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Comments on the movie The Big Short

Posted by John Reed on

I saw the movie The Big Short last night. I recommend it, although the book was far better. 

Good explanations of the technical aspects

They had an interesting approach to explaining the technical aspects of the sub prime crisis. Namely, they would essentially, stop the movie, and have the actors and celebrity experts in other fields speak directly to the audience using analogies to explain mortgage bundles, credit default swaps (insurance against bond defaults including mortgage bonds), side bets on the mortgage bundles, etc.

Written by Michael Lewis

The Big Short book by Michael Lewis (who also wrote Blindside and Moneyball) is a true story about about a dozen shrewd investors who saw that the subprime mortgage loans were going to go bad and placed huge bets against them. They collectively, and in many cases, individually made a billion or more personally. Another book that I read on the subject was titled The Biggest Trade Ever. It referred to the fact that these few guy made more money on shorting the Subprime Mortgages than anyone else ever made on any investment before or since.

The article I wrote for my newsletter Real Estate Investor’s Monthly was titled “How I made $6 billion in real estate in my spare time in three years without knowing anything about real estate.”

Real Estate Investor’s Monthly newsletter

Living treasures

Two of The Big Short players—author Michael Lewis and Dr. Michael Burry—are on my list of living human treasures whom we do not value enough.

‘Mark Baum’/Steven Eisman

I had a third guy on that list who is in The Big Short: Steven Eisman. Dr. Michael Burry is portrayed by an actor and they use the real name Dr. Michael Burry, an M.D., in the movie. Eisman, however, to portrayed by an actor although they call him “Mark Baum,” apparently a fictional character. He is probably the main character in the movie.

I removed Eisman from my list because in a subsequent short, he tried to get the federal government to hurt the value of the stock he had shorted with new laws. I said at my treasures list,

On 5/31/11, the media reported that he had shorted corporations that owned and operated for-profit adult schools. I have no problem with that. But he was also working hard to get laws and regulations imposed on those schools that would substantially reduce the value of their stock which, in turn, would mean he would make a lot of money. I have no objection to shorts or to shorts explaining their reasoning for shorting a stock. However, I oppose short sellers trying to take action or persuade others to take action, to hurt the value of a company’s stock.

Compressed into composites

As always with Hollywood, of necessity, the compress characters and events into composites. A movie without such composites, like this which covers around ten years of financial history, cannot cover ten years in 90 minutes without composite characters and events. For example, the guys betting against the subprime mortgage bundles wanted a cleaner vehicle than such trades as shorting Countrywide Mortgage stock. To put it in technical terms, they wanted basis risk reduced if not eliminated. 

Elimination of basis risk through CDSs

In the movie, this was done by the shorts requesting it and the investment bankers simply saying okay. In reality, a Deutsche Bank employee named Gregg Lippmann saw the need for the standardized, no-basis-risk instrument and called a meeting of key Wall Street investment bankers and lawyers to create the new instruments: collateralized debt obligations and credit default swaps. That is what you would expect, not the movie’s casual conversation agreement on creating CDSs on the spur of the moment.

 The Gregg Lippmann counterpart in the movie was a guy named “Vennett.” He also was a sort of star of the movie and of the events in question. He was not one of the shorts. He was a broker who saw the opportunity to make a lot of commissions giving two sides of these deals what each wanted. Or at least what each wanted initially.

Investment bankers wanted out

As events unfolded the smug, establishment investment bankers, realized they were on the wrong side of the trades and, in an exhibition of pure sleaze, sold their losing positions to their customers implying or saying that they were good investments. The insurers also were suppressing the news of the actual values to which the CDSs had risen because they were trying to buy the CDSs themselves, especially the ones they themselves were going to have to pay claims on.

The movie appropriately make much of this—mortgage default rates rising, but the bundles containing those same mortgages were not falling in value. But I wonder if the movie audience understood what was being depicted.

It was as if your homeowners insurance company reacted to your house catching fire by building a high wall around the fire and claiming there was no fire—until after they managed to sell the insurance company and its in-force policy liabilities to some dopey third parties, or persuaded you to cancel the policy. That is what was going on with the CDSs at the end of the movie if you saw it and did not understand.

‘I may have been early, but I’m not wrong.’

There was an interesting exchange in the movie. Two of Burry’s investors wanted to get out of the subprime short because staying in was costing millions a year in losses—the premiums being paid to keep the insurance (CDS) in force and—to continue the home fire analogy. Those two investors essentially were saying cancel the fire insurance on the house  because it’s taking too long for the house to catch fire. Perhaps more precisely, they did not believe the house was ever going to burn down and wanted to stop paying the premiums.

Dr. Burry calmly responded, “I may have been early, but I am not wrong.”

“It’s the same thing,” screams the investor.

It is true that being early is often the same thing as being wrong on Wall Street. But that is only the case when the position has carrying costs of one kind or another—CDS annual premiums in this case—and the amount of earliness is so great that the years of carrying multiplied by the annual cost of carrying exceeds the potential profit.

The answer in this case was the big short guys were not shorting at all. They were insuring, which has much lower carrying costs in relation to the potential profits that the carrying costs of things like actual shorts which have margin calls.

Way too early

People who bought real estate at the bottom in the 1920s and early 1930s were not very happy about it for a long time. They were right about it being the bottom, but they were not only early, they were way early. 

Am I the ‘Mark Baum’ of hyperinflation?

Some of my readers may think I am the “Mark Baum”/Steven Eisman of a future hyperinflation crisis—because I wrote the book How To Protect Your Life Savings from Hyperinflation & Depression, now in its second edition.

How to Protect Your Life Savings from Hyperinflation & Depression, 2nd edition

First, I am not the only person or even one of a few who sees a heightened risk of high inflation as a result of “quantitative easing” (printing trillions of dollars so the government can keep spending beyond our means). Virtually everyone has put themselves on the record as saying current U.S federal monetary and fiscal policies are “unsustainable,” including Obama.

The big shorts like Eisman saw a bubble that others did not. In contrast, the coming troubles from too much entitlement spending and deficit spending and too much national debt have been called “the most advertised and warned-about financial crisis in history.”

 So Steven Eisman et al. were seers. I make no such claim. You don’t have to be smart to see the rising hyperinflation danger. You have to be willfully blind not to.

Insurance approach

My advice in How To Protect Your Life Savings from Hyperinflation & Depression approaches the problem using an insurance mindset, not a short mindset. In other words, my approach is like that of the Big Short guys after they switched to using CDSs (insurance policies) instead of shorting mortgage lender stock.

Look at fire insurance again. On my house, the cost is about $2,000  a year. But the potential payoff in the event of a total loss from fire is something over a million dollars. In the movie The Big Short you often heard them talking about payoff ratios of 10 to 1 and 25 to 1 and 50 to 1. Those are the ratios of insurance, not Wall Street, unless you are talking about options which are extremely risky and have margin calls. Insurance is not risky and has no margin calls.

Get rich on hyperinflation?

Would you like to get spectacularly rich from hyperinflation? No problem. Buy as many hard assets as possible with as much fixed-rate, borrowed money as possible.

Would that be low cost and low risk like insurance? Hell, no! Because it is neither, it is a great example of the situation where being right, but early, would have a good chance of killing you financially.

Not gold

The average person, and a lot who ought to know better, would simply say the way to get rich in hyperinflation is just to buy gold. No way. For one thing, gold has generally always been overpriced when there was any fear of inflation. The average price of gold adjusted for inflation has been about $642 per ounce in today’s dollars since 1968. Ever since U.S. hyperinflation has been a fear, the price of gold has been way above that historical average.

Also, hyperinflation always ends and it always ends overnight and when it does the price of gold plummets to below its historical average. See my article on the disadvantages of gold as an inflation hedge. 

So with gold, you not only have great too-early risk, there is also horrendous too-late risk with regard to when you get out of it.

‘Protect’ not ‘profit’

Remember my book title’s third word is “Protect,” not “profit” or “get rich.” Like insurance, you are not supposed to make a profit. You are just supposed be made whole—restored to your financial position before the loss.

That may not sound exciting. Well, when everyone around you has lost their ass, as in Germany during their early 1920s hyperinflation, preserving your life savings was a hell of a trick. My book does tell you to use leverage, which would result in a real profit if there was hyperinflation. But I say to only use as much leverage—mainly a home mortgage—as you can comfortably afford and carry even if the inflation never happens.

No CDSs for hyperinflation

Can you buy hit-the-jackpot insurance against hyperinflation the way you could against mortgage bundle defaults? No. That was a maybe unique moment in time when some idiots with a lot of money got into the insurance business without understanding even the most basic aspects of insurance.

The most notable idiot was Joseph Cassano, the American head of AIG Financial Products, which happened to be in London. Where did Cassano get the billions to pay off the big shorts? AIG was a huge financial company with a AAA credit rating. And it was taken over by the US Federal Reserve during the subprime crisis.

The risk of lots of mortgages defaulting is arguably not an insurable risk. To be insurable there must only be a relatively few claims at any given time. That’s why mass events like wars and riots are excluded from life insurance policies. No one could insure against a crisis like the subprime crisis because there would be massive claims filed simultaneously, and there were.

Another basic principle of insurance is the insured must not profit from a claim—only be made whole. Letting the insured profit creates “moral hazard:” temptation to commit fraud or cause the loss to happen. That’s why there are deductibles in insurance—to make sure the insured is a bit worse off in the event of a loss to deter then from causing the loss themselves.

None of these principles were followed in the CDSs.

Is anyone writing hyperinflation insurance? The U.S. Treasury sells Treasury Inflation Protection Securities (TIPS) bonds, They are indexed to inflation. But the rate at which they adjust to inflation is too slow during hyperinflation. Furthermore, hyperinflation always ends with the death of the currency in question. So a promise to give you huge additional amounts of the currency in question in the event of hyperinflation is is no value if the currency in question ceases to exist. In Germany in the 1920s, for example, the Deutsch Mark, which became inflated, was replaced by the Rentenmark.

So they would give you the new currency instead? No. They can’t afford to. In Germany, after the hyperinflation ended in Germany in the 1920s, the government gave pensioners, who got creamed, some little 5% or so compensation for what they lost. They also slapped a special tax on those who made out like bandits because they had borrowed with a 5% or so clawback windfall profits tax.

The subprime crisis is different from US hyperinflation risk

In short, Steven Eisman et al. saw a situation few others saw, plus they requested, and got, crazy generous insurance policies from companies that, one way or another, had the wherewithal to actually pay the claims.

What I have done with regard to hyperinflation risk, that few if any others have, is to ask what actually happens when the “unsustainable” stops, and tell readers how to make sure they are not among those destroyed by it. If you read Anna Eisenmenger’s diary from Austria in the early 1920s, where they had similar hyperinflation as Germany, you will agree that saving you from that would be a tremendous thing. The diary is available for free on the Internet:

But for the reasons I listed above, it’s NOT the next Big Short.

Blamed ‘immigrants and poor people’

The movie said twice that Wall Street blamed the Subprime Crisis on “immigrants and poor people.

That’s a lie.

I read almost every book and saw almost every movie on the Subprime Crisis. No one on Wall Street blamed “immigrants and poor people.” The movie writers made than up, apparently to appease The Left in Hollywood.

Follow the money

Here is some insight on the Subprime Crisis that I have not seen anywhere else, and the other writers are wrong for not saying it.

If you want to see where the money was made before the crash—when the misbehavior was occurring—look at an average house sale—in particular—look at the HUD-1 settlement statement. It will easily show that the biggest check issued by the title/escrow company went the the seller of the house

The second biggest check went to the Realtor®. Smaller checks went to the mortgage company, appraiser, and assorted service providers like surveyors, title insurers, and so on.

So am I saying the blame should be allocated by the percentage of the average deal each group got? No. Actually, it was almost the opposite.

Stealing on commission

I thought I had written a web article on this but it was apparently in my newsletter Real Estate Investor’s Monthly. It was titled “Stealing on commission.”

White collar criminals steal huge amounts of money, but rarely go to jail. Why? Because they steal on commission. The guys who go to jail for stealing take all the money in the victim’s pocket. White collar criminals like Wall Street help average people steal money—in this case by committing felonies to get a mortgage they are not qualified for—and only take a commission on the deal.

Wall Street was in the mortgage-selling business

Is the money Wall Street got on the average Subprime Crisis house sale on the HUD-1? No, they got paid at a subsequent sale of the mortgage taken on by the “immigrants and poor people” and others.

Wall Street bought the mortgage on that average deal from the mortgage originator who created it, then marked it up and resold it to affluent people on Main Street and to institutions like pension funds and governments.

Is the amount of money Wall Street made on marking up that one mortgage more than the amount made by the seller or Realtor in that deal? No. Here is the key to understanding why the Wall Street individuals got filthy rich on this deal, but the average people involved made only modest profits.

Tens of millions of commissions split among a relatively few Wall Street guys

The number of mortgages per home seller was typically one. The average number of mortgages per Realtor® or mortgage lender or appraiser was typically dozens or hundreds. But the number of mortgages per Wall Street investment banker or hedge fund manager was in the thousands. They made far less per mortgage deal, but they did far more deals per person.

That discussion was about the run up in the number of houses sold and mortgages created—approximately 2000 to 2007. The people featured in The Big Short made NO money in that phase. Indeed, they lost money in that phase—paying premiums on their CDS insurance and such.

The reason the shorts made even more per person than the filthy rich investment bankers and hedge fund managers is because there were even fewer of them. Roughly speaking, their deal was the mirror image of the run up. They made money on the losses suffered by others.

Are shorts evil?

The movie bought into the widespread myth that there is something evil about making a profit from the losses of others. That is utter bullshit! In the movie, they sort of had the guys who made billions feel bad about it. Maybe they did, but they should not have.

Doctors make money from the medical ignorance of the sick and injured. Body shops make money from car accidents. Would those who claim people who make money off the misfortune of others let the sick and injured go untreated or the mangled cars stay mangled?

The shorts on Wall Street—those who bet on things going down in value—serve the purpose of telling the investment world that a lot of investors think there’s something rotten in the assets they short: early warning. Every transaction on Wall Street is between an investor who thinks the asset being bought and sold is going up and one who thinks it’s going down. (Okay, some sellers just need the money for their divorce.)

So if the shorts are not the bad guys, who are?

The liars. The appraisers, the mortgage borrowers who lied about their income and net worth, the mortgage brokers who knew they were lying and encouraged them to do so, the bond-rating agencies who said the bad mortgages were AAA, the Wall Street bankers who bought the bad mortgages and resold them to Main Street investors, FNMA and FHLMC.

The incompetents. The politicians and regulators who either thought they could buy votes by increasing the percentage of homeowners or who went through the motions of regulating but who were incompetent or who backed off when the regulatees complained.

Those who sinned by silence when they should have protested: Realtors® and title/escrow companies. Unlike the liars above, they did not have to sign off on the lies, but they profited from them and knew they were lies.

A trillion dollars of value wiped out

The movie and others say the 2008 crash wiped out a trillion of value. Bull! 

That “value” was the bubble that the substandard lending created. The crash essentially was values going back to the normal they were at when mortgages were only made to people who could pay them back.

Were any of the above liars, incompetents, or knowing participants sent to jail? No. They could all point the finger of blame at others and the government was one of the others and did not want to receive any blame.

Did any who made money on the way up lose it on the way down? Hell, yes, notwithstanding many saying Wall Street suffered no financial losses. Bear Stearns shareholders lost something like 90% of their share value. Something similar happened to Lehman employees and shareholders, although I think Lehman ultimately turned out to be more illiquid than bankrupt. All the independent investment banking companies had to be taken over by banks or become bank holding companies so the Federal Reserve could be involved in their bailouts.

Did the taxpayers get screwed? That was the claim, but as with Lehman, I think when all was said and done, the government’s net losses were far smaller than initially feared. Again, the bailed-out companies often had the needed net worth and when their assets were liquidated, the government got paid off.

Who lost when the shorts won?

So who funded the gains of the shorts? Well, although they made the biggest profits individually, there were only about a dozen of them. I would guess they split about $30 billion total profits, which is a tiny fraction of the $82 trillion world bond market.

Who lost the $30 billion? Companies like AIG Financial Products, Goldman who were, to an extent, on the other side of the bets by the shorts. And the Main Street boobs and pension funds and other institutions in America and around the world who ultimately ended up buying the mortgage bundles containing the bad mortgages. As with the arithmetic of the average deal on the way up, the arithmetic on the way down was that many lost a little so that a dozen shorts could individually make more than anyone previously in history.

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