The the foundations of the US banking industry,

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Last updated: September 29, 2019

The Big Short,a 2015 film directed by Adam McKay, follows three separate but parallel storiesof the US mortgage housing crisis.

  Thefirst story follows Michael Burry, a capital hedge fund manager, who accuratelypredicts the housing bubble and decides to short the housing market.  Thefilm begins by explaining what would eventually become one of the foundationsof the US banking industry, the mortgage backed security, or MBS.  A mortgage backed security is an asset backedsecurity where the asset is a typical home mortgage.  Mortgage backed securities were authorized in1968, when President Lyndon Johnson authorized the Charter Act.

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  In addition to creating Fannie Mae, theCharter Act gave banks the ability to sell mortgages to non-bank investment institutions.  Typicallyafter a bank or mortgage company makes a home loan, they then sell the loan to aninvestment bank who bundles the loan with other mortgages of similar interestrates.  This bundle is placed into ashell corporation called a Special Purpose Vehicle, which is specificallydesigned to insulate the mortgage backed security from the bank’s otherservices. (Amadeo, 2017)  TheCharter Act was not intended to remove good lending practices.  However, banks began to realize that asmortgage backed securities became more popular, they were able to sell theirmortgages and recoup the cost of the loan with little or no risk to them.  This lead to banks approving variableinterest loans to customers that were normally considered ‘at-risk’, also knownas a subprime loan.

  “While subprimerates vary from lender to lender, the Federal Reserve defines a subprime loanas one that carries an interest rate at least three percentage points higherthan the rate on a US Treasury bond that has the same term as the loan.  Subprime loans may provide credit toresponsible people who may not have a strong credit history. However, subprimelending practices can be abusive or predatory, trapping unsophisticatedborrowers in a cycle of debt while providing initially large profits for thelender.”  (“Subprime Loan”,2008)Inthe film, hedge fund millionaire Michael Burry, played by Christian Bale, comesto the realization that the housing market is backed by subprime loans, wherethe majority of them have variable rate interests that will rise in secondquarter of 2007.  Betting on the factthat the high risk subprime loans will default when their rates rise, he beginsto engage the large Wall Street institutions, expressing the idea that the mortgagebacked securities will fail, and creating a credit default swap market.

  A credit default swap is a “contract betweentwo parties where the buyer makes periodic payments (over the maturity periodof the CDS) to the seller in exchange for a commitment to a payoff if a thirdparty defaults.” (“Credit Default Swap”, 2011)  In other words, the CDS is insurance againstthe failure of specific mortgage backed securities.  To further compound the issue, investmentbanks were creating Collateralized Debt Obligations, or CDOs, that were made upof the lowest tier of mortgage backed securities.  The film ends in 2008with the collapse of the US housing market. As predicted by Burry, customers began to default on their loans due tohigher interest rates and mortgage backed securities began to fail.  Therefore since the flow of cash to the CDOsdried up, the CDO managers could no longer make payments to their bondholders, resultingin millions of dollars paid to the holders of credit default swaps.

  

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