Film analysis: The Big Short

Foreward

A pervasive moral stigma follows the financial sector, which has a dogged reputation for unethical and illegal behaviour. However, the ethical lapses often associated with finance are not always intentional. Instead, a contributing factor is that the teaching of finance and other business disciplines presents the challenge of linking theories and conceptual models to the “real world”. Entertainment media – such as films or books – are useful in this aspect as case studies; they provide students with an organisational frame of reference to better understand both situational contexts, and importantly, the human dimension behind financial numbers.

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the The Big Short film and explains the related financial concepts.

The film “The Big Short” recounts the subprime housing bubble which lead to the financial crisis in 2008. Through a compelling storyline, the complexities of the financial market – including CDOs, mortgage backed bonds, and the reckless trading of complex derivative instruments – lead to the subsequent financial collapse of the US housing market.

Film summary

“The Big Short” directed by Adam McKay and based on the best-selling book by Michael Lewis, explains how the subprime housing bubble, caused by increasingly risky subprime mortgage bonds, lead to the 2008 financial crisis. The danger was hidden such that only a few players predicted the collapse and used it to “short” the market. Once the bonds failed, the value of billion-dollar securities dropped to nothing, which bankrupted major investment banks and forced a government bailout to prevent economic collapse.

The film is presented as three concurrent stories about the investors who realised the risk of the subprime housing bubble and predicted the 2007 housing market crash. Wall Street investor Michael Burry realised that many subprime home loans packaged in the bonds were in danger of defaulting, and bets against the market with one billion dollars in credit default swaps. We also follow the stories of banker Jared Vennett, hedge-fund specialist Mark Baum, and two younger investors – Charlie Geller and Jamie Shipley – who work with retired banker Ben Rickert. After reading Burry’s findings, they also make a series of successful bets and profit off the downfall of the economy.

The subprime housing bubble caused worldwide chaos as banks entered a liquidity crisis, stock markets crashed, reputable companies collapsed, and millions suffered in the wake of the disaster. The crisis was felt worldwide, irrespective of your position and whether you benefited, survived or lost everything you’d worked towards. This movie helps those who aren’t in the financial sector, understand exactly what happened.

Financial concepts from the The Big Short film

Financial derivatives

Leverage

Financial leverage can be used to increase (expected) profits but also increases risk by accentuating the gains and losses of a market position. When the largest banks and financial institutions in the world leveraged using derivatives, CDOs and other highly complex securities – the exacerbated losses can lead to collapse.

CDO

A Collateralised Debt Obligation (CDO) is essentially the repackaging “old” products as new, by the securitisation of loans into a product sold to investors on the secondary market. Another example are synthetic CDOs, which essentially bets on the direction the market is going to take and amplifies the monetary gain of a bullish market, but heavily exacerbates the losses from a bearish one.

Subprime Mortgage Backed Securities

Subprime mortgages are a loan to borrowers with a low credit rating, which increases the risk that they will default. Tranches in subprime mortgage-backed bonds are when subprime mortgages are mixed with top-rated mortgages, which effectively hides their risky nature from unsuspecting customers. These top-rated securities could not stand when the subprime mortgages failed, but the danger was looked over even by the banks who sold them.

‘Shorting’ the market

By predicting the danger of mortgage-backed securities and expecting defaults on subprime mortgages, some investors profited from the crisis through credit default swaps. However, this does not mean shorting the market is a good idea. As said by J.M. Keynes; the market can stay irrational much longer than you can stay solvent. Due to unpredictable factors such as politics, going short is a bet that can run out of time – even with a simple options strategy, your options will eventually expire. Sticking with a long term, value-based approach eliminates that problem. Keep short investments on the side to meet short term cash flow needs, but also know that a quality company will generate profits, dividends, and market returns over the long term, without ever expiring.

High Risk vs High Reward

Why did the banks making the loans expose themselves to subprime borrowers at such high levels? Because high-risk borrowers also offered high rewards. Before home prices imploded and the labour market tanked, banks were able to charge sufficiently high interest rates on loans to subprime borrowers which more than overcame the costs of their higher default rates. This combined with the banks’ ability to securitize loans and sell them meant that banks thought their risks were mitigated. Instead they focused on how higher subprime interest rates could boost their margins and profits. However, those default rates eventually grew too high for any interest rate to justify the risk, and the entire system collapsed.

Impartial assessors

Impartial regulators and assessors are critical to the safe functioning of the financial sector. A contributing factor to the crash was years of financial malfeasance and incompetence among the top salesmen and executives among Wall Street’s largest banks. Conflicts of interest and abuse of power by the banks meant credit rating agencies as well as professionals supposedly managing CDOs for the benefit of the customer, were in fact working in the bank’s interest. This fraudulent system meant the credit rating agencies were rating housing debt securities highly, right up until the crash.

Counter-party risk

This simply means the risk of the other party, if their investments are not able to pay out when the time comes. An example is how Baum and Geller bet against the banks, but when the crisis hit the banks eventually went bankrupt – these two investors had to be careful about receiving payment before the banks became insolvent.

Key insights for investors

Trust your instincts

It’s important to do your own homework and trust your instincts. Despite external pressure, the investors shorting the market held their ground, ensuring their investments paid off in the long-term. When the numbers go up and down, it’s important to be patient and study the reasons behind any change. While investment advice is useful, the incentives of others may conflict with yours. It’s your money, and just because an opinion is popular, doesn’t mean its correct.

See the reality

When buying securities, it’s vital to understand the reality of what the numbers represent – real people, real companies. In the film, we see workers paying off loans for three properties at varying rates, and how the incentive system cushioned bank managers’ salaries, helping the mortgage market expand. “No-one can see a bubble; that’s what makes it a bubble” – people lost their ability to see the forest for the trees. They were the weak link in the chain, which once broken, caused the crisis. Your finances are only as strong as their weakest link, so it’s important to diversify your risk.

Mentors

In the film, Geller and Shipley asked their mentor and retired trader Rickert for his support to meet the ISDA threshold. More than that, he taught them that greed is not good, and that their win was at the expense of millions of Americans who would lose their jobs. Have a mentor to guide you both morally and financially.

Opportunity in adversity

A final lesson from this movie, albeit a dark example, is that you can find the good in adversity. By shifting your mindset when facing failures or disasters, you can learn to find opportunity in anything.

Relevance to the SimTrade certificate

Through the SimTrade course, as well as a strong understanding about trading platforms and orders, you are taught about information in financial markets and how to use this to make successful trades. Several case studies teach you how to analyse market information to make valuations, and correctly assess how market activities will affect your own trades. The simulation and contest allow you to compete against others in the course and deepen your understanding of how a market reacts to different players.

Famous quote from the The Big Short film

An investor: “No one can see a bubble. That’s what makes it a bubble.”

Trailer of the The Big Short film

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About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).