The Greatest Irony in The Big Short
Explaining credit default swaps and investigating the realities of the mortgage crisis
“We are going to wait, and we are going to wait, and we are going to wait, until they start to feel the pain — until they start to bleed” — Mark Baum
Everybody knows this scene in The Big Short. It’s the part where Mark’s team is trying to convince him to sell something called ‘swaps’ when the market opens. They are afraid that if the banks will go under, they will lose their position because the market to sell these securities won’t exist.
So, let’s go over exactly what the hell they are talking about, and, why they seem to be arguing with each other toward the end of this scene.
You need a succinct introduction to something called naked credit swaps.
But, to introduce you to that, you need to understand that a credit default swap itself is just an insurance policy. Let’s say some bank owns your loan on your home. The bank feels weird about your ability to pay the loan back in full. They buy insurance, or, sell a credit swap on that loan they own. This makes the purchaser of the swap liable in the event that the loan goes into default (they will owe the seller of the swap the full price of the remaining loan plus any rolling fees they paid up to that point). In the event that the seller of the swap is wrong, they will lose the insurance premium they paid to the buyer.
The best analogy to the stock market is purchasing a put option. In the event that the stock is destroyed in value, you’re guaranteed the value of your stock at a strike price.
As you can see above, if you own a stock that is selling for $150 currently, you can purchase this above. If you own the underlying asset for which you are purchasing this form of insurance, it is called a protective put. As your actual holdings fall in value, your contract increases by that exact amount + a little time value — also known as the premium you paid (in this case, $5 a share).
Here is a snippet from Michael Lewis’s book, The Big Short:
“The only problem was that there was no such thing as a credit-default swap on a subprime-mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn’t even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage-bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit-default swaps on subprime-mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.”
However, in the stock market, you don’t need to own the underlying asset to purchase the put. In that case, you are buying what is called a naked put. You can routinely bet on the downfall of entities and assets that you don’t directly own.
There is no equivalent for this in the mortgage-backed security world outside of credit default swaps. The best analogy for a credit default swap is a protective put.
Fast forward now to Burry and Baum. These guys wanted to do the equivalent of purchasing a naked put, but they wanted to do this for the subprime mortgage bond market. Remember how we went over how that credit default swap was essentially an insurance plan to protect the lenders who loaned money to bad debtors? Burry and Baum knew that the credit default swap market worldwide had ballooned over $60 trillion by 2007. They knew it wasn’t sustainable but they didn’t have an instrument to bet against this gigantic explosion except to actually own the assets and then sell the bonds themselves for insurance.
So, those scenes where they are talking to the middle-market banks are exactly that; trying to figure out a way to create an instrument to bet against the bad debtors without actual direct involvement with the asset at all.
For this reason, the naked credit default swap market has been compared to buying fire insurance for your neighbor’s house — creating an incentive for arson. Other criticisms include that the naked default swap market is now up to 80% of the total credit default swaps in circulation. In line with not actually owning the underlying asset themselves, the naked default swap is also called synthetic because there is no true limit on how many can be transacted (i.e. original lender can write a default swap to a buyer who then sells that swap off to another buyer if the basis points on that swap go up — meaning the original debtor becomes less likely to pay their obligations. This pattern can go on for a good while.
Most people have asked for a complete ban on these securities that Baum and Burry asked to be created because their main method of profit is to hope that the foundation of the financial system itself will collapse.
However, regardless of opinion, Burry and Baum wanted to hold as long as possible because the idea is that the banks were either the
- lenders for the bad debts.
- purchasers of the first credit default swap on the loans.
In either case, the vast majority of them had a direct involvement in the creation of the system that was going to collapse.
The mathematics works out something like this:
A bank has handed out loans for homes. These loans span from great credit, medium credit, and bad credit. They group these loans into something called collateralized debt obligations, or, in our specific case, mortgage-backed securities. These are basically bonds, but for home-loans.
These bonds can then be insured by what we went over beforehand. The bank who owns these loans can buy insurance, or a credit-default swap, from another bank like itself. If, let’s say, the bank wanted to insure a $20 million bond for the bad credit group, then they will attempt to sell that bond to someone who is willing to back it, for a small premium (Assume something like 5–10% of the total value).
Now that the secondary bank purchased this insurance, or credit default swap, one of two things to occur:
- They wait for the debt obligation to be fully paid (in which nothing changes but they gain their 5–10% in premium).
- The debt obligation is due because the debtor defaults (whichever point this happens, the secondary bank owes the primary bank whatever the remaining value is for the bond).
So, Baum and Burry created a third option. The initial bank (the lender) can create a new financial instrument that allows people to bet on downward movement (or collapse) of that asset. In this case, the lender can create a naked put option; or, a way to bet on whether that underlying asset will fall apart or not. This means that the original payment that is meant to go to the lender in case of the collapse of the asset will instead go to the person or entity purchasing this put naked. I’m saying naked puts, but this can also just be seen as short-selling. Looking at the graph above helps understand this a bit better.
In that event, let’s say that Baum and Burry imagined a scenario where they thought the housing crisis was right around the corner, then they would have purchased a naked credit default swap with a 5% premium over the original swap. This means that they are only buying the derivative product and have nothing to do with the underlying asset. Graphically, that means they would be able to acquire the full profit imaginable (on the graph above, they’d be all the way to the left before expiration of the loans).
But, in this case, it isn’t a stock you’re after, it’s people’s homes. The blowback to the banks is that there won’t be enough cash to help keep them solvent since the credit default swaps were originally meant to pay-out to the lender being insured, but the lender now sold that pay-out to someone betting on economic calamity.
In that case, the fund betting against the lenders and for the housing crisis win and the lenders who were guaranteed the payment to stay afloat due to their insurance policy is left with nothing. Less than nothing, in fact. They are left with less since the debtors completely defaulted and the assets are now in a distressed state.
Here is what the process might look like:
The lender sells credit default swap to the bank for a guarantee of the asset ($20 million in loans).
The bank now has the premium and the obligation to pay lender in case of economic downfall.
Lender also sells someone a security betting on the loans collapsing (meaning that they want the $20 million insured in payment). This is without ties to the actual asset.
In the event of the lender failing to recover the loan payments, the bank who originally insured their loans would pay them $20 million minus the premium minus the amount of time that had gone by in payments. However, since another fund sold a default swap betting on the original default swap, the $20 million doesn’t go to the lender but to the fund who bet against the financial soundness of the loan.
The fund would end up getting paid $20 million minus the first bank’s premium minus the amount of time that had gone by in payments minus their premium.
All in all, since Burry and Baum knew the collapse was imminent, the longer their naked CDO runs its course, the higher their profit margin becomes. The banks continue suffering until full misery is accomplished where the debtors fully default and the insurance payment goes to the entity they sold the additional naked security to. One extremely important aspect of the movie, and throughout the convention of this naked swap, was that it was being mispriced even as the default levels went up. This is directly related to the aspect of selling to make banks miserable because the banks continued the process of selling AA and AAA naked bond swaps that were known by most to be absolute garbage. However, the people owning those swaps didn’t realize a gain over time because the bond values actually moved up even though they were defaulting, causing the premiums on the naked swaps to decrease in valuation (causing the people shorting to lose money in the short-run and continue to pay their obligations on the loan and save the banks).
In the second half of the movie, you see that the banks are still demanding the loan payments on the bonds even though they’ve passed their breakeven price. This would be the equivalent of purchasing a naked put on an equity for a premium only to have that stock value go down but your premium stays the same or decreases in value. The other thing they share a concern about is the fact that the institutions who wrote these shorting instruments might go bankrupt and cease to exist, and their contracts might go into that bankruptcy as a line item, rendering their contracts worthless.
When Mark finally realizes what is happening on that phone call at the end of the movie, he says, “If we sell [our swaps], we will be just like the rest of them.”
He’s taking a look at how his fund will profit over a billion dollars but that the average person is going to lose their home and that the suffering won’t be on the part of the banks but on the American people: The taxpayer.
And, he was right. The taxpayer essentially bailed out the banks that caused an entire economy to globally collapse, and the American people cumulatively lost around $7–8 trillion in homeowner equity over two years or so.
So while that scene Mark wanted to watch the banks suffer, by the end he realizes that his profits will be directly connected to the misery of the average American family losing their home.
In that scene, he’s angry and wants correction. By the end, he’s disgusted by the system and himself.
It’s the greatest irony in The Big Short.