“The Big Short” — some questions

Note:  Netflix added The Big Short recently and I watched it a couple of nights ago.  It’s an excellent film and quite innovative in its faux-documentary style.  But it left some very big questions in my mind.  As it happens, I know a couple of M.B.A.’s, and so I sat down and wrote one of them an email yesterday.  The M.B.A. in question hadn’t seen the film yet, but I thought I’d send my questions before s/he did, to prime the pump a little, so to speak.  Here’s my (slightly amended) email, FYI.


Christian Bale as Dr. Michael Burry

I think what I’ll do is ask my questions first, if you don’t mind, and then you might be able to watch the film – with your M.B.A. eyes – and see what I missed.  I think it’s an excellent film, although very unusual in its mixed-format mode of presentation.  Interesting to see Steve Carell play a heavy for a change, too – and he played his part well, I thought.  The film was quite different from what I thought it would be.  It turned out to be the semi-coordinated story of how four different Wall Street players — namely, Dr. Michael Burry, Mark Baum (and his crew), Jared Vennett, and the team of Charlie Geller and Jamie Shipley — came to pretty much the same startling conclusion that the then-booming housing market was in fact a bubble waiting to explode.  They all, therefore, decided to bet, and bet big, on the immanent failure of the bonds that reflected the great wealth accumulating in grand pools of U.S. mortgages owned by big banks or investment firms – like Bear-Stearns or Morgan.  In the parlance of the film, they “shorted” those bonds and then waited around for the housing/bonds market to crash.  The waiting, with its various perils and disappointments, supplies the dramatic tension of the film – and it’s good stuff.  One of the film’s chief strengths is that it educates financial dolts like me about how the whole thing happened and unfolded.  I particularly liked the blackjack scene with the Spanish actress, explaining what “synthetic” CDOs or CBOs or something like that actually were.  Anyhow, good as the film was in its educational methods, it still left me with some major unanswered questions.  So here goes:    

  1. The whole “shorting” thing is unclear to me.  The banks that held these bonds or securities seemed to be willing to sell, in effect, “insurance” that they would not fail.  These were called “Credit Default Swaps” or “CDSs.”  These CDSs had enormous payout ratios – like 100-to-1 or even 200-to-1.  And they, ultimately, would become the source of the great wealth that our courageous, go-their-own-way investors would reap when the housing/bonds market did indeed crash.  But here’s what I don’t get.  We’re talking about enormous – I mean ginormous! – quantities of money here.  Where did all that money come from.  The whole CDS idea was still quite new in 2005-7.  Wikipedia says it was invented in 1994.  Moreover, the courageous investors found that their requests to buy the CDS, in big numbers, were greeted with laughter by the sellers – that, because “nobody in his right mind” at that time was, or would have, bet against the housing boom.  Well, if no one was buying those CDSs, then there weren’t a lot of premiums being paid into the reserves that backed them in case the housing market actually did fail.  So, where was all the money coming from that backed, and ultimately paid out, these CDSs?  It can’t have been just from the premiums paid by our four brave Wall Street mavericks, that wouldn’t supply enough money, and anyway they’d have ended up getting their own money back in the end.  No big jackpot.
  2. Moreover, the CDS seem to have been sold by the very companies holding these big reservoirs of bad mortgages.  So, when those companies failed – because of the crash – why didn’t their capacities to fulfill their obligations to the CDS holders also fail.  This possibility seems to play a prominent part in the late-middle section of the film.  But then the mavericks still make out like bandits and all their dreams come true.  I don’t get what happened to the looming threat that when the crash came it would bring down the banks and investment firms so completely that they’d have no money to pay off the CDS holders.
  3. Steve Carell’s character is under a lot of pressure to try to sell his CDSs when something strange happens.  The mortgage default rate climbs to a perilous level, suggesting that the whole bonds and “Collateralized Debt Obligation” (CDO) market was going to fail big.  But the bonds prices, mysteriously, stayed high, even when the underlying securities or mortgages they represented were collapsing.  So Carell’s backers wanted him to sell; he didn’t.  He held on a long time, but even after everything collapsed his assistant was begging him to sell.  This raises two questions for me:  What was the source of the assistant’s urgency near the end of the film?  In other words, if Carell held out past the Armageddon in these bonds, then what was the additional failure he would face if he held on a little longer?  Second question, if these CDS, by so late in the game, were in peril of becoming worthless or nearly worthless (as the assistant worried), then who in their right mind would have bought them off of Carell at that point anyhow?

I have more questions.  But I’ll stop there.  It’s all really quite opaque to me even though I think the film actually tells a very simple underlying story:  namely, (a) some mavericks independently figure out the housing bond market is actually built on sand, (b) they bet very, very big on that being true by shorting that market bigtime, (c) they are deeply stressed by the failure of bonds prices to reflect the skyrocketing mortgage default rate behind those bonds, and then, finally, (d) they get the payday they dreamed of.  Even simple as all that is, it leaves a lot I can’t quite grasp.

Hope you can help me out with this!  Thanks.

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