 and do a whole load of dodgy deals, package them up, ship them on, make some money, do it again.

00:05:47.000 Why do I care if the underlying is dodgy? And so that started to lead to, well, a boom in mortgages

00:05:57.300 and lending and debt-fueled investing. You've got to remember the demographics are changing at this

00:06:04.520 time as well. Boomers are a big generation and they are just starting, some of them, the earliest

00:06:12.000 retirees are starting to retire at this time. And certainly, you know, there's going to be a lot 0.60

00:06:17.940 more of them retiring over the coming years. Pension funds need yield, they need income,

00:06:25.040 and mortgage-backed securities look like the perfect mechanism for doing this, so that provided

00:06:29.620 it as well. And actually, one other factor that I might as well throw in is the perceived safety,

00:06:37.100 which was a product of the rising liquidity throughout this era. I mean, I talk about liquidity

00:06:40.820 a lot at the moment because it's becoming particularly acute. We've got into these liquidity cycles.

00:06:44.680 Actually, they really started around the dot-com bubble. You've got on this four to eight-year

00:06:49.840 cycle of liquidity surging up and down. It started in 2008 and it looked, sorry, started in 2000

00:06:58.680 and then every four to eight years you have some, well, every four years you have some kind

00:07:03.540 of blow-up and quite often every eight years you have a much bigger blow-up. That was happening.

00:07:10.500 Banks were deploying value-at-risk models, which were basically telling them that everything

00:07:17.080 looks good because your value-at-risk is manageable. Basel II regulations, might as well throw that in,

00:07:26.840 that encouraged holding safe investments. What do they define as safe investments? Government debt

00:07:32.500 and mortgages. So you've got a whole bunch of factors, not blunt, because this film very much

00:07:40.180 focuses on, oh, the banks are bad. Yes, but the government also, the reason I ran through that

00:07:48.360 whole list is because the government did a mountain of stupid shit that then allowed the banks and set the

00:07:57.820 condition for the banks to do what the banks do, which is to make a turn on it, because you've

00:08:02.420 created a system where they would basically be stupid not to do it. Right, now we need to move on

00:08:10.220 to, before we get into playing any video clips, this story is not going to make any sense unless I explain

00:08:17.120 the financial products that go into it. Now, I remember doing a whole bunch of financial exams in my

00:08:24.200 youth. A whole bloody load of them. And I didn't realise it at the time, but this movie, The Big Short,

00:08:32.720 has explained to me that actually the way that you get across explaining complex financial products

00:08:40.600 is to have Margot Robbie in a state of undress, which seems obvious in retrospect. But I didn't know

00:08:47.600 that at the time, but who am I to question financial orthodoxy on this particular occasion?

00:08:55.940 So, here we go. Here's Margot Robbie in a state of undress. And we are going to use that to explain 1.00

00:09:05.140 mortgage-backed securities, just like they do in the movie. I'm not going to use her explanation

00:09:10.500 because it wasn't that good, but mine is better. So, basically, you've got a mortgage. You know

00:09:15.380 what that is. The bank, well, actually, you sell the bank a mortgage contract. It's technically the

00:09:21.100 way it works, but okay, fine, whatever. The bank sells you a mortgage or whatever. And you then pay

00:09:27.280 them money every month. And depending on the type of borrower you are, you have got good capital

00:09:35.720 behind you, good job, very industrious, very conscientious. You know, you're very likely

00:09:41.840 to pay your mortgage. Or you could be somebody who's income, you could be a shit borrower,

00:09:52.840 to be honest. It could be that. So, you get a whole bunch of these mortgages and you package them up.

00:09:58.560 And the best stuff, the best mortgage lendees go in the first tranche of this product,

00:10:07.480 the senior tranche, AAA rated. So, bond rating agencies will look at the mortgage product

00:10:17.500 that you put together, a bundle of mortgages. And, you know, the package will be this. And the deal

00:10:23.320 will be basically, okay, this package contains really good mortgages, probably okay mortgages

00:10:30.040 and dodgy mortgages. And you can choose which tier of this product you want to invest in.

00:10:36.400 So, the senior tranche, the mezzanine tranche, and the equity tranche. Now, the way it works is the

00:10:43.360 yield gets higher the lower quality you go because you're taking more risk. If you want to take less

00:10:48.480 risk, you just buy the senior tranche. And these guys, when income comes in from wherever it's

00:10:54.300 coming in, senior tranche always gets paid out first. And then once they've been paid,

00:11:00.360 mezzanine tranche gets paid out. And then equity tranche gets paid out, okay?

00:11:05.180 All right, makes perfect sense. Collateralized debt obligations, a little bit trickier. So,

00:11:11.080 we're going to need Margo again to help out. So, what that did is, okay, let's say

00:11:16.100 you've launched your mortgage-backed security and you've sold out of the senior tranche

00:11:23.600 because the type of people who buy fixed income products, they don't like risk, but they do like

00:11:33.420 income. So, that sells out. And only a bit of your mezzanine sells out, none of your equity tranche

00:11:39.140 sells out. Well, what are you going to do with it then? Well, what you can do is you can basically

00:11:44.800 take the stuff that didn't sell and you can repackage it into a new product, into a collateralized

00:11:52.300 debt obligation. Thank you, Margo, for helping. So, this was normally loads and loads of mezzanine

00:11:58.300 tranche. But if we take a whole lot of them, so there's lots of them in a new product, well, now

00:12:08.560 we are, and this is the clever bit, diversified. And that reduces risk. If you are, if you have

00:12:17.840 been trained by the books in finance, diversification lowers your risk. So, if you take a whole load of

00:12:24.300 shit, but there's a lot of shit, now it's good shit. Hope that makes sense. So, then you've got

00:12:30.820 a new collateralized debt obligation. And now, the senior tranche of this is made up of the middle

00:12:38.900 tranche of the previous lot, but just more of it. And that gets a AAA rating. And now, the insurance

00:12:48.580 companies and the pension providers and the foreign governments or whatever, who are looking to buy

00:12:53.080 this product, don't drill down right down to the underlying level. They just look at the rating and

00:12:58.000 say, oh, look, senior tranche, AAA rated. Yeah, I'll have some of that. So, that then goes in.

00:13:04.980 And then, you've still got the lower tranche of this, except the lower tranches of this really are

00:13:08.820 absolutely toxic. Bad shit. Now, we need to get into credit default swaps. This is going to be the

00:13:16.800 most complicated bit. So, I needed Margo completely nude for this. We've added a couple of the Lotus 1.00

00:13:23.500 Eater stickers, just because it was a little bit raunchy. Well, I suppose she's not complete. She's got 0.80

00:13:27.320 stocking on us, but stockings don't cover anything important. So, that's fine. It works for this

00:13:30.920 purpose. Right. Credit default swaps. What's going on with this? You can buy insurance on your car,

00:13:38.080 right? And that is, if you have an accident, you will be made whole on the cost of repairing your car.

00:13:47.240 Right. But what if you could buy insurance on somebody else crashing their car? That's kind of

00:13:58.380 it. So, a credit default shop is basically just insurance. And normally, you would buy this

00:14:07.720 insurance if you held the underlying bond. But actually, they are tradable. So, you don't have

00:14:16.100 to hold the underlying bond. You don't have to use it for its original intended purpose.

00:14:24.320 You can just take a view that I think that such and such a thing is a bit suspicious, and therefore,

00:14:31.600 I'm going to do it. Now, credit default swaps on mortgages is not a thing until we get into our

00:14:37.920 characters. When we get to Michael Berry, we're going to talk about how he sort of effectively

00:14:42.260 created this market. It didn't exist. But credit default swaps will exist on things like government

00:14:47.080 debt and corporate debt and a whole bunch of stuff. So, this was a well-established product.

00:14:52.160 And here's where it's get clever, you see, because it's insurance. The cost of insurance

00:14:58.640 is linked to how risky a thing is perceived to be. So, look, I've got the tranches up here on my

00:15:05.640 little slide. And at the bottom there, we've got the senior tranche. Now, let's say you are going to

00:15:12.460 deploy 50 million of your capital to buy insurance. If you are buying insurance on something extremely

00:15:20.040 safe, then the insurance is not going to cost you very much, right? So, your 50 million of insurance

00:15:30.260 buy could get you a notional cover of billions. So, your likely payout could very well be billions

00:15:45.200 because you're insuring something that is supposed to be safe and not going to need the insurance and

00:15:52.060 therefore they sell the insurance to you cheaply. Whereas up at the equity level, the chances of them

00:15:59.040 having to pay out is a lot higher and therefore your 50 million buy gets you a notional smaller level

00:16:06.920 of coverage. You know, just like if you're a 17-year-old boy racer driver, your insurance is

00:16:13.300 going to cost you more than if you're a very safe, sensible, you know, Miss Daisy or something. 0.62

00:16:19.440 You know, you're going to pay a lot less for your insurance. This will be key later on when we get

00:16:27.060 into the characters, which I think is about our time. Right. So, having explained how all of that

00:16:37.540 works, we now need to talk about our first character, Michael Berry. Now, he was a clever chap. He was a

00:16:48.520 former neurologist, I think it was, self-taught investor. He founded Scion Capital, it was, in 2000.

00:16:57.060 He did, it was a family money and personal funds, was very successful and he started to attract

00:17:05.340 additional capital. Other people came on board. He was a deep value investor, a Warren Buffett

00:17:11.300 style investor. And by 2004, after only being in business for a few years, he had 600 million

00:17:18.180 under management. The way that these hedge funds work, it's a very attractive model. You get,

00:17:25.480 it's what's called the two and 20 model. You basically get 2% of whatever it is you're managing

00:17:32.880 every year as a fee. And then if you outperform, you get 20% of the upside. So, it's a very attractive

00:17:38.740 model. Now, in 2005, he started looking at the prospectuses for the mortgage loans, for the mortgage

00:17:48.980 backed securities. It actually started just sitting there and reading through them. Must have taken him

00:17:53.200 a very long time. He read all the small print and he started to realise that these things were

00:18:01.880 nowhere near as high quality as they were supposed to be. Especially the CDOs, the collateralised

00:18:10.420 debt. You know, the bundles of mortgages. What was in the bundles wasn't that good. Now,

00:18:18.260 I think maybe at this point, we need to sort of play our, oh, I need to put my earpiece in.

00:18:23.840 We need to play our first clip to get at what is going on. So, let's play this.

00:18:31.220 It's a matter of time before someone else sees this investment. We have to act now.

00:18:38.100 How do you know the bonds are worthless? Aren't they filled with fucking thousands of pages

00:18:43.180 of mortgages? I read them. You read them? I read, yeah. No one reads them. Only the lawyers

00:18:50.260 who put them together read them. I don't think that they even know what they've made. The housing

00:18:57.100 market is propped up on these bad loans. It's a time bomb and I want to short it. Through

00:19:05.040 what instrument, Michael? There are no insurance contracts or options for mortgage bonds. The

00:19:10.540 bonds are too stable. Lawrence, this is what I'm going to do. I am going to get a bank to

00:19:20.740 make me one. Then I'm going to buy it.

00:19:28.680 Right. Okay. So what's happening there? He's gone through these mortgage agreements. He's

00:19:34.800 realized that they're bad. They're full of trash. And actually the key thing that he realized

00:19:41.400 is that a large number of these loans in there were not only subprime, what we now call shit

00:19:48.660 mortgages, but they were adjustable rate mortgages. Meaning that you started with a teaser trailer

00:19:55.140 and then the rate went up quite significantly after that. And the people who were buying these

00:20:02.960 subprime mortgages could probably afford the teaser trailer, but they definitely couldn't afford

00:20:09.100 it when it adjusts. And because we had got into bubble territory, more and more of these mortgages

00:20:14.720 had been sold. There was going to be a big glut of people who had to refinance in 2007 once

00:20:23.280 the teaser trailer rolls off. And then it was going to lead to a glutton supply in the housing

00:20:29.700 market. And that the mortgage-backed securities were basically going to go bad. Yeah, 2007,

00:20:40.800 2008, there was going to be a huge amount of these adjustable loans rolling over. He realized that

00:20:47.360 many borrowers had no income verification, no assets. Was it ninja loans? They called them no income,

00:20:54.360 no job. Can't remember what the A was now. And the loan to value ratio were ridiculously high. I mean,

00:21:05.080 sometimes, you know, more than 100%. So he realized that the default weights were going to rise

00:21:11.920 dramatically. And that the MBSs built on these loans and these CDOs built on these loans would

00:21:17.800 implode. Basically, he understood that the borrowers were never going to be able to repay. And it wasn't

00:21:26.880 a probability, it was a certainty. But in order to get there, you had to do a lot of work. And most people

00:21:34.680 just don't do that. But he did. So he was in the situation of having to try and explain to his

00:21:45.440 investors, you know, what is, why is he doing this? And that is a consistent problem that he has in this

00:21:55.900 movie, that he doesn't, he isn't able to communicate what he's doing to his investors that leads to all

00:22:02.440 sorts of problems. And it's also really interesting how he was able to do this, because as his investor said in

00:22:10.240 the video that we just watched, nobody offers credit default swaps on this market, because it's

00:22:17.080 considered too stable. That didn't slow him down. He was a Wall Street insider. He had a big fund,

00:22:25.300 respectable name. So he basically just went to Goldman Sachs and Deutsche Bank and so on and said,

00:22:30.720 I want you to create a market, explain what he wanted to do. And their team of lawyers and product

00:22:37.660 engineers went together and they put together something because he wanted to put 100 million

00:22:43.040 on this. So that was enough for them to go. And normally the way it works in banks is you've got

00:22:48.200 a whole bunch of salespeople who are flogging stuff, but every so often they have a new idea

00:22:52.260 for something that they can sell and they create that product and then they go around and ship it.

00:22:59.040 But in Michael Berry's case, he came to them and said, look, if this product were to be created,

00:23:04.160 I would buy it and I'd buy a lot of it. And so their people went to work and they put together

00:23:09.000 the product and he told them which mortgage bonds specifically he wanted to take out a credit

00:23:15.080 default swap insurance against. If they went bad, this would pay off. And he was focusing on

00:23:22.460 a bunch of, what was it, 2005, 2006 vintage mortgage-backed securities, which were heavy

00:23:33.360 on adjustable rate mortgages. So they were going to tick up in 2007, 2008 and focused mainly on

00:23:41.980 California and Florida, which were the most bubbly bits in his view. And so they went away and they

00:23:47.120 created this product. Now, the credit default swaps that these banks came back with had a five-year

00:23:55.020 maturity on them. So, you know, this has got to pay out in five years or it goes away. Furthermore,

00:24:05.760 the notional that what it would pay out was going to be 1.3 billion, which is a lot.

00:24:14.920 But here's the catch. Just like if you buy car insurance, you have to pay an annual premium.

00:24:24.140 And these CDSs, this insurance, came with an annual premium. And he was having to spend

00:24:31.860 something like 80 to 100 million a year on paying these insurance premiums for something that had

00:24:40.980 never happened. The ability to short the housing market didn't exist until he created it. So he

00:24:49.040 really is the one who should get most of the credit for this story. Right. But his investors are looking

00:24:56.680 at this and thinking, well, this is mad. You're betting on something. They haven't done the work,

00:25:00.380 remember? Their money is tied up in this fund. He's betting on something that's never happened.

00:25:07.300 And the premiums he's paying is going to wipe out the fund in fairly short order if the thing that

00:25:13.060 never happens doesn't happen fairly imminently. And that led to, I think, this scene is probably

00:25:19.740 the next one to watch when two of his big investors march into his office and demand an explanation.

00:25:25.900 You have no confidence in your ability to identify macroeconomic trends.

00:25:33.340 You flew here to tell me that? Why? Anyone can see that there's a real estate bubble.

00:25:39.780 Actually, no one can see a bubble. That's what makes it a bubble.

00:25:43.040 That's dumb, Lawrence. It's always markers. Mortgage fraud was quintupled since 2000,

00:25:51.860 and the average take-home pay. It's flat, but home prices are soaring. That means the homes are

00:25:57.500 debt, not assets. So Mike Burry of San Jose, a guy who gets his hair cut at super cuts and doesn't

00:26:04.160 wear shoes, knows more than Alan Greenspan and Hank Paulson. You need to be a doctor, Mike Burry. Yes,

00:26:11.520 he does.

00:26:11.960 I mean, he's getting to the heart of it. He's done the work. He understands that this is a genuine

00:26:19.580 thing. But most people are operating, his investors are financially sophisticated guys. They're operating

00:26:27.440 in the swamp. They're operating in a world where this simply doesn't happen. The fish can't see the

00:26:35.940 water it's swimming in. These guys can't see the problem. I've got a lot of sympathy with Barry here.

00:26:42.480 I feel the same way about Bitcoin, to be honest. I know the financial system is broken, and it is

00:26:48.880 only a matter of time until something quite nasty happens, and therefore I want my insurance. So for

00:26:54.820 me, Bitcoin does not feel like a speculative bet at all. I know this is going to happen. The difference

00:27:03.240 of Bitcoin is lots more people see it now, especially post-2008, a lot more people see it. But there's

00:27:07.960 still plenty of established finance for people who just cannot see that the set of economic rules

00:27:14.700 that we're working under are ever going to change. And that was also the case with his investors here.

00:27:19.440 Let's play a bit more.

00:27:23.440 That's cute. That's cute. Are you being sarcastic with us, Mike?

00:27:27.140 Lawrence, I don't know how to be sarcastic. I don't know how to be funny. I don't know

00:27:37.460 how to work people. I just know how to read numbers. How big's your short position right

00:27:45.960 now?

00:27:47.960 Just the $1.3 billion.

00:27:50.380 And the premiums?

00:27:51.320 Well, we pay roughly $80 to $90 million each year, which is high, but I was the first

00:27:59.640 to do this trade. Watch. It will pay. I may have been early, but I'm not wrong.

00:28:05.260 So his investor's got legitimate concerns here. He's got a large short position.

00:28:13.020 Now, traditionally, with a short position, let's say you're going short on an equity,

00:28:17.160 that's very dangerous because if you go short on equity, you're betting that price will

00:28:22.140 go down. And if the price of the equity goes up, then your short can lose an infinite amount

00:28:27.200 of money because shorts are more dangerous than long positions because with a long position,

00:28:32.280 the most you can ever lose is 100% unless you've geared up, unless you've levered up,

00:28:38.400 you're on the bubble. But normally, if you buy an equity, you can only lose 100%.

00:28:42.760 With a short, you can lose infinity percent if the price keeps on rising because there's

00:28:47.680 no upper limit on price. And therefore, your short, which is the inverse of that,

00:28:50.740 which is your position, can go down infinitely.

00:28:54.480 And what his investors here has asked him is, okay, how large is your position and what's

00:28:58.140 your monthly premium? And he's quickly seen that the premiums alone are going to wipe out

00:29:05.280 the fund in about five years, maybe a bit less. Let's play a bit more.

00:29:11.160 It's the same thing. It's the same thing, Mike.

00:29:14.260 You're managing a...

00:29:15.120 Okay, let's also comment on that. He says, I'm not wrong, I'm early. And the other investor

00:29:19.600 says, it's the same thing. Okay, yes, this is also very true. You can be right about something,

00:29:27.020 but if you're right too early, you're basically wrong.

00:29:31.800 If you would like to see the full version of this premium video, please head over to

00:29:35.640 lotuseaters.com and subscribe to gain full access to all of our premium content.

00:29:41.160 Thank you.

00:29:42.020 Thank you.

The Podcast of the Lotus Eaters - October 14, 2025

PREVIEW： Brokenomics ｜ The Big Short

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