2008 was a tumultuous year for the economy the housing market collapse created One
financial crisis after another and it often seems as if the news could only get worse
and ultimately our country could experience a long and painful recession fellow citizens we must not
let this happen now in predicting when and how the collapse would occur my focus was again on
the actions of our government what I think people are most upset about is that nobody went to jail
you know if people had gone to jail they would be quite so upset about the financial crisis
another part of what drove this was belief that home prices would never go down the big short with
its all-star cast recounts the events of three groups of traders that bet against the housing
market in the years before the subprime mortgage crisis that would eventually result in the failure
of key financial institutions people have sort of a cursory knowledge of what happened in 2008
but when you start peeling away the layers of the fraud it's incredibly terrifying The Big Short is
unique as a high budget Hollywood production that actually takes the time to properly portray the
way that Finance really worked behind the scenes and used as Financial events to progress the plot
rather than focusing on wild parties sports cars and sexy ladies like some other equally fantastic
movies that took a very different approach to storytelling the real question is this was all
this legal absolutely [ __ ] not similarly to The Wolf of Wall Street The Big Short is a movie based
off of a book Only The Wolf of Wall Street was an autobiography written by Jordan Belfort himself
and The Big Short inside the Doomsday machine was a standard non-fiction title that described
the role of several players in the creation of the credit default Market betting against
the American housing market a bunch of people who borrowed money to buy a house and are they
going to pay off their loans or are they not and that and and people and the vast majority of the
financial system was betting yes that they're basically going to repay their loans and some
people BET The Big Short was written by Michael Lewis a veteran Financial journalist and the book
really does read like a 320-page financial article in that it's very information dense but also very
well researched and verified for this video we will only be looking at the players that are in
the movie but the book does go into detail on some people that were either entirely cut from the film
or merged into other characters to make the movie entertaining to a broader audience unfortunately
in the process of making it as appealing as possible to cinema goers the movie did cut out
some very important details and also just straight up got some things wrong the biggest disadvantage
we had was about the financial instruments and how to explain them that was really the problem I saw
thought the characters were incredible so it's time to learn how money Works to give you guys
the investment Banker's insight into what really happened in The Big Short this week's lesson was
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to blinkist.com forward slash how money works big short told the story of three main Partners who
took a short position or bet against the American housing market in the financial system that had
grown around it in the early 2000s the first of the three was the now Infamous Michael J bury a
physician who gave up being a medical doctor to start a hedge fund Scion capital in 2000.
this Murray had a lot of success in the hedge fund by shorting overvalued tech stocks and returned an
average of 25 to his investors over the first four years which is incredible by 2004 he was managing
600 million dollars for investors which meant with his returns he was making about 30 million dollars
a year for himself from a traditional hedge fund fee structure of 2 and 20. this means that the
hedge fund manager was making two percent of all assets under management no matter what so
two percent of 600 million is 12 million and 20 of the returns generated over the market twenty
percent of the excess returns he was generating at this time would have conservatively made him
18 million dollars his fun was so successful that by 2004 he stopped accepting new investors because
his strategies relied on being able to move in and out of markets without influencing the
markets themselves with huge order values the brewery depicted in the movie was a bit of an
Eclectic guy but it probably didn't do a great job of showing that he was already extremely wealthy
by this point Steve Eisman played by everybody's favorite regional manager Steve Carell had also
managed to hedge fund FrontPoint Partners but his name was changed in the movie to Mark Baum Iceman
and his team also worked with Greg Lipman a Deutsche Bank traitor who was also betting
against the housing market and was portrayed in the film by Ryan Gosling with his name changed to
Jared Vanette and last there is Cornwall Capital renamed to Brownfield capital in the movie which
had a much smaller pool of capital at play but ended up generating the highest returns because of
a clever play that will make sense by the end of this video Brewery Scion Capital bombs FrontPoint
partners and Brownfield Capital all had a problem they wanted to short the housing market but that's
not possible to do directly a short position normally works by temporarily borrowing an
asset and selling it immediately for the current market price we told that it will be less in the
future if the price does fall the short seller can buy back the asset give it back to the person
they borrowed it off of and make a profit on the difference between the sale price and the purchase
price that's much harder to do with housing because nobody is going to let you borrow their
house to sell it all of the parties therefore ended up using credit default swaps credit default
swaps sound complicated but they are nothing more than regular insurance contracts that you would
have for your car or your house car insurance is a contract between an insurance company and a car
owner that promises to pay out in the event that the insured car gets into an accident a credit
default swap is an insurance contract between an insurance company or an investment bank and the
owners of an interest-bearing asset like bonds or mortgage-backed Securities mortgage-backed
Securities are supposed to pay out a fixed rate of return to their holders and if they don't the
insurance company will pay out to make sure they are covered what Michael burry was doing
in the scene was basically taking out insurance on a car he didn't own if that car crashed he
would be able to collect the payout even though he never owns the car in the first place now replace
the car with mortgage-backed Securities and you should understand how this scene plays out the
problem for Brewery is that he took out a lot of credit default swaps and just like getting a lot
of car insurance he had to pay out the quarterly premiums on these policies to keep the coverage up
if the mortgage-backed Securities never crashed he would never get a payout and he would have spent
all of his investors money on the Wall Street equivalent of Geico premiums one thing that
the movie doesn't quite get right is that bury later tells his investors that he had a number of
Wall Street Banks create these credit default swaps insinuating that taking out insurance
on mortgage-backed Securities was a totally new thing that bury came up with credit default swaps
the insurance contracts had actually been used since the 1990s and they were used for a really
interesting reason mortgage-backed Securities were a collection of thousands of mortgages all put
into a single pool to be sold off as a low-risk investment to other institutions selling these
mortgages onto other investors gave the banks making these loans more cash so they could give
out more mortgages which Washington really loved because it gave more people the opportunity to
be homeowners making mortgage-backed Securities and then selling them on the market is however
a slow and complicated process done by lawyers and bankers who need to make sure thousands of
mortgage contracts are properly accounted for in every single new mortgage-backed security they
made most lenders Outsource this tedious process to bigger investment Banks this meant that the
investment Banks had to buy mortgages from the small Banks and then keep those mortgages on
their books for the two or three months it would take to properly package them as a new Financial
product during that time the bank ran the risk of those mortgages defaulting which would cost them
money normally this wouldn't be a huge deal but the scale of mortgage-backed Securities operations
meant that some of these Banks had trillions of dollars worth of mortgages on their books
at any given time which presented risk well above their tolerance the investment Banks didn't expect
anything to go wrong at least when they first started making mortgage-backed Securities but you
also don't get car insurance expecting anything to go wrong you get it because a car crash could cost
you more than you could afford if you were unlucky enough to be involved in one credit default swaps
let the investment Banks keep trillions of dollars worth of assets on their books and collect their
fee for making these products without the risk of anything going wrong unless of course a company
like AIG which was writing all of these insurance contracts became insolvent but that wasn't really
seen as a possibility these private insurance contracts were called credit default swaps and
would ultimately expose the giant conglomerate to 64 billion dollars in potential subprime mortgage
losses and when the housing bubble burst AIG didn't have enough money to meet its obligation
back to Michael burry he started taking on these insurance contracts in 2005 which was three years
before he would eventually cash them out for a profit of over 800 million he took Insurance
on some of the riskiest of mortgage-backed Securities which is the next mistake the
movie made it heavily implied that these Financial products never went wrong prior to 2008 which they
did especially at the riskier Securities this is why the insurance contracts existed in the
first place in other words we lose Millions until something that's never happened before happens
correct riskier assets would command higher premiums and the premiums we pay uh roughly
80 to 90 million each year which is uh but I was the first to do this trade watch it will
pay I may have been early but I'm not wrong a 22 year old with a DUI will pay a higher premium to
ensure their 2004 Subaru WRX than a 45 year old with a perfect driving record will on their 2022
Civic it all comes down to the chance that the insurance provider will need to pay out in a
later scene we see morph bomb's hedge fund front Point by credit default swaps on Triple B rated
mortgage-backed Securities a triple B rating means that these assets are risky and have
approximately a one percent chance of failure in a given year according to rating agencies
mortgage-backed Securities could become safer or riskier in two ways the first way is if they were
just full of really safe mortgages of people with high incomes good credit scores and low
loan sizes relative to the value of the homes by the early 2000s these didn't really exist
and good borrowers were mixed together with bad borrowers altogether I think it's was in fact in
retrospect a great big National and not just National Global Ponzi scheme Banks Dead made
their products safer or riskier by layering them into tranches imagine three buckets that could be
filled up with cash the cash would come from the payments that people would make on their homes all
of this cash would go into the top bucket first and then would overflow into the second bucket
and then to the third and so on the final bucket is the last to get paid so it's the cheapest to
buy which means buying this bucket could generate a really good return on investment if everybody
is paying their mortgages all of the buckets get filled up and all of the investors get paid their
money if some people don't pay their mortgages the last bucket in line might make nothing but that's
the risk that investors seeking higher returns would take structuring the mortgage bonds and
cascading buckets for money created some desirable properties for investors the first bucket would
be much safer than any generic mortgage ever would be by itself and the last bucket would
offer higher returns than the interest rates on the loans this created a market for risk seeking
investors and conservative investors all with one asset class the diversification that came with
blending thousands of mortgages together into a single flow of money meant that returns were much
more predictable which gave a few Wall Street guys an idea if you can mix together lots of mortgages
maybe you could do the same thing with lots of mortgage-backed Securities which themselves
were a mix of a lot of mortgages this was a collateralized debt obligation or CDO the thesis
for these Financial products was that they offered safety through diversification by getting returns
from lots of risky mortgage buckets they expected one or two of these buckets to fail but those
losses would be made up for by the high returns generated by the thousands of other buckets that
they put into the product a lot of these cdos were also layered with their own buckets and
you might be able to see where this is going some firms took the lowest buckets from these cdos and
mix them together to make new cdos which became known as CDO squared the diversification that
came from mortgage-backed Securities did protect investors from the risk that a single mortgage
would default or that even an entire region would default but no amount of diversification could
protect the system from the hose of cash feeding the entire system being shut off like it was in
2008. fortunately it was possible to take out insurance on any of these buckets that investors
wanted by using credit default swaps now that you know the difference between mortgage-backed
Securities and collateralized debt obligations and how these products work I can also point
out one other little mistake that the movie made in the sequence when Michael burry goes between
the investment Banks trying to get them to write insurance contracts on mortgage-backed Securities
he hands his counterparties to prospectus on the mortgage bonds that he would like to Short
on six mortgage-backed Securities I'm not sure
Dr Barry these should be fine yeah we're prepared to sell you five
million in credit default swaps on these mortgage funds can we make it 100 million
absolutely we can make it 100 million the real Michael burry actually took out swaps
on collateralized debt obligations which were the buckets made from the lots of other buckets right
we bought basically short 8.4 billion of credit default swaps related to mortgages or financial
companies you must have been pretty confident that this thing was going to blow we had a giant bet
for us and and I was extremely confident in the outcome were your investors as confident it's not
a big mistake at all but it's something you can annoyingly point out to your friends next time
you decide to watch this movie the finale of The Big Short plays out as the now Infamous events of
2008 start occurring and the incredibly complex Financial products that these three parties have
been betting against start falling in price at this point Brownfield Scion and FrontPoint had two
ways to turn their short positions Into Cash they could wait for the assets that they bet against to
collapse and collect their insurance payout or they could sell those insurance contracts back
to the banks that were now desperate to get back that security it's Dr bird looks like the collapse
the financial sector is imminent start to sell my position it's 1.3 billion they all opted for
option two because as Michael burry alluded to in an earlier scene there was a possibility that
these institutions would collapse and they would never be able to collect on the payouts that were
owed to them you wouldn't bet against the housing market and you're worried we won't pay you yes
this would be like if you crashed your car only to find out that Geico had gone out of business
before you could claim your insurance money the reason that Brownfield was able to make much
higher returns than Burien bomb was because they bought insurance contracts on the assets that were
much safer the A and double A buckets instead of the Triple B buckets that the larger hedge funds
were buying because these assets were safer the premiums on insurance contracts were lower which
meant that the pair could buy more with them with the limited pool of investor money they had this
is what we did that no one else thought of not even bomber Berry thought the short the Double
A's but we did the final mistake I think the movie made was that they didn't do a great job of saying
that almost all AAA mortgage-backed Securities and more than 90 percent of a and double A Securities
did not fail which meant that Brownfield wouldn't be able to collect on their premiums but because
the banks were so desperate to get their hands on insurance as the financial system was unfolding
they were able to sell the contracts that they paid very little money for back to the banks at
a huge premium in the aftermath of The Big Short all of the parties were left with a lot of money
Scion Capital was shut down immediately after because Michael burry made so much money that
he could support himself by just managing his own Capital rather than dealing with the stress of
outside investors which was portrayed very well in this movie This is called a family
office and the movie said that he only invests in water which isn't true and he has famously
traded some well-publicized short positions in Tesla as well as Kathy Woods Arc Innovation
ETF none of his traits to date have been as successful as his one in The Big Short
Brownfield which is really Cornwall Capital still operates to this day and has 262 million dollars
in assets under management according to their most recent form 13f down from their all-time
high of 1.4 billion but it's possible that this drop is due to investor withdrawals not
investment losses America's angriest hedge fund FrontPoint Partners was shut down in 2011 after
one of its senior managing Partners chip scowrin played Loosely by Jeremy Strong in the film pled
guilty to insider trading and was sentenced to five years in prison these hedge funds made
billions of dollars by executing the big short but to some companies that's less than they make
or lose every single day if you want to learn about companies managing trillions of dollars
you should go and watch my video on Blackstone and BlackRock to find out how they work and if they
are the evil empire secretly pulling the strings of global Finance from behind the scenes a special
thanks again to blinkus for making it possible for everybody to keep on learning how money works
for sale 742 Evergreen Terrace detached single family dwelling now who'll start me off so