Understanding “The Big Short”

January 6, 2022

The 2008 financial crisis hit the American public and populace with brutal and devastating losses for homeowners and also the lenders holding the loans. Economists officially name September 2008 as the beginning of the crisis, which was when Lehman Brothers filed for bankruptcy. The firm was a major hedge fund operating as an investment bank, and specializing in real estate. Lehman Brothers had invested heavily in high-risk real estate that quickly tanked and sent other companies into a tailspin as the market began to reel. But in actuality, the 2008 crash brought to life in The Big Short (2015) began around 2005.

In the early 2000s, giddy Americans were able to buy homes or take out additional mortgages in record numbers as a Republican presidency loosened lending restrictions and pumped money into the market. This looked a lot like standard growth and prosperity as neighborhoods began to see young couples with working or white-collar jobs moving into the suburbs. However, while these couples and others looked like charming neighbors, they were often unqualified for the type of loans they had taken out on their homes. Many were locked into unaffordable loans, and as depicted in The Big Short, while the neighborhood birds chirped and sprinklers rotated, time was running out for these families.

Meanwhile, in the world of Wall Street, hedge fund manager Michael Burry is portrayed as being the first to notice that the housing market was unstable, and many would be unable to afford their mortgage payments. Burry and others in the industry, including those who were buying collateralized debt packages and selling bundles of loans amongst themselves, decided to bet against the housing market. The bankers who were creating the loans were reselling them in bundles, the agencies rating these trades were saying the mortgages were top quality, and the reality was the people would end up defaulting on the loans.

Therefore, Burry (Scion Capital), FrontPoint Partners (another hedge fund that worked with Morgan Stanley), executives at Deutsche Bank, Brownfield Capital (based on Cornfield Capital), and others realized that they could profit by shorting the mortgage market. The banks originating the loans and the agencies supposed to monitor the loan bundles were lying to the public and other banks about the quality of the loans.

The loans were actually subprime, which means they contained loans like balloon loans, a type of loan where a homeowner often must randomly come up with a huge payment as the loan reaches maturity. Many people would be unable to meet that threshold and lose their homes. Or, more commonly, the loan would be an adjustable-rate mortgage, and the rates were bound to go up when changes in the economy occurred. This began happening in the late aughts when the economy slumped.

Other mortgages were doomed because the brokers and closers who sold the loans to people knew that most would not be able to sustain high mortgage payments, but they received bonuses and were paid well to remain complicit. Others simply didn’t care.

Several of these companies resold these mortgages to firms on Wall Street that would buy those Collateralized Debt Obligations (CDOs). This had the impact of creating large pools of bad debt that were circulating amongst these companies and some were so cosseted from the housing market that they didn’t realize how unaffordable these loans would be to the average person who signed the contracts. It is a common practice to trade in loans sold in other areas of the market on Wall Street in a process known as securitization. Bundling these loans together into packages reduced the risk of loss. Yet, these loans being traded could often include ones that were doomed to fail, but this was disguised by the ratings industry. Other investors were still told these were good loans.

While the ratings industry and American media, which is often influenced by the millionaires and billionaires who own the networks, sang the praises of the housing market, a crash loomed by 2007. Even the Federal Reserve’s government officials were pretending that the housing market was booming. All of this type of activity made the frenzy of high-risk lending and trading even worse and had an impact on deceiving the American public.

While many banks and hedge funds would end up tanking when people defaulted on the loans, those who realized this would happen capitalized on it. They began betting on its collapse and realized the lenders were doing short sales. As the media hype and housing bubble grew, the lenders stood to lose more and more because they would take these financial obligations, sell them out, and expect to collect on returns later. Unfortunately for homeowners and the companies, they would never get their money back and this would destabilize the market. Their competitors, such as the hedge funds mentioned, bet against the mortgage market itself and started doing short sales while the others in the market bet long.

A short is when a stock is sold to the market, then repurchased at a lower rate. The short seller who repurchases the loan walks away with a profit when the price declines. Technically, people aren’t supposed to short stocks. This is considered unethical, but a lack of oversight shows that people are still shorting stocks today. Most notoriously, people are shorting GameStop stocks, but Volvo, AMC, and many other companies have gone through short sales fiascos.

The situation with the investors who shorted doomed collateral debt on the market is a little more complex than a short sale with a company like GameStop, which involves the stock market. Shorting bundles of mortgages is considered ‘the big short’ because it was such a massive short on all the mortgages and all the companies involved. Metaphorically, they were betting against the strength of the market, the ability of the American people to repay their mortgages, and counting on all the dishonest lending and ratings. They took the negative view that it would fail, and was only possible because of rampant corporate greed. Viewers of The Big Short should take heed that while the updates to those involved in the business, the companies, and the homeowners scroll at the ending of the movie, that there is a warning that the banks were, again, allowed to issue the same types of mortgages to homeowners. If The Big Short has taught one anything, it’s that there will be another one as the primary conditions of greed, lack of financial education, capitalism, and deregulation will always flourish if left unchecked.

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