PREVIEW： Brokenomics ｜ The Big Short
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Summary
In this episode of Brokonomics, I review the movie The Big Short, using the movie as a prop. Before we get into the movie itself, I thought it would be useful to give a quick run down of the background of what led up to the housing crash of the late 90s and early 2000s.
Transcript
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Hello and welcome to Brokonomics. Now in this episode I have been asked many many times to,
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because I did the review of Margin Call, my favourite financial movie, I've been asked
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many many times to cover The Big Short and well if it is demanded then so I shall provide. This
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is going to be my review of The Big Short and a little, well actually it's mostly an explanation
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of what went on using the movie as a prop but you know gets us to the same place.
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Right, now before we go into the movie itself, which you can buy on YouTube or
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presumably a whole bunch of other places, Prime and whatever, before we get into that
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I thought let's give a few minutes just on the background of what led up to it because it was
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a kind of perfect storm of factors that led into it. I want to start the story, you could start the
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story in a number of places but I want to start it in 1997-1998, the Asian financial crisis,
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this was basically a whole bunch of Asian economies and Russia racking up far too much debt, a bit like the
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Western world is today and the Western world doesn't seem to have any problem with it because
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it seems to think, you know, debt crisis is what happens to other countries, not us. But anyway,
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the Asians got there first, that blew up rather nastily and emerging economies, Asian economies,
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they started thinking, okay, well let's keep our money in the US because that would obviously be
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better and it basically started to channel a whole load of money towards the US, that sloshes around and
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ultimately ends up in houses, in mortgages because it's got to go somewhere, that's the route that it
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went, it was a path of least resistance for a whole bunch of reasons, regulatory reasons, cultural reasons
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and so on. So massive glut of capital comes into the US, starts to push houses higher from about, you know,
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99, 2000 onwards. I remember this is just when I was getting into, getting in, out of university and
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starting to look for a house and just every year houses just went up and up and up, same in the US,
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same across the Western world. The next prelude point would have to be the dot-com crisis,
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which was, actually that was the thing that was crashing just as I came into finance.
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NASDAQ lost 78% of its value in a very short order and the key thing from our point of view
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is that Alan Greenspan, who was the Treasury Secretary at the time, he decided, okay, the solution to this
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problem is if we make money really, really cheap and so he slashed interest rates down to 1%,
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did a whole bunch of things that gave rise to a, just a cheap money environment
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where if you've got cheap money, people leverage up, they take on more debt, they don't worry about
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the interest cost of all of this stuff. Again, sounds very familiar to the crisis that is brewing
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right now in the Western world. And the Fed basically decided, yeah, rather than deal fundamentally
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with the dot-com crisis, rather than, you know, have a genuine clear out and a reset of the system,
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we're just going to paper over the cracks and we're just going to get the party started again.
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Probably a bad idea. The next prelude to it is going to have to be a whole bunch of policies,
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largely in the Clinton era. What did they have? They had an affordable housing markets bill or
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something like agenda, whatever. And they set these, what do they call them, GSE standards,
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which basically led to a race to the bottom in who was eligible to get money for a house.
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It had always been the case that banks were incentivized to lend money to people who could
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actually pay it back. Now, for the younger members of my audience, that might seem a bizarre concept,
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only lending money to people who could actually pay it back. But that is genuinely how the financial
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world used to work at one time. So Clinton came along and he was like, no, no, we want immigrants
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and people from disadvantaged backgrounds, however that is defined, to be able to buy a house, even if
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they can't afford it. Don't let a little thing, like them not being able to afford it, stop them
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from buying a house. So they did, was it CRA enforcements, the other thing they did. There
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was loads of pressure to reduce racial inequality in who was getting a house, because of course the
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only reason why people with different levels of melanin might not own a house is nothing to do with
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their propensity to pay what they owe. It must be racism on behalf of the banks. So that was all,
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well, with social engineering through the markets, effectively. I'll also flag securitization rule
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changes. So the Fed and the SEC basically changed how quickly a financial institution could basically
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shift something off their books. Why does this matter? It's because if you, if you make a loan
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and you have to sit with it for a number of years, you're going to be careful about that loan
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not being shit. But if you can ship it on to somebody else, somebody who looked less closely
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at it, the ability of the underlying to pay than you did, well, you don't care. And actually,
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if you can make a turn by doing that, suddenly you're thinking, what I can do is I can just go
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and do a whole load of dodgy deals, package them up, ship them on, make some money, do it again.
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Why do I care if the underlying is dodgy? And so that started to lead to, well, a boom in mortgages
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and lending and debt-fueled investing. You've got to remember the demographics are changing at this
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time as well. Boomers are a big generation and they are just starting, some of them, the earliest
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retirees are starting to retire at this time. And certainly, you know, there's going to be a lot
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more of them retiring over the coming years. Pension funds need yield, they need income,
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and mortgage-backed securities look like the perfect mechanism for doing this, so that provided
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it as well. And actually, one other factor that I might as well throw in is the perceived safety,
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which was a product of the rising liquidity throughout this era. I mean, I talk about liquidity
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a lot at the moment because it's becoming particularly acute. We've got into these liquidity cycles.
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Actually, they really started around the dot-com bubble. You've got on this four to eight-year
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cycle of liquidity surging up and down. It started in 2008 and it looked, sorry, started in 2000
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and then every four to eight years you have some, well, every four years you have some kind
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of blow-up and quite often every eight years you have a much bigger blow-up. That was happening.
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Banks were deploying value-at-risk models, which were basically telling them that everything
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looks good because your value-at-risk is manageable. Basel II regulations, might as well throw that in,
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that encouraged holding safe investments. What do they define as safe investments? Government debt
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and mortgages. So you've got a whole bunch of factors, not blunt, because this film very much
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focuses on, oh, the banks are bad. Yes, but the government also, the reason I ran through that
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whole list is because the government did a mountain of stupid shit that then allowed the banks and set the
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condition for the banks to do what the banks do, which is to make a turn on it, because you've
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created a system where they would basically be stupid not to do it. Right, now we need to move on
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to, before we get into playing any video clips, this story is not going to make any sense unless I explain
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the financial products that go into it. Now, I remember doing a whole bunch of financial exams in my
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youth. A whole bloody load of them. And I didn't realise it at the time, but this movie, The Big Short,
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has explained to me that actually the way that you get across explaining complex financial products
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is to have Margot Robbie in a state of undress, which seems obvious in retrospect. But I didn't know
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that at the time, but who am I to question financial orthodoxy on this particular occasion?
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So, here we go. Here's Margot Robbie in a state of undress. And we are going to use that to explain
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mortgage-backed securities, just like they do in the movie. I'm not going to use her explanation
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because it wasn't that good, but mine is better. So, basically, you've got a mortgage. You know
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what that is. The bank, well, actually, you sell the bank a mortgage contract. It's technically the
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way it works, but okay, fine, whatever. The bank sells you a mortgage or whatever. And you then pay
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them money every month. And depending on the type of borrower you are, you have got good capital
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behind you, good job, very industrious, very conscientious. You know, you're very likely
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to pay your mortgage. Or you could be somebody who's income, you could be a shit borrower,
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to be honest. It could be that. So, you get a whole bunch of these mortgages and you package them up.
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And the best stuff, the best mortgage lendees go in the first tranche of this product,
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the senior tranche, AAA rated. So, bond rating agencies will look at the mortgage product
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that you put together, a bundle of mortgages. And, you know, the package will be this. And the deal
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will be basically, okay, this package contains really good mortgages, probably okay mortgages
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and dodgy mortgages. And you can choose which tier of this product you want to invest in.
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So, the senior tranche, the mezzanine tranche, and the equity tranche. Now, the way it works is the
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yield gets higher the lower quality you go because you're taking more risk. If you want to take less
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risk, you just buy the senior tranche. And these guys, when income comes in from wherever it's
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coming in, senior tranche always gets paid out first. And then once they've been paid,
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mezzanine tranche gets paid out. And then equity tranche gets paid out, okay?
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All right, makes perfect sense. Collateralized debt obligations, a little bit trickier. So,
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we're going to need Margo again to help out. So, what that did is, okay, let's say
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you've launched your mortgage-backed security and you've sold out of the senior tranche
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because the type of people who buy fixed income products, they don't like risk, but they do like
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income. So, that sells out. And only a bit of your mezzanine sells out, none of your equity tranche
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sells out. Well, what are you going to do with it then? Well, what you can do is you can basically
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take the stuff that didn't sell and you can repackage it into a new product, into a collateralized
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debt obligation. Thank you, Margo, for helping. So, this was normally loads and loads of mezzanine
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tranche. But if we take a whole lot of them, so there's lots of them in a new product, well, now
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we are, and this is the clever bit, diversified. And that reduces risk. If you are, if you have
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been trained by the books in finance, diversification lowers your risk. So, if you take a whole load of
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shit, but there's a lot of shit, now it's good shit. Hope that makes sense. So, then you've got
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a new collateralized debt obligation. And now, the senior tranche of this is made up of the middle
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tranche of the previous lot, but just more of it. And that gets a AAA rating. And now, the insurance
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companies and the pension providers and the foreign governments or whatever, who are looking to buy
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this product, don't drill down right down to the underlying level. They just look at the rating and
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say, oh, look, senior tranche, AAA rated. Yeah, I'll have some of that. So, that then goes in.
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And then, you've still got the lower tranche of this, except the lower tranches of this really are
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absolutely toxic. Bad shit. Now, we need to get into credit default swaps. This is going to be the
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most complicated bit. So, I needed Margo completely nude for this. We've added a couple of the Lotus
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Eater stickers, just because it was a little bit raunchy. Well, I suppose she's not complete. She's got
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stocking on us, but stockings don't cover anything important. So, that's fine. It works for this
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purpose. Right. Credit default swaps. What's going on with this? You can buy insurance on your car,
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right? And that is, if you have an accident, you will be made whole on the cost of repairing your car.
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Right. But what if you could buy insurance on somebody else crashing their car? That's kind of
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it. So, a credit default shop is basically just insurance. And normally, you would buy this
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insurance if you held the underlying bond. But actually, they are tradable. So, you don't have
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to hold the underlying bond. You don't have to use it for its original intended purpose.
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You can just take a view that I think that such and such a thing is a bit suspicious, and therefore,
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I'm going to do it. Now, credit default swaps on mortgages is not a thing until we get into our
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characters. When we get to Michael Berry, we're going to talk about how he sort of effectively
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created this market. It didn't exist. But credit default swaps will exist on things like government
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debt and corporate debt and a whole bunch of stuff. So, this was a well-established product.
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And here's where it's get clever, you see, because it's insurance. The cost of insurance
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is linked to how risky a thing is perceived to be. So, look, I've got the tranches up here on my
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little slide. And at the bottom there, we've got the senior tranche. Now, let's say you are going to
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deploy 50 million of your capital to buy insurance. If you are buying insurance on something extremely
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safe, then the insurance is not going to cost you very much, right? So, your 50 million of insurance
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buy could get you a notional cover of billions. So, your likely payout could very well be billions
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because you're insuring something that is supposed to be safe and not going to need the insurance and
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therefore they sell the insurance to you cheaply. Whereas up at the equity level, the chances of them
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having to pay out is a lot higher and therefore your 50 million buy gets you a notional smaller level
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of coverage. You know, just like if you're a 17-year-old boy racer driver, your insurance is
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going to cost you more than if you're a very safe, sensible, you know, Miss Daisy or something.
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You know, you're going to pay a lot less for your insurance. This will be key later on when we get
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into the characters, which I think is about our time. Right. So, having explained how all of that
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works, we now need to talk about our first character, Michael Berry. Now, he was a clever chap. He was a
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former neurologist, I think it was, self-taught investor. He founded Scion Capital, it was, in 2000.
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He did, it was a family money and personal funds, was very successful and he started to attract
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additional capital. Other people came on board. He was a deep value investor, a Warren Buffett
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style investor. And by 2004, after only being in business for a few years, he had 600 million
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under management. The way that these hedge funds work, it's a very attractive model. You get,
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it's what's called the two and 20 model. You basically get 2% of whatever it is you're managing
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every year as a fee. And then if you outperform, you get 20% of the upside. So, it's a very attractive
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model. Now, in 2005, he started looking at the prospectuses for the mortgage loans, for the mortgage
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backed securities. It actually started just sitting there and reading through them. Must have taken him
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a very long time. He read all the small print and he started to realise that these things were
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nowhere near as high quality as they were supposed to be. Especially the CDOs, the collateralised
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debt. You know, the bundles of mortgages. What was in the bundles wasn't that good. Now,
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I think maybe at this point, we need to sort of play our, oh, I need to put my earpiece in.
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We need to play our first clip to get at what is going on. So, let's play this.
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It's a matter of time before someone else sees this investment. We have to act now.
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How do you know the bonds are worthless? Aren't they filled with fucking thousands of pages
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of mortgages? I read them. You read them? I read, yeah. No one reads them. Only the lawyers
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who put them together read them. I don't think that they even know what they've made. The housing
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market is propped up on these bad loans. It's a time bomb and I want to short it. Through
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what instrument, Michael? There are no insurance contracts or options for mortgage bonds. The
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bonds are too stable. Lawrence, this is what I'm going to do. I am going to get a bank to
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Right. Okay. So what's happening there? He's gone through these mortgage agreements. He's
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realized that they're bad. They're full of trash. And actually the key thing that he realized
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is that a large number of these loans in there were not only subprime, what we now call shit
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mortgages, but they were adjustable rate mortgages. Meaning that you started with a teaser trailer
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and then the rate went up quite significantly after that. And the people who were buying these
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subprime mortgages could probably afford the teaser trailer, but they definitely couldn't afford
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it when it adjusts. And because we had got into bubble territory, more and more of these mortgages
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had been sold. There was going to be a big glut of people who had to refinance in 2007 once
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the teaser trailer rolls off. And then it was going to lead to a glutton supply in the housing
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market. And that the mortgage-backed securities were basically going to go bad. Yeah, 2007,
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2008, there was going to be a huge amount of these adjustable loans rolling over. He realized that
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many borrowers had no income verification, no assets. Was it ninja loans? They called them no income,
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no job. Can't remember what the A was now. And the loan to value ratio were ridiculously high. I mean,
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sometimes, you know, more than 100%. So he realized that the default weights were going to rise
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dramatically. And that the MBSs built on these loans and these CDOs built on these loans would
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implode. Basically, he understood that the borrowers were never going to be able to repay. And it wasn't
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a probability, it was a certainty. But in order to get there, you had to do a lot of work. And most people
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just don't do that. But he did. So he was in the situation of having to try and explain to his
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investors, you know, what is, why is he doing this? And that is a consistent problem that he has in this
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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,
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respectable name. So he basically just went to Goldman Sachs and Deutsche Bank and so on and said,
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I want you to create a market, explain what he wanted to do. And their team of lawyers and product
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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.
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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
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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,
00:26:11.960
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.
00:27:23.440
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
00:27:51.320
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.
00:29:15.120
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
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