An Economic Analysis of

The Big Short

By:
Francheska Margaux Calma
Bachelor of Arts in Political Economy 1-3
 The Big Short is a 2015 film directed by Adam McKay starring big names such as Christian Bale,
Steve Carrell, and Ryan Gosling. It was based on the book with the same title published in 2010, written
by American author Michael Lewis. The Big Short dramatizes the real-life events leading up to the
collapse of the housing market, which not only affected the US where it happened, but also had
repercussions for the whole world, leading to a severe economic recession. The film explains how the
crisis happened, but mostly focuses on the men who saw it coming and decided to bet against the housing
market in order to gain more money when the market does fail.

The film starts off by telling us that back in the 1970’s, banking was utterly boring, and not
exactly something that people came into to make a lot of money. That is, until Lewis Ranieri came on the
scene. Ranieri forever changed banking, basically revolutionized it so that bankers could make more
money. His big idea was to bundle mortgages together and sell them to investors as securities. He called
these mortgage backed security, or private-label MBS. He claimed that a single mortgage only had a small
payoff, but a lot bundled together would have a bigger payoff, but still be labeled safe, as he jokingly
mentioned, “Who the hell doesn’t pay their mortgage?” Aside from this, Ranieri claimed that the bonds
were AAA rated–the highest rating that can be given to a bond–which encouraged investors to purchase
more. With more and more money being poured into this, America’s number one industry soon became
banking.

The year 2005 is when the movie really takes place. Michael Burry is one of the main characters
of the film. Burry is an investor and hedge fund manager who founded the hedge fund Scion Capital and
ran it from 2000 to 2008. He first got the idea to short the housing market when he was going through
mortgages in the top selling mortgage bonds and noticed that a lot of mortgages were not being paid on
time. Burry claimed that the MBS were filled with risky subprime adjustable-rate loans. He added that
when the adjustable rates would kick in in about 2 years, or around 2007, people who took out those
mortgages would not be able to pay, meaning it would fail. If 15% or more fails, the whole bond would be
considered worthless–it would lose its value. The reason why there were so many of these subprime
mortgages was because Ranieri’s mortgage bonds were so profitable that banks wanted to keep churning
out more of them. The problem with this however is that there are only so many houses and people that
actually have the money to buy them. So, wanting to keep their cash flow, banks instead started filling the
bonds with riskier mortgages–or subprime mortgages, which is honestly just code for not good–instead of
the AAA ones they once used. They repackaged these subprime mortgages together and sold them,
claiming that at least 65% of the mortgages in the bond were AAA, but they were not. Burry saw all this,
which is why he figured that he needed to short the bonds, or in other words, bet against them.

Burry was insistent that they needed to short the bonds immediately to get ahead of everyone else.
It was hard to make people believe him however as everyone genuinely thought that the housing market
was rock-solid and stable, since well, they are houses. He, on the other hand, believed that the bonds were
built on bad loans and would soon collapse. Burry was warned that insurance contracts or options for
mortgage bonds did not exist, so he said that he would ask a bank to create one for him. He approached
banks saying he wanted to bet against the housing market. Bankers called it a foolish investment but took
Burry’s money anyway, because to them, they had nothing to lose since the housing market was so solid.
He bought credit default swaps from several banks such as Goldman Sachs, Deutsche Bank, Bank of
America, and Bear Stearns to name a few. In total, Burry spent $1.3 billion on credit default swaps.

We are then introduced to a different character, Mark Baum. Mark Baum is actually not the
character’s legitimate name in real life, it is Steve Eisman. For the sake of this paper, he will be referred to
as Mark Baum, seeing that our focus is more in line with the movie. Baum is a businessman and investor
who now works as the managing director of Neuberger Berman, an investment management firm.
Similarly, Jared Vennett is also not a real person and is only based on Greg Lippmann, a hedge fund
manager and Deutsche Bank executive in charge of global asset-backed securities trading. We will also be
referring to him as his on screen character, Jared Vennett.

Vennett was the first to hear about someone betting against the housing market, who unlike his
fellow bankers laughing at the trade, actually realised that Burry was indeed right to do so, and that the
housing bubble would pop eventually. He contacted other banks about it, but was laughed out of the
room. Due to a misdial, Vennett ends up meeting with Baum and his team. Vennett explained that the
bonds were currently at 4% (up 3% since the last year) and would fail when it reaches 8%. When Baum
questioned him saying that the housing market is way too stable to collapse, Vennett explained that unsold
bonds that are deemed too risky to sell are simply repackaged with other bonds that have not yet sold and
put into a Collateralized Debt Obligation (CDO). These bonds are then rated 92%-93% AAA (even when
they are filled with B-BBB rated mortgages) and sold. A CDO is basically that, repackaged bonds that
have not yet sold because they are bad or risky. People think that they are buying this brand-new thing,
when really it is just stuff that has been on the market for a while and has not sold yet because others do
not want it.

Baum’s team was hesitant to do the trade. They thought that Vennett was simply playing them for
fools. Baum however, wanted to find out if Vennett was right, and convinced the rest of his team to look
into it. Two guys from Baum’s team headed to a town to survey mortgage owners who were late with
their payments. They were met with tenants who were unaware that their landlord’s were not paying their
mortgages, and empty houses that seemed like the owners had no plans of paying their mortgages or
coming back at all. They visited almost a hundred houses and noted that only a scarce amount of people
lived there in total.

Baum digs a little deeper and talks to some mortgage brokers about the current state of the
market. The brokers write around 60 loans a month, saying that 90% of the loans were adjustable-rate.
Applicants were never rejected, even if they did not have a source of income or a job. The brokers even
admitted that they targeted vulnerable people because they were less likely to understand what they were
getting into, and they would not realise that the interest on the mortgage they are paying could go up by a
significant percentage. Seeing all this, they were slowly realizing that Vennett was right, and that there
was a housing bubble that would indeed collapse. Baum bought $50 million in credit default swaps.

There are still a few characters who have not been introduced yet, namely Charlie Geller (based
on Charles Ledley) and Jamie Shipley (based on Jamie Mai). The two are small-time traders, who started
with a capital of $110,000 but grew it to $30 million within 4 years. They caught wind of Burry and
Vennett betting against the housing market and realised that they were right. Their problem however, is
that they could not purchase credit default swaps as they did not have an ISDA (International Swaps and
Derivatives Association) agreement. An ISDA Agreement is an agreement that lets an investor make
high-level trades not available to others. One would need this in order to become a high-stakes trader.
Geller and Shipley were denied an ISDA by all banks because the capital requirement for it was $1.5
billion. They approach Ben Rickert (based on Ben Hockett), former Deautsche bank trader, for help.
Rickert agrees to talk to banks to get the two an ISDA.

Back to Burry’s side of events, he was soon visited by Lawrence Fields, who is actually Joel
Greenblatt in real life, but will be referred to with his screen name in this paper. He is a hedge fund
manager, a value investor, and works with Burry in Scion Capital. He is highly against Burry betting
against the market, because he strongly believes that there is no housing bubble. He hassles Burry to give
him back his money, but Burry insists that the payout in ‘07 would be great and to wait.

The film then skips to January of 2007 where mortgage delinquencies have reached an all time
high of more than a million. A mortgage delinquency is basically just when the person who took out the
mortgage loan is late on their required payments. Baum thought this meant that they successfully bet
against the housing market, but was informed that subprime mortgage bond prices are actually up and not
down. This was strange as why would the bond be up when the subprime loans it is made up of is down?
A rating agency claims that the delinquency rates are within their models, which is why the bonds are still
rated AAA. In other words, they still believe that the loans are solid and that people would pay eventually,
because again, who does not pay their mortgage? It was also revealed that banks who come to this
particular rating agency, Standard and Poor’s, would always receive the ratings they wanted, because the
agency did not want the banks to go to other competing agencies instead. They wanted to keep the banks’
business. It was like they were not even actually evaluating the bonds anymore, they were simply
slapping a AAA rating on a bond as long as they got paid.

While scouting for information in a convention, Geller and Shipley realise that AA bonds might
also be as bad as AAA bonds, so they purchase AA tranches. They were actually the only ones to do this,
as Burry and Baum only went for AAA. In the same convention, Baum meets who he is betting against, a
CDO manager, Wing Chau (same name in real life). Chau explains that there are actually a lot of CDOs,
one being CDO squared and another being synthetic CDOs. In the simplest of terms, a synthetic CDO is
basically a bet on the outcome of another bet, and so on and so forth. Baum realises that the economy
failing was no longer a mere possibility, but an inevitability.

Around April of 2007, news broke that New Century Financial, a subprime mortgage lender that
was a leader in its industry, filed for bankruptcy. It was also reported that the manufacturing index–which
is a monthly indicator of economic activity based on a survey–also fell. Overall, economic growth was
slowing down. However, the price of our protagonists’ shorts remained the same, as banks claimed the
CDOs have not moved, which felt to them like fraud as we have mentioned earlier that the mortgage loans
that comprised the bonds were failing. Geller and Shipley came to the conclusion that this was happening
because banks were first unloading their bonds, and would only devalue them after they get the bonds off
their books. In other words, they think that the bonds would only lose value when banks have gotten rid of
theirs, and they have little to no money left to lose since they have already sold their bonds. The two went
to the Wall Street Journal about this to try to get a journalist to write about the story, but seeing as they
were not a reputable source and they had no proof, nothing came of it.

Although there was no official news about the mortgage bonds being devalued, word around the
street was quick to spread. Soon enough there were more people trying to buy swaps rather than the usual
bonds on the mortgages. In short, people were now looking to bet against the housing market. Even
without an announcement, people were beginning to realise that there really is a problem in the housing
market, and that it would soon come crashing down and lose a lot of its value. It was not as solid as they
thought it was.

During this time, Geller, Shipley, and Burry were starting to unload their swaps. Geller and
Shipley sold theirs for $80 million, while Burry got what he initially invested, $1.3 billion, and then some,
with a total profit of $2.69 billion. Vennett, though he did not own any swaps, got a bonus check worth
$47 million from his deal with FrontPoint. Baum on the other hand, refused to sell as quickly as the
others. When Baum eventually does sell, they make a billion dollars.

In September of 2008, Lehman Brothers stocks dropped to zero. They were an investment
banking company that was a wall street giant, and they filed for bankruptcy just like that. All of their
employees, an estimated 26,000, lost their jobs overnight. Despite this crisis being the cause of several
people’s oversight, willful neglect, and ignorance, only one banker was imprisoned. Kareem Serageldin, a
former executive at Credit Suisse. He was caught mismarking bond prices to hide losses. No one else was
burdened with the responsibility of the crisis. An unsatisfying ending for many I’m sure, but such is life.
 A scene from the film that stuck with me was when Baum was talking to mortgage brokers, and
they just admitted to him that most of the loans they wrote were adjustable-rate loans, and that all
applicants for it were always accepted. Their goal was not to help people get loans so they could buy a
home. Their goal was to sell whatever loan would get them a higher commission. They were bragging
about preying on people who did not know any better, people in a vulnerable sector like immigrants and
strippers who usually had all their money in cash and therefore could not really use it to build credit. All
those brokers cared about was earning a profit. I understand that we live in a capitalistic society where
people do what they can to earn money; but at some point, these people need to realise that the way they
are earning is immoral.

Another scene that comes to mind was when Geller and Shipley danced in the casino to celebrate
because they were sure that the AA bonds would fail and they would get a huge return on their
investment, Rickert was feeling more solemn. He was slowly realising the ramifications they would face
if they were right, if the bonds (both AA and AAA) did fail. People would lose homes, jobs, retirement
savings, and pensions to name a few. Rickert even pulled up statistics saying that every 1% that
unemployment goes up, 40,000 people die. It would not be an exaggeration to say that the outcome they
are hoping for would simultaneously make them rich and ruin thousands and millions of people’s lives.
Yet almost everyone in the film only cared about making more money. While I do understand that this
film is about how these men made millions, it is sobering to think and see that rich people will always get
to run away scott free, while the working class suffer. It really makes you feel bad for the ordinary man.

At the core of the crisis lies the housing market. To be more specific, it was the spread of
subprime mortgages, and the bundling of those into bonds, which were then sold with AAA ratings.
Subprime mortgages were loans made for people with bad credit, frequently with adjustable interest rates
that reset to higher levels after an initial low-rate period. These bad and frankly, dangerous loans were
packaged into mortgage-backed securities (MBS) and marketed to investors, giving a false impression of
security. They told investors that it was relatively low risk and high yield, which was always enough to
reel them in. The economic theory of moral hazard can be applied here. Lenders, knowing they could sell
dangerous loans as securities, did not really need a reason to ensure borrowers' ability to repay. This
resulted in a housing bubble, with rising home prices driven by greater demand and easy lending. When
interest rates were adjusted and borrowers started defaulting, the bubble burst, forcing property prices to
plunge and leaving banks with worthless securities.

CDOs and credit default swaps (which will be referred to simply as swaps) made the crisis worse.
Again, CDOs are formed by pooling various types of debt, which includes these subprime mortgages, and
then selling portions of those pools to investors. Rating agencies, tormented with the thought that their
clients would patronize a different agency, gave these CDOs AAA ratings. They disregarded that these
assets were unsafe and simply lied by omission to investors about the risk. Swaps, on the other hand, were
basically like insurance arrangements for these assets. Investors such as Burry and Baum bet against the
housing market by buying these swaps, expecting the bubble to burst and the value of MBS to plummet.
This type of speculation, while rewarding for some investors, exposes that there truly are risks and
vulnerabilities in financial markets, not to mention their lack of transparency.

So now you might be thinking, why was all this allowed to happen? Well, there was a severe lack
of regulatory agencies to look over the market. Yes, the SEC does exist, but they did not seem to be
paying close attention when all this happened. Either that, or they knowingly allowed this to happen. The
film talks of the failure of regulatory bodies to rein in the financial industry's excess. It criticises
institutions such as the SEC and the Federal Reserve for failing to identify and manage developing
problems in the housing market and banking industry. This failure may be in part of the view that the
market self-regulates.
 The crisis not only affected the US, but the whole world. It triggered a severe global recession,
with millions of people losing their homes and jobs, and countries experiencing negative GDP growth.
Several big name companies went bankrupt. Global stock markets plummeted, and trillions of dollars
were lost in the blink of an eye. There was a lack of credit availability, which made banks reluctant to
lend. The prices of homes dropped. There was a sharp decrease in consumer spending, and these were
only the short-term effects. Long-term, this worsened economic equality. The gap between the rich and
the poor was only exacerbated by the crisis. For a long while, interest rates were kept at a low level, as
banks wanted to encourage people to borrow, as borrowing money and spending it would help stimulate
the economy. Banks and brokers became a lot more strict with who could get approved for mortgage
loans. There was a rise in distrust in financial and political institutions.

It was not at all easy to try and pick up the pieces that the crisis left behind. With 8 million people
jobless and 6 million people homeless in the US alone, it would be extremely difficult for these people to
get back up on their feet. This problem was not one that could be solved by private institutions alone; they
needed the help of the government. So, in October of 2008, US Congress passed the Emergency
Economic Stabilization Act, which created the Troubled Asset Relief Program (TARP). This program
authorized the Treasury to purchase up to $700 billion in troubled assets from financial institutions. TARP
sought to stabilise the financial sector by pouring capital directly into banks, taking their toxic assets to
get rid of, and rebuilding trust in the banking industry. Not just this, but in February of 2009, the Obama
administration implemented the American Recovery and Reinvestment Act (ARRA), which is a $787
billion stimulus package designed to jumpstart the economy. The ARRA included tax cuts, expansion of
unemployment benefits, and funding for infrastructure projects, education, and health care, with the goal
of boosting demand and creating jobs for the millions of people the crisis left jobless.

The Federal Reserve System, the central banking system of the US, also jumped in to help. Led
by Chairman Ben Bernanke, he took unprecedented steps to stabilize the economy. This included
lowering the federal funds rate to near zero and implementing quantitative easing (QE) programs. QE is a
form of monetary policy, wherein a central bank like the Federal Reserve would acquire securities from
the open market with the goal of reducing interest rates and increasing the money supply. The Federal
Reserve bought large quantities of government securities and mortgage-backed securities. With this, they
wanted to inject liquidity into the financial system, lower long-term interest rates, and support mortgage
markets. The Federal Reserve also established several emergency lending facilities to provide liquidity to
banks and other financial institutions, ensuring that they had enough capital to function and lend to
consumers and companies.

The US Congress also passed the Dodd-Frank Act in 2010. It was considered the most
comprehensive financial reform since the great depression almost 70 years before. The act sought to
reduce the risk of future financial crises by heavily increasing control and regulation over the financial
industry. With this, the Federal Reserve began performing annual stress tests on large financial institutions
to assess their ability to withstand economic declines. These tests tested banks' capital sufficiency and
resilience in the face of bad economic conditions. To avoid excessive risk-taking, banks were forced to
keep more capital and implement strong risk management practices. The government was trying to ensure
that nothing of this scale and magnitude would ever happen again.

If we look closely at the government’s response to the crisis, you may notice that all of the
solutions were just for the financial institutions; the banks, the people who ran them, the people investing
in them. Where were the solutions for the ordinary joe? Nowhere. All they wanted to do was restore and
stabilize the housing market, and set the foundation for a gradual economic recovery. Having taken a
course in international relations, I do understand that the government only ever does what is best for the
country as a whole. They always, always keep their national interest close at heart. I get that that is what
they have to do, but it does not mean I agree with it. The conflicting thoughts of finding all this hard to
stomach, but still realising that it is what needed to be done, can coexist.

To quote Mark Baum in the scene where he debates Bruce Miller, “At the end of the day, average
people are going to be the ones that are gonna have to pay for all this. Because they always, always do.”
Those rich people in suits might lose a couple millions, but it is just chump change to them. The average
person would, and did, lose everything. And when everything came crashing down, who did the
government rush to aid? The masses? No. They hurried to bail the banks out of a mess they themselves
created all because of their greed.

This whole situation angers me, because did not one person think about what would happen if the
CDOs they sold failed? From a young age I have been taught to always question and second guess
everything. My dad taught me to look for holes and inconsistencies in things so that I could always be
ready with a backup plan if necessary. It makes me wonder why not a single person had the foresight to
do the same thing. Everyone’s excuse here seems to be that “the housing market is solid.” People must
remember that the only constant is change and to thus be prepared for it.

What the banks did to people was nothing short of fraud. They knew they were selling bad CDOs;
that it was full of subprime mortgages. They knew that the rating agencies were not accurately rating
them. Yet, they marketed the bonds as AAA anyway; said they were solid and unloaded them to investors.
Time and time again were we taught in our class that greed is good. Greed makes the world go round and
keeps the economy pumping. Greed motivates us to earn more, so that we can spend more and consume
more. But at some point we must stop and ask ourselves, to what extent is greed good?

In an email to his investors about his decision to close down Scion Capital, Burry writes, “This
business kills the part of life that is essential. The part that has nothing to do with business.” I agree with
his sentiment. People, especially the ones depicted in the film, have become so consumed with money,
and making it, and spending it. Their relentless pursuit of profit often makes them lose sight of things that
actually matter. They focus on metrics, and data, and stocks, and bonds, and nothing else. Too often are
there stories of people who only realise what is actually important to them when they lose it. I will not
allow my life to be one of those stories.