Analysis of The Big Short movie

This article written by Akshit Gupta (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) analyzes The Big Short movie.

The Big Short (2015) is an American financial drama film based on the famous book “The Big Short: Inside the Doomsday Machine by Michael Lewis” portraying how few financial industry professionals predicted the buildup of the real estate bubble before the crisis of 2008. It shows how professionals working at large hedge funds and investment banks made fortunes after the collapse of the housing bubble. The movie gives a very good insight into the functioning of the biggest investment banks and events that led to a huge financial crisis in 2008 affecting the entire world economy and leaving millions of people homeless.

Key characters in the movie

Michael Burry, Hedge fund manager at Scion Capital
Jared Vennett, Executive at Deutsche Bank
Mark Baum, Hedge fund Manager at FrontPoint Partners
Charlie Geller & Jamie Shipley, Founders at Brownfield Capital
Ben Rickert, a retired trader

Summary of the movie

The Big Short movie

The movie starts by introducing Lewis Ranieri, an executive working at Solomon Brother, a person responsible for the popularisation of Mortgage-Backed Securities (MBS) in the late 1970s. The demand for these MBS spread like wildfire with every investor running to own a couple of them. The investment banks started buying several home mortgages from commercial banks and packaged them into single bond-like security which came to be known as Mortgage-Backed Securities. The demand for these securities soared and commercial banks started issuing fresh subprime level mortgages to fulfill the demand for these products. During 2005, a hedge fund manager named Dr. Michael Burry, working at Scion Capital studies the mortgages that are been bundled into these securities to check upon their credibility. As per his findings, a housing bubble was being formed and the adjustable-rate mortgages that have been used to build these securities would eventually start defaulting. He sensed an underlying crisis in the second quarter of 2007 as the interest rates were supposed to rise by then which would affect the adjustable-rate mortgage payments.

He sees a great opportunity in short selling these instruments to make huge profits for the fund. He buys credit default swaps against these securities from different investment banks with a cumulative position of $1.3 billion. The structure of these swaps was set as pay-as-you-go which meant Dr. Burry had to pay regular premiums as the value for these bonds moved in an unfavorable direction. The premiums amounted to around $80 million each year, which upsets many of his large investors, who start demanding the withdrawal of their investments.

Jared Vennett, a salesman at Deutsche Bank, gets to know about Dr. Burry’s deal with large banks from one of his colleagues and starts to look into the real estate market eyeing a huge commission on the sale of these swaps. In the next scene Mark Baum, a lead fund manager at FrontPoint Partners, is introduced, who thinks the entire system is full of fraudulent people and low business ethics. Jared Vennett wrongly calls Mark Baum’s office, but they eventually end up meeting for a discussion over the credit default swaps that Dr. Burry has bought. Vnnett explains the concept of Collateralised Debt Obligations (CDO) to Mark and tells him about the AAA rating these bonds have despite their high-risk exposure. Seeing an opportunity, Mark, along with his team, starts their investigation into the real estate industry and visits several residential sites to know about the mortgage default risks. As per their finding, a bubble was being built up and they decide to buy credit default swaps from Vennett.

The third scene introduced Charlie Geller & Jamie Shipley, Founders at Brownfield Capital, who finds a copy of a presentation about credit default swaps by Jared Vennett at the reception of JPMorgan Chase. They become increasingly interested in this opportunity and call their friend Ben Rickert, a former trader at Deutsche Bank, to help them with buying these swaps.

In early 2007, the mortgage default rates started rising significantly but the ratings on these bonds remain unchanged and their value rises. Confused by the market movements, Mark Baum visits an acquaintance working at Standard & Poor’s to enquire about the unchanged ratings. He discovers the conflict of interest existing in these rating agencies and gets frustrated at the same.

Mark is introduced to Mr. Chau, a business, who has created synthetic CDOs, a structured product used to double the bets on the housing markets. Mark senses the downfall of the entire US economy and increases his short position the bonds by buying more credit default swaps.

Charlie Geller & Jamie Shipley plan to buy credit default swaps against AA rated securities, which are considered to be the safest investments, and get offers with really low premiums and high payouts. Ben grows increasingly concerned about the impending fall of the US economy and lashes out at Charlie for placing a bet against the entire financial sector of the economy.

During 2008, the market finally starts coming down with big banks defaulting on their payments and going bankrupt. All the professional holding credit default swaps make fortunes out of the market but none of them seems to be happy about the current health of the financial system and the immoral business practices followed within it. As predicted by Mark Baum, big banks are rescued using public bailouts and the entire blame is put upon the suffering lower strata of the society including immigrants, poor people, and teachers.

Relevance to the SimTrade course

The concepts shown in the movie perfectly correlates to the learnings taken from the SimTrade course. The imbalance between the ‘Demand & Supply’ function is what led to the creation of this big housing bubble wherein the banks issued sub-prime category loans to fulfill the increasing need for mortgage-backed securities. To have an efficient financial system, a proper balance and check are required for the smooth functioning.

The concept of ‘Short Selling’ is depicted in the movie which correlates to Period 3 of the SimTrade course. The bankers short MBS using credit default swaps to benefit from the negative movement in market prices of the bonds. Short selling is a famous trading strategy used to benefit from the predicted fall in the market prices of securities and is widely used across derivatives and equity stock markets. It is necessary to bring liquidity to the market.

Also, the movie shows complex structured financial products like collateralized debt obligations, synthetic CDOs, and credit default swaps which play a pivotal role in driving the revenues for big investment banks. These structured products are very well explained in the movie using small cameo appearances by guest speakers. The demand for these products led banks to have high financial leverages which later proved to be a bane for them. An effective risk management system is required to sustain such complex products and the dearth of these led to the collapse of some biggest investment banks. The lack of business ethics and excessive greed are also well represented in the movie where the bankers resort to creating more complex securities which come tumbling down like a domino effect when the foundation of these instruments, mortgages default.

A famous quote from the movie

“While the whole world was having a big old party, a few outsiders and weirdos saw the giant lie at the heart of the economy, and they saw it by doing something the rest of the people never thought to do: They looked.” Jared Vennett

Financial terminology

Mortgage-Backed Securities (MBS)- These are asset-based securities that are secured by a collection of mortgages. The mortgages held by commercial banks are sold to investors, which are mostly institutions, who combine them into MBS which can be further sold to individual investors. The MBS can be mainly divided into two types namely pass-through certificates and collateral debt obligations.
Collateral Debt Obligations (CDO)- Mortgages belonging to different risk categories, also called tranches, are combined into bundles based on their credit ratings, time to maturity, and payment terms. These securities have quite complex structures, making it difficult to regulate them.
Synthetic CDO- A modern form of traditional collateralized debt obligations, a synthetic CDO is based on non-cash income-generating assets that propose high yields, rather than bonds, mortgages, etc. These synthetic securities are based on instruments such as credit default swaps and their values are derived from the premiums paid on such swaps.