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I'm your host, Richard Coffin. We're back once again with another movie review. This time, finally going after the one that's been highly requested ever since I started this series, the big cheese in the space of finance films, The Big Short.
This is a very popular film with a star-studded cast including the likes of Christian Bale, Ryan Gosling, Steve Carell, Brad Pitt. Margot Robbie's in there for a bit. It's a movie based on the Michael Lewis book that follows three separate groups of investors that all realize the housing market's about to crash leading up to the 2008 financial crisis.
And they all decide to take a big bet against the housing market. Hence the title, The Big Short. And in the process of researching for their investments, they uncover a number of unethical and unnerving things happening on Wall Street that would ultimately turn this housing market correction into a global financial crisis. It's a really well done film and it's actually one that I've talked about before. One of my earlier videos was explaining the celebrity explanations in the big short because one of the things this movie is known for are these celebrity cameos where these people come on and explain complicated financial products using easy to understand analogies.
Nonetheless, I have had a lot of requests to revisit the film and cover the plot at a higher level. Given that as great as the movie is, it does get complicated at times and can be hard to follow and on top of that, the original video of mine did actually get copyrighted by Paramount Pictures, so part of this is out of spite. Nonetheless, I will leave a link to that video if you do want to check it out because I'll probably be skimming over the celebrity cameos for this video. But without further ado, let's hop into the big short. Our movie begins in the past with an introduction to Louis Raniere, the guy behind the popularization of the mortgage-backed security.
Security that's really central to the 2008 financial crisis, even though there are derivatives of the security. that exacerbated the situation. This is really the investment that's at the core of the problem. And the way the mortgage-backed security works, as explained in the film, is an investment bank will go out and purchase the rights to a bunch of mortgages, meaning the actual home loans that people have taken out to purchase properties, combine them into a pooled investment, and then allow investors to buy shares of that pool so that they can receive the interest mortgage payments from those homeowners.
Now because there are thousands of mortgages inside of these mortgage backed securities, they're considered diversified and relatively safe, even if one person defaults, it's not going to impact the whole security by very much. Not to mention that mortgages, as you know, are backed by the value of the property. So if that person does default on their mortgage, you get the property to try and recuperate your losses.
So they were considered relatively safe. And they're said in the movie to have a triple A credit rating. This bond, gentlemen, is triple A rating.
Credit ratings are something provided by an independent institution to tell you how safe or risky they think an investment is. There are a few different scales, but this one goes triple A, double A, single A, triple B, double B, single B, then the Cs and D thereafter, with each of the tiers having a positive or negative modifier to expand the breadth of the scale. And it's worth highlighting that anything triple B or higher is what's called investment grade, meaning that they're generally considered low risk, or at the very least, you're likely to get your money back.
Whereas anything below that level is called speculative or junk, meaning that there's a higher risk of the borrower defaulting. So that's the mortgage-backed security and as shown in the film, investment banks and investors love this thing. But then we fast forward to 2006 and we're introduced to our first short seller, Dr. Michael Burry, based on the real Michael Burry who runs the Sound Capital Fund.
And in this first scene, we see him expressing some skepticism about the US real estate market to a new recruit. And he gets this person to pull him all the data on the thousands of individual mortgages that make up the popular mortgage-backed security so that he can analyze them and see how healthy they really are. And he comes across some pretty concerning things.
Late payments, low FICO scores, meaning that the actual borrowers had low credit themselves, and high LTVs or loan to value ratios, meaning that a lot of these homeowners had borrowed a significant amount of their property, say 95% of its value to make the purchase. He also points out that a bunch of these mortgages are subprime and adjustable rate loans. A prime is simply an interest rate benchmark. It refers to one of the better rates you can get from financial institutions.
So a subprime loan, it might seem counterintuitive, but it means that you're getting a worse interest rate than that prime rate because you're a higher risk borrower. And adjustable rate loans mean that the mortgages themselves see their interest rates change depending on whatever the market interest rates are, which is important because rates during this time are actually on the rise. Even though these loans do have a fixed period where they keep what's called a teaser rate, there is a point after which it will regularly adjust to whatever the market rate is. With Michael Burry expecting that to kick in in the second quarter of 2007, after which he expects a bunch of these mortgage borrowers to not be able to afford their payments, which will cause a bunch of the mortgages to fail.
which is why he wants to short that market. Now, as for why these mortgage-backed securities saw their mortgages deteriorate so quickly, we get this quick scene from Margot Robbie where she explains that because banks earn a 2% fee whenever they sell a mortgage-backed securities, but there's only so many mortgages out there that are higher quality or not so risky, they stretch a little bit. They start putting some subprime mortgages into their investment product. That way, they can keep that profit machine churning, right? Which.
as you would expect, will eventually cause problems if people are treating these investments as low risk. So how does Michael Burry go about shorting this mortgage-backed security? Well, he decides to go to a bunch of banks and get them to make him a new type of product, a credit default swap against the mortgage-backed security.
Now, a credit default swap is what's called a derivative, which is a contract or some sort of investment that derives its value from the value of something else. And the best way to describe a credit default swap is like an insurance contract. where basically Michael Burry is taking an insurance contract against a mortgage-backed security default.
So if homeowners start to default on their mortgage payments and the mortgage-backed security is no longer able to pay its investors what they're owed, then Michael Burry will receive a big payout. Now also like an insurance contract, Michael Burry will have to make regular premium payments. And this is where we're presented with one of the first problems these short sellers face, which is that if this bet takes too long to pay off, if it takes too long for that event to happen, they might run out of money because they have to make these expensive premium payments over time to keep this contract active. Even if they end up being right, it won't matter if they run out of money. And in a later scene where one of Burry's investors storms his office demanding his money back, we're actually presented with another challenge, which is that Michael Burry has to keep his investors in the fund, even though he's actually losing them money on these regular premiums.
Because if they try to withdraw their money and if they reduce the capital within the fund itself, it will actually void the contract agreements with... the banks that he took this credit default swap against, meaning that all the lost money would be for nothing. So that's the introduction to Michael Burry. Throughout all of this, we're also introduced to our second short seller group, which is Mark Baum and his fund, Front Point Partners.
Now Mark Baum is a different name, but it's based on the real Steve Eisman, who, like Dr. Michael Burry, did in fact, you know, take these short positions against the housing market. And in the movie, his fund happens to get a wrong number call from a banker from Deutsche Bank. who's trying to sell them on these credit default swaps that Michael Burry is buying up so rapidly. Now the banker in question is actually the narrator of the movie Jared Vanette, who overheard from some other bankers who were celebrating at a bar, some idiot is going around buying a bunch of credit default swaps, which they think are more or less free money for them.
He looks into it and sees what Michael Burry sees and goes to present the opportunity to Mark Baum and his fund, which is where we get this famous Jenga block scene, which he uses to demonstrate how messed up the mortgage backed security market has become. And is used to describe the concept of tranches. To quickly explain how tranches work, while a lot of the older mortgage-backed securities were simple pass-throughs, meaning that investors just split whatever interest payments were made into the pool, tranches were a way for investors to take on different risk and return characteristics from the same pool of mortgages, with the idea being that investors can buy different tranches of this security.
and be given different payment priorities and different payment amounts. So you can buy a B tranche of this investment and get paid more of the interest that goes into the pool, but if there are any failures, you're the first one to take those losses and lose that return. Or alternatively, you can take a AAA tranche, which would get first priority for payments.
You might earn less, but you're also given a lot more of a safety net. So you can see why investors would think that these higher tranche options would be deemed relatively safe. But as Jared explains, these mortgage-backed securities have filled up with riskier and riskier mortgages, which is threatening the whole security all the way up to the top. And then that happens. What is that?
That's America's housing market. Worse yet, in the scene, we're introduced to the collateralized debt obligation or CDO, which the easiest way to explain is that it's like a mortgage-backed security of mortgage-backed security tranches with itself having its own tranche structure. So naturally, it really obscures the actual underlying and the risk you're facing as an investor.
With Jared explaining that banks are actually taking the lower tranches from mortgage-backed securities that they can't sell, the single Bs and double Bs that are deemed too risky, and they're throwing them into these collateralized debt obligations. And because these things are considered diversified, they themselves are getting AAA credit ratings. And this is where we get the Anthony Bourdain scene, where he compares the whole thing to taking fish that people don't want to eat in your restaurant.
and throwing it into a seafood stew. So there's a pretty bleak picture about the financial engineering happening on Wall Street, but Mark Baum and their gang decide to investigate for themselves. They go to a number of actual neighborhoods, find for themselves a bunch of abandoned properties, discover a bunch of mortgage fraud where people have lied about their names or occupation on their applications.
And in this scene, we also uncover some shady business coming from mortgage brokers themselves. The mortgage brokers I talked to explain how 90% of their deals are adjustable rate, how they're even willing to give out ninja loans, which means no income, no job. approved. And as for why they're making all these risky loans, they explain that not only do they themselves actually earn a higher commission from these riskier mortgages, the mortgage originator is actually able to sell the mortgage to an investment bank over just a couple of days.
So they themselves, even though they lent out this money, don't retain any of the risk because they get their money back in selling this mortgage to an investment bank, which leaves us with a pretty ugly chain of conflicts of interest. The mortgage brokers and originator don't care about the risk of the loan. Because they're able to sell it to an investment bank and the brokers themselves actually earn a higher commission from higher risk loans. And the investment banks don't care about the risk of default because they're simply taking the mortgages, packaging them into mortgage-backed securities, and then offloading them onto investors. So they don't retain any of that risk themselves.
Which is how Mark Baum happens to have come across a stripper who has five different properties. Hey, there's a bubble. So Mark's right-hand man Vinny calls Vinette to buy the credit default swap and during this call I won't spend too much time on it but Vinny asks Finette what's in it for him. Why he's willing to make them this trade despite the fact that he represents the bank that will make a massive loss if they end up being right. To which he says this.
What do I get out of it? Easy. I got a 20 million a month negative carry.
Now to quickly explain a carry simply refers to the return you earn simply by holding something. So a negative carry is the cost of holding something. Things like commodities like physical metal and oil. will have a cost of carry because you have to store it somewhere.
So Vanette's explaining that he has some investments that are costing him $20 million a month that his employer is trying to pull the plug on. This credit default swap will help to offset that with the premiums it brings into the company. And when Mark Baum and his team go to sell their credit default swap, they'll have to go through Vanette.
And Vanette admits that he'll fleece them on the price, kind of charging a massive implicit fee to keep himself. But that at the end of the day, they won't care because of how much money they make with the credit default swap. So even though Vanette's employer is going to suffer, he's going to get himself a very nice paycheck.
Right now I get the sprinkles and yeah, if this goes through, I get the cherry. But you get the sundae, Vinny. You get the sundae.
So that's how Mark Baum and his gang end up with their short position. To take a quick pause, it should be obvious by now that complex financial engineering presenting a pretty scary risk to the finance sector here. But fun fact for you, finance also faces a big risk from cybersecurity, having the second highest average cost of data breaches behind only healthcare.
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already have on top of that nordvpn also has this awesome new feature called threat protection which helps block intrusive ads and trackers scans downloaded files for malware and blocks non-malicious sites so you get a lot for the one subscription and if you'd like to check them out you can visit nordvpn.com slash the plain bagel to get extra subscription time on a two-year plan with a 30-day money-back guarantee so you can try it risk-free again that's nordvpn.com slash the plain bagel the third group of short sellers we meet earlier on in the film i'm kind of jumping around to keep the stories linear is Brownfield Investment, which is two guys, Jamie Shipley and Charlie Geller. They're again fictional characters, but their fund is based on the very real Cornwall capital. And at the beginning of the movie where we meet them, we see them trying to get what's called an ISDA agreement with JP Morgan.
I don't think the movie does a great job of explaining what an ISDA agreement is. They just describe it as getting a seat at the big boys table. But to quickly describe it, ISDA stands for International Swaps and Derivatives Association. And an ISDA agreement is simply a set of terms between two parties that will let them buy and sell over-the-counter derivatives with one another, meaning that they don't have to go through an exchange or some third party.
They can agree to derivatives contracts directly with one another. So an ISDA agreement with JP Morgan would mean that this fund would basically get access to a bunch of derivatives. that they can buy and sell with JP Morgan directly. Now, the two characters sort of have this humiliating rejection from JP Morgan because they're far too small to get an ISDA agreement. But in the lobby of JP Morgan, they happen to cross the investor presentation of Vanette for the credit default swap that he goes on to pitch to Mark Baum.
They look into it, realize that there's something to this thesis, and decide to reach out to an ex-trader friend of theirs, Ben Rickert, to try and get an ISDA agreement through him. And after some convincing, he gets them in agreement with Deutsche Bank and Bear Stearns, allowing them to short the lower tranches of different collateralized debt obligations. So that's more or less the first part of the movie. We jump a little further ahead to early 2007. And even though delinquencies are starting to rise, our investors are not making any money. In fact, the subprime mortgage bond prices are on the rise.
So obviously our investors are frustrated and Mark Baum decides to go to a rating agency to see why they haven't updated the credit ratings for these mortgage bonds that are clearly deteriorating. With them approaching Standard & Poor, the same people behind the S&P 500, and they more or less admit to Mark Baum and his team that their ratings don't mean a whole lot. And you name one time in the past year where you didn't give the banks the AAA percentage they wanted.
If we don't give them the ratings, they'll go to Moody's. Right down the block. Adding yet another player with a massive conflict of interest causing this perfect storm.
So at this point, the investors are pretty much losing faith in the system as a whole. And they decide to go to the American Securitization Forum to do a bit more digging to see if there's something they're missing. Or if people really are just asleep at the wheel here. With there being a lot of evidence of the latter.
The Brownfield gang meet up with a bunch of bankers who have no interest in talking about the risks of the market. They also talk to an SEC representative who admits that they don't have any oversight of the mortgage market. And she's actually there floating her resume with a bunch of the big banks, which might sound like a made up scenario.
But we have very real examples of this happening. I wanted to let you know, Saruthi, raise your hand, Saruthi. On Monday, she becomes a Bank of America team member. So I hope you'll take good care of her. We will do that.
And her father already works for us. Meanwhile. While Mark at the same conference manages to get a one-on-one meeting with a CDO manager, discovers some more conflicts of interest. This guy who supposedly represents the investors of these CDOs is basically taking whatever bonds the bank sends him and putting them into these products.
Doesn't take on any risk himself. But the really key thing from this scene, which is kind of the climax of the movie, if you will, is when Mark Baum discovers how massive the market for speculating on mortgage-backed securities really is. How much bigger is the market for insuring mortgage bonds than actual mortgages? About 20 times. Meaning that despite all the issues we've seen to this point, the problem actually ends up stretching much further and broader than originally expected.
The CDO manager describes two other products, the first one being the CDO squared, which is a CDO of CDO tranches, yet another layer of complexity and obscurity. But he also describes the synthetic CDO. A synthetic investment refers to something that mimics the return of something without actually holding that thing.
And a synthetic CDO is made by taking the opposite side of the credit default swaps that our short sellers are buying. With the idea being that the premiums being paid by these insurance buyers into this pooled investment will mimic the mortgage payments from a mortgage-backed security. So investors can get that similar exposure through a synthetic CDO.
So to quickly summarize, not only do you have mortgage-backed securities, which are filling up with riskier and riskier loans, not only do you have collateralized debt obligations, which are taking the riskiest tranches of those mortgage-backed securities and putting themselves into highly rated investments, not only do you have CDO squareds, which are taking the worst of those and possibly putting them again into another security with a high rating, but you also have a massive pool of people on the sidelines betting on the outcomes of these. Securities. With our final cameo scene, which has Selena Gomez and the very famous behavioral economist, Richard Thaler, describing it as being like a bunch of people making bets on a blackjack hand that they have nothing to do with. and that they can't afford but they assume is a sure bet so this is the peak insanity that we reach mark bomb decides to buy more short everything that guy has touched about half a billion more swaps michael burry actually restricts his funds withdrawals to avoid that risk of investors running away it's actually a very common thing you can see with hedge funds because they obviously don't want to be forced out of positions that are illiquid they can't sell right away and later in the year the dominoes start to fall we see some bankruptcies But the shenanigans don't stop. The investors are having a hard time getting a fair valuation for their credit default swaps as they speculate that the big institutions that they're betting against are trying to buy themselves time now that they recognize that the market's failing to exit their own exposure.
I think you mean that you've secured a net short position yourself, so you're free to mark my swaps accurately for once, because it's now in your interest to do so. And I'll quickly skim over the rest of the movie, but I do want to dive into one more scene, which is when Mark Baum's called into Kathy's office. She's his representative at Morgan Stanley, who Baum actually operates his fund under, which I don't think I mentioned at this point, but his fund is technically owned by Morgan Stanley.
And he sees that Morgan Stanley is laying off a bunch of people, and after prying at Kathy, trying to figure out what's going on, going on he learns that a single trader Benny Klieger has caused the company to have a 15 billion dollar exposure to the very real estate market that Mark Baum is betting against which means that even though his fund made the right call in the situation the company that owns his fund did not and if they happen to go under his fund will be rolled up in all of it. Now the funny thing about all this is that it's based on the real story of Howie Hubler who holds the record for one of the largest trading losses. in Wall Street history.
And the odd thing is that he technically made the right call. You see, like Mark Baum and the others, he actually did bet against the housing market. He bought credit default swaps on the lower tranches of BBs and that sort of riskier side of the mortgage-backed securities. The problem is that to afford the expensive premiums of these credit default swaps, he at the same time sold credit default swaps for the higher tranches, the AAA level.
Which again, a lot of people didn't expect that these would fail because they're the last ones to take losses, but because of that they have a significantly higher payout than those lower tranches. So on a net basis, when the whole security collapses, they ended up losing a significant amount of money. The long exposure is 15 billion. So yeah, just a fun fact about the 2008 financial crisis. And the rest of the movie really sees that crisis playing out.
We see companies going under, people being laid off. But we are also presented with a final risk faced by our investors, even though their bets are turning out to be correct, which is counterparty risk. Even though they have these massive insurance contracts that they should be paid out, with these companies going under, there's the risk that the person who owes them this insurance payout isn't able to eventually afford it, that they don't get paid what they're owed, which is notable for Brownfield because their largest credit default swap is with Bear Stearns, the financial institution that famously went under during the financial crisis. From the time you guys started talking, Bear Stearns stock has fallen more than 38%. Boom!
So our investors all managed to sell their credit default swaps on the market, with Mark Baum being the last one to sell as he's holding out, really hoping to kind of make the bank suffer, partly out of spite for all the wrongdoings they've done to customers. But as he learns that there's this bailout that's going to save the banks using taxpayer money, we're left on this somber scene where he finally decides to sell. Okay, sell it all.
And that's more or less the movie. We are given a few sort of fun facts towards the end. The very final scene in the movie ends by saying that in 2015, banks began selling what was called a bespoke tranche opportunity, which has simply been called another CDO.
Seeming to suggest that this problem might recur, but to quickly address that, yes, the bespoke tranche opportunity, my understanding, is just a sort of tailored... collateralized debt obligation. But the CEO market as a whole is still a fraction of what it was before the 2008 financial crisis. So it's still kicking, but it's pretty far from where it was back then. But that is our movie review of the big short.
Thank you guys for joining me today. I hope you found this video helpful and hopefully didn't get too technical at times. But if you did find it helpful, please do make sure to like, subscribe, all that good stuff. It does help the channel tremendously.
And let me know your thoughts in the comments down below of the movie. I know it's pretty cliche for a finance professional to say The Big Short is their favorite film, but it's up there. I quite like it. I think it's actually a good time, despite it covering a depressing aspect of US finance.
Thanks again for joining. Let me know if there's anything else you'd like me to review on the channel, and see you in the next one.