Listen, open the darn Fed window. He has no idea how bad it is out there, he has no idea!
He has no idea!
-Cramer...
I have talked to the heads of almost every single one of these firms in the last 72 hours and he has no idea
what it's like out there, none!
And Bill Poole has no idea what it's like out there!
My people have been in this game for 25 years! And they are losing their jobs and these firms are gonna go out of business
And he's nuts, they're nuts! They know nothing!
You may be old enough to remember exactly how bad fiscal year 2008 was for America.
If so, you were probably one of eight million people that lost their jobs as a result.
But if you're like me and you were too young at the time to understand what was going on,
allow me to explain exactly what happened and why.
A little finance 101 to get us started. When an organization needs to raise money, one of the ways it does so is by issuing bonds to investors.
Bonds are a lot like their title infers,
they are a contract to pay a lump sum at a predetermined date, along with any and all
recurring interest or coupon payments over the life of the bond.
Unlike stocks, the value of your bond does not decrease based on the value of the company.
The bond is exactly that - a bond between two parties. Because of this, bonds are
generally seen as safer investments. So in the late nineteen seventies, Lewis Ranieri
came up with the idea of a mortgage-backed security.
But what is a mortgage-backed security? Well, let's dissect this quick. So the bank issues
mortgages but these mortgages have a perceived risk of the customers
defaulting on the payments. The bank doesn't want to take on the risk
involved in these mortgages, so it gathers up hundreds of mortgages and sells them to
a trenche. A tranche is essentially a pool of like-investments. So this tranche takes
in all of these mortgage loan payments and is in business. The tranche in turn issues bonds
leveraged against the income provided by the mortgage payments. So you and I and even
the banks can buy these bonds that are sold by the trenche. In fact, a lot of
pensions bought into these bonds because they have a high return with relatively low risk
because it's.. a mortgage.. who the hell doesn't pay their mortgage? However, the banks
doubled down on these bonds because they received a commission for not only
selling the mortgages to the trances, but they also received the benefit of buying
the bonds leveraged off of these same mortgages.
The banks won big time and took on none of the risk because if some of the mortgages
didn't get paid - the bond still got paid. But if the bond still gets paid, how did
these mortgage-backed securities cause the economy to go into a deep recession?
Well, because the company can go out of business and default on its creditors,
there is some risk involved. To measure the degree of risk involved in the
purchase of a certain bond, there are rating agencies such as the Standard and Poor's and
Moody's. Each of these agencies rate the amount of risk involved in each
investment based on an alphabetical system, where a AAA-rated bond is a
significantly safer investment than a C-rated bond - which is commonly known as a
junk bond. So, because these huge banks were incentivized issue more mortgages
to in turn sell to trenches and buy securities off of, they started unscrupulously
issuing more mortgages - mortgages that were issued in great numbers to
people with shitty to no credit scores. Mortgages that were unlikely to be paid.
At this point, anyone could get a mortgage. Even the high school dropout living off
of welfare. This availability caused housing prices to go up because the
house was virtually certain to be paid for by the bank issuing the mortgage.
And you might be thinking, "well, so what? Wouldn't the S&P or other rating agencies still give
those tranches a 'C' rating?" In a perfect world that's exactly how it would work.
But not in the world of investment banking. Initially, the bonds would be ascribed a
'C' rating and wouldn't sell. So what do the banks do? They take the bonds that don't sell and they
pile them up in a portfolio that rating agencies deemed to be diversified
enough to receive a AAA-rated rating. See where the problem lied? In 2007 alone,
$500b in housing bonds were sold. As these mortgages
continued being issued to people who were unable to afford the premiums, the
default rates increased. In 2006, the default rate was 1%. In 2007, it
was 4%. The default rate only had to reach 8% for the entire housing
market in the United States to collapse in a chain reaction. And in 2008, that's
exactly what happened.
So what did our protagonists do? They shorted the bonds. A short position, or
short, is a sale of a borrowed security, commodity, or currency, with the
expectation of the asset falling in value. In the Big Short, Michael Burry does
this with mortgage-backed securities. Michael goes into a series of banks and
ask to borrow a billion dollars in mortgage bonds with a short position,
asserting that he believes that the bond is going to decline in value - meaning that
the housing market is going to stumble or collapse.
How a short position works, is that party a borrows a billion dollars worth of bonds
from party B and sells them immediately on the market. In the future,
Michael is expected to return the borrowed bonds by repurchasing them at the future
value which is expected to be lower. When this happens, Michael keeps the
difference. The common consensus is that the housing market has been the
strongest investment for the past 30 years, and it is beyond foolish to bet
against. However, Wall St is greedy and will take advantage of "foolishness"
when given the chance. To sweeten the deal, Michael requests a contract in
payment in the form of a credit default swap. A credit default swap is a
financial tool available for those who want to purchase insurance on an investment.
How it works is that party A buys a bond issued by party B. Party A, feeling
uncertain about whether party B will default on the payment of the bond or not,
can offer to buy a credit default swap from an insurance company, party C.
So Michael takes all of the investment pool he owns and puts it into purchasing
mortgage-backed securities and corresponding credit default swaps.
From 2006 to 2008, when millions upon millions of Americans defaulted on their
mortgages, this caused the tranches to subsequently default on their payments
of the bonds. As you remember from earlier, these were awesome investments
at the time. And trillions of dollars, trillions, went into the purchase of
these bonds and their derivatives. So in 2008, when the roof caved in,
Michael Burry walked away with a personal profit of $100m.
Well everyone, I hope you enjoyed this explanation of The Big Short and I hope
it makes a little bit more sense to you now. In closing, I'd like to share with
you one of my favorite scenes from the movie, which I think really hits home.
For the opposing view, Mr. Baum.
I gotta stand for this.
Okay, hi. My firm's thesis is pretty simple, Wall St. took a good idea, Lewis Renierie's
mortgage bond, and turned it into an atomic bomb
of fraud and stupidity that is on his way to decimating the world economy.
- How do you really feel? - I'm glad you still have a sense of humor. I wouldn't if I were you.
Now, anyone who knows me knows that I have no problem telling someone they're wrong.
But for the first time in my life, it's not so enjoyable.
We live in an era of fraud in America.
Not just in banking, but in government, education, religion, food, even baseball.
What bothers me isn't that fraud is not nice
or that fraud is mean. It's that, for
fifteen thousand years, fraud and short-sighting thinking have never ever worked.
Not once.
Eventually, people get caught. Things go south. When the hell did we forget all of that?
I thought we were better than this, I really did. And the fact that we're not doesn't make me feel alright and
superior. It makes me feel sad.
And as fun as it is to watch pompus, dumb Wall Streeters be wildly wrong - and you are wrong, sir - I just know that at the end of the day,
average people are going to be the ones that are gonna have to pay for all of this.
Because they always, always do. That's my two cents. Thank-you.
Does our bull have a response?
Only that in the entire history of Wall St, no investment bank has ever failed unless caught in criminal activities.
So, yes, I stand by my Bear Stearns optimism.
- Mr. Miller, I'm sorry, quick question. From the time you guys started talking, Bear Stearns' stock has fallen
more than 38%. Would you still buy more?
(Nervously) Yeah, sure, of course I'd buy more, why not?
- Boom.