Disclaimer: All the details mentioned here are from the movie and not independently researched to be accurate by the author. Any opinions expressed here are my own and do not reflect the opinions of my employer.
This is the continuation of the story from Part1 which introduces many to the world of collateralized debt obligations, subprime mortgages, credit default swaps and bundling leading to the depression of 2008.
“The Big Short” Movie for a trading novice
As part of my curriculum for Machine Learning for Trading (CS 7646) in my OMSCS course, we were asked to watch the…
The next important sequence happens when Jared Venett with Deutsche Bank (played by Ryan Gosling) learns about Dr. Burry’s theories and attempts to find an investor to place a similar bet with Deutsche Bank.
In this exchange, the cause and impact of the toxic buildup of mortgage bonds and how they are being hidden in plain sight from the market is explained. The earliest Mortgage Bonds when originally created had thousands of “AAA” rated mortgages bundled together and guaranteed by the US government.
However, there are only so many “AAA” mortgages available and since they almost never defaulted, the banks got greedier and started creating modern bonds with layers of “Tranche” (French for portion of something). These “Tranche” is composed in such a manner with the highest level AAA ratings getting paid first and lower level of B getting paid last.
They are advised as being a little more riskier as the lowest rated ones defaults first which composes of buyers with No income check, low FICO scores and existing bad debts.
This has led to a steady rate of increase in defaults from 1% to 4% and when this reaches 8%, even bonds with lot of “BBB” rating are also going to fail. The greediness of banks have reached a level such that bonds with “AAA” rating from the rating agencies have around 70% of mortgages given to buyers with around 550 FICO score.
Credit Default Swap — is Insurance against such bonds failing. Since the banks and the markets believe that these bonds are infallible, the insurance coverage or “returns” can be 10:1 or 20:1.
Jared urges Mark Baun and his team to buy these “Credit default Swap” insurances effectively shorting these mortgage bonds.
Collateralized Debt Obligation (CDO)
This is where we are also introduced to the term “CDO” which was created to mask the banks’ attempts to float the sub-prime mortgages as AAA bonds. When a market deems a bond too risky to buy, instead of dissolving them, they are repackaged with other bonds that didn’t sell and set it up as CDO — Collateralized Debt Obligation.
This enables a lot of “BB” and “BBB” rated bonds to be mixed with some “AAA” rated ones and then floated as “Diversified” with the rating agency (S&P) giving them a 92% rating.
They also got Anthony Bourdain to give a chef’s take on what CDOs are.
In order to verify these claims, Mark Baun and his team look into the ABX Index which tracks these sub-prime mortgage bonds and found that they are indeed showing distress signs. More details this article
They conduct an independent research by visiting some of these properties which are mortgaged as part of these CDOs. They were shocked by their abandonment or clear violations and lax enforcement of mortgage loan eligibility. They meet the real estate agent loan officers who facilitated similar loans and made the decision that this is a ticking bomb waiting to explode.
The Third Group
Then we are introduced to the third group which bets on the mortgage industry to fail — Charlie Geller and Jamie Shipley
They are small investment company working out of a garage and are in the city for getting an ISDA (International Swaps and Derivatives Association) Agreement. At the beginning of the movie, they usually buy options on highly improbable cases, so if they lose, they have smaller loses, but returns are great if they are correct and they needed an ISDA agreement for high stakes trading.
An agreement that lets an investor sit at the “big boy table”, and make high level trades not available to amateurs.
In the movie, it was shown as that they come across Dr. Burry’s theories and credit default swaps by accident. However, in real life, in seems that they heard it from one of Jamie’s friends.
They usually confer with Ben Rickert (played by Brad Pitt) as a mentor who was a former trader for Chase in Singapore.
Like any good story, the movie takes us through the struggle by the protagonists who hold on valiantly against surmounting odds.
At this point of the movie, Dr.Burry is under tremendous pressure as he has already pledged most of his company’s investment to buy credit default swaps, while the mortgage market keeps getting stronger with the banks demanding more premium to keep the swaps afloat. His company’s (Scion Capital) stock price keeps plummeting.
At the same time, Detusche bank (Jared Venett) also demands a higher premium while pacifying Mark Baun that the research is indeed correct.
With the three groups hanging on with their fingernails, unknown to each other, all of them decide to attend the Las Vegas Securitization Forum.
With a sheer stroke of genius while attending this conference, Charlie Geller &and Jamie Shipley decided to short even “AA” rated bonds which were considered to be the golden standard as they would be first ones to be paid out. Neither Mark Baun nor even Dr. Michael Burry didn’t foresee such a catastrophical collapse.