The hugely inspirational Big Short

Dear Traders,

If you remember my Top 5 trading movies article , you might ask why I haven't written about The Big Short yet? In short, I hadn't seen it yet. Now I have watched the movie and I think it deserves not only a place on my favourites list, but also an Oscar.

This movie is joyous, even brilliant and yet still manages to shed a bright light on a complex, important financial subject. With a by Hollywood standards low budget of approximately USD28m, the site Box Office Mojo claims the movie has managed to quintuple investment by skyrocketing its profit to an estimated USD121m worldwide.

A star studded cast

The movie cast four famous actors including my favourite actor Christian Bale, together with Steve Carell, Ryan Gosling and Brad Pitt. All of them are witty, funny and generally clever in that their performances (along with the script) manage to sweep away any concerns about rooting for people who get rich by betting against the overall health of the US economy. In fact there's even mention that whenever 1% of unemployment goes up, 40,000 people die. Is what these traders did the right thing to do? Well it's perhaps morally questionable, but in trading terms it was an epically good move.

The movie is a display of acting prowess, wrapped in a true event's credibility.

Bale's performance is both hilarious and socially awkward. For example, his character Michael Burry, waltzes into some of the biggest banks in New York with an agenda to bet against what was widely considered an unbreakable US banking system. With a deadpan expression, Burry buys credit default swaps over various mortgage debts, after he discovers that there are large impending defaults on these debts.

Steve Carell's quality of acting in this movie is outstanding too and uncharacteristically drama rather than comic based.

Ryan Gosling first captured my attention in one of my favourite movies called Stay. His portrayal of Jared Vennett a.k.a Greg Lippman - a Deutsche Bank trader who believes in Burry's mortgage market predictions and cashes in on them - is Oscar worthy in The Big Short.

A long take on a short event

The intrinsically unique quality of The Big Short script is that it takes a highly complex economic subject and relays it in an understandable form for the masses.

The admittedly long duration movie was infact first introduced as a much longer award-winning book entitled The Big Short: Inside the Doomsday Machine by Michael Lewis. Paramount acquired the rights to make the movie in 2013 and has kept the film true to the book's plot.

The Big Short is essentially about the Global Financial Crisis (GFC) and how the USA's banks were knowingly:

  1. making loans to people who could not afford repayments - especially those termed No Income, No Job Applicants; then
  2. unethically packaging their loan books with collateralized debt obligations (CDOs) and selling them off to investors.

The plot explains how traders like Burry found out about these CDO's possibly collapsing in 2007 and started taking large short trades on various banks that were exposed to these CDO's. These short trades were effectively over-the-counter (OTC) credit default swaps (CDS) that netted these traders billions. But before I clarify why the movie should inspire traders, let me explain two of the acronyms that were frequently used during the movie.

CDOs

The collateralized debt obligations are a group of loans that a bank holds on its balance sheet like a debt portfolio, that are bundled into a product called a CDO Note. These CDO Notes are:

  1. sold to investors (usually hedge funds, superannuation funds, high net worth individuals, other banks)
  2. offer average returns for the underlying debt portfolio
  3. usually sold in different tranches:
    • which attach different credit ratings; with
    • the top tranches of the CDO attaching the highest credit rating with lowest credit risk (therefore lowest average return on investment) and vice versa.

The lower tranches of many CDOs originated in the USA during the GFC and involved a large proportion of subprime mortgages that were on the verge of defaulting. During this time, US Banks were most likely aware that they were originating bad loans and therefore accelerated their selling of CDOs to reduce their risk.

CDS

Credit default swaps can act as a hedging instrument - like insurance against a non-payment of a debt issuer - or for speculative means.

A buyer of a CDS can either mitigate the risk of default by a debt issuer, or speculate on the default of a debt issuer in exchange for a periodic fee to the CDS writer/seller. In this way the:

  1. buyer of a CDS receives credit protection, or a profit if the debt issuer defaults
  2. seller of the CDS guarantees the creditworthiness of the debt issuer.

For example:

  1. if the debt issuer defaults on repayments, the CDS seller has to reimburse the CDS buyer for the unpaid interest and principal of the debt
  2. If the debt issuer honours debt repayments, the CDS buyer will lose the amount paid (known as CDS premiums paid to the CDS seller).

CDS on the US housing market

In The Big Short, large investment banks like Deutsche Bank and Goldman Sachs were the writers of CDS to various investors who were using CDS as a speculative tool. In the end, housing loans across the USA defaulted on masse and as large US banks like Bear Stearns went in Bankruptcy, banks like Deutsche Bank had to make large pay-outs on the CDS they sold. Key movie character Burry received one of these payouts, earning himself USD100m and a profit of USD700m for his Scion Capital investors.

Bespoke Portfolio (CDO)

First, one must describe what a Synthetic CDO is, and that is a variation of a CDO that generally uses CDS and other derivatives to obtain its investment goals. Thus, it is a complex derivative financial security, sometimes loosely referred to as a bet on the performance of other mortgage (or debt) products, rather than a real mortgage backed security like traditional CDOs. The movie refers to Bespoke Portfolios as the new wave of CDO's, but in fact they have been around since the 1990s. They are often very hard to calculate as they involve very complex calculations, and are not really liquid, but they are cheaper to originate than traditional CDOs.

So why was this movie inspirational?

What distinguishes established traders from the rest, is their ability to control emotions in highly volatile markets. Michael Burry epitomises this behaviour. He also reminds us that believing in your trading strategy despite what the less informed may say, can lead to enormous financial returns.

The fact that these abilities are not specific to high stakes, big player CDO traders is pure inspiration for any Forex trader too. For example, last year's Black Swan move in EUR/CHF was a game changer for those that stayed informed, calm and focused - people who shorted the SNB floor made millions of dollars therein.

Federal regulations have tightened up in the USA since the previous collapse. Today we don't have such hype about mortgage lending practices. There are liquidity buffers, stress-tests, risk management, compliance and additional supervision. However, if you want to trade Forex, you can still taking educational inspiration from The Big Short's storyline and choose to pro-actively do so with a transparent, regulated broker.

The Big Short's outro tells us that Burry only invested in one commodity, water. Who would have thought that such a common commodity, could be so attractive? Again inspirational, because the example shows everyday traders that it doesn't matter what you choose to trade - careful planning, determination and risk management are crucial regardless.

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Still have unanswered questions about The BIg Short, CDOs, CDS or the GFC? Or perhaps you just want to add something? Feel free to do so in the comments section below.

Cheers and safe trading,

Nenad