This is going to be the worst movie review ever as I have only seen the first 79 minutes of the movie “The Big Short”. I watched the first 60% of the movie on the flight from Chicago to Toronto, then wandering around the airport I saw the book sitting prominently in a store display shelf. Five days later I finished the book. Wow, it’s good.
It’s been eight, nine years, since the bottom of the “housing crisis” happened, we’ve all heard about mortgage backed securities (MBS), sub-prime mortgages, and even CDOs (collateralized debt obligations). I understood this stuff decently well, before seeing the movie and reading the book, but it clarified things related to the derivative market I just never really understood. For example, I get that in the derivative world you can buy fire insurance on homes in the mountains in remote California before fire season. I didn’t understand that there are people who wanted to sell you fire insurance on remote mountain homes in California before wild fire season.
In other words, short sellers made the collapse even worse because they helped fuel credit default swaps. You see, to short the market, you have to sell high first, then some time later buy low, ideally buy at zero, bankruptcy. So when you short something there is a really big and important question, who is buying at this price? I sold my Tesla stock at about $80 in early 2013, because I thought it was overpriced. Since then it has gone up to $286 and already back down to $201. For a company with hardly any earnings, by classical valuations, it should not have a market cap of $26 billion. I’ve never shorted anything, but Tesla would be near the top of my list. And I’m saying that as a guy that wants to buy a Tesla. I think one day it will be worth more than $26 billion, but we are not yet at that day. Point being, there are people that believe in Tesla so much that at $201 a share they want to buy more stock.
Back in 2005 through 2007 a handful of people, like ten, were buying credit default swaps, insurance, on CDOs and sub-prime MBS bonds, and you have to wonder, who in the world was selling them this stuff!? It was pensions and hedge funds and of course the big banks, and none of the bankers really cared, because they get paid on commission. Granted these guys shorted tens of billions of dollars. The book mentions John Paulson who has been vilified for his role in the whole collapse, but really he’s one of the few who realized how crazy it really was. The movie the Inside Job vilified him too, because he convinced the big banks to create these derivatives. The funny thing is though, when they first started shorting these various bonds there was no real mechanism to short, no credit default swap for much of this stuff. Later on, it became a hot commodity and the banks were happy to broker between the short sellers and the pensions and hedge funds.
I really need to make a graphic to describe it because it makes a lot of sense in my head but I am struggling to explain it. (45 minutes later...)
|Credit Default Swaps|
Credit Score: 610
Length of History: 10 years
Type of Mortgage: 2/28
Credit Score: 685
Length of History: 4 months
Type of Mortgage: No money down, interest deferred upon request, adjustable rate
So it's a little simplified, I neglect tranches totally. Every arrow represents where a banker has to do something, and gets a commission. That helps to explain why bankers were so willing to do these transactions, more volume = more commissions and higher pay. Now "The Big Short" doesn't go into detail on the investors that bought credit default swaps, but if I had to guess I would guess there were sold nearly the same as the underlying bonds and CDOs. The problem was when this machine got rolling there was more incentive for everyone in the sub-prime market to make the market bigger, and get more commissions because the people who ended up owning the risk were the investors who really had no idea what exactly they were buying, except that a huge chuck of this stuff was rated AAA, as good as debt gets, because the Wall Street guys manipulated the ratings agencies into giving out such good ratings.
Fraud? What this all a bunch of fraud? Well, the more I think about it, I don't actually think so. Sure there are some examples here and there, but most people up and down the financial chain were blissfully unaware of what could happen. I mean, if housing prices didn't increase at 5%, it would all collapse. But in their ignorance everyone from the mortgage sales people on the ground to the "CDO managers" selling to investors did not think that prices could drop, or that when they did drop they would drop all across the country, and even world.
Point being, if you have two hours, watch "The Big Short", and if you have ten hours, read "The Big Short".
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