The Big Short Movie is based on the 2008 financial market crash. This crash was so big that it put the whole world into recession. Everyone was losing jobs and was not even able to feed their families. But there was one person who profited the most from this crash; his name is Michael Burry, a hedge fund manager. How did Michael Burry figure out about the potential crash? Why exactly did the financial crisis happen? We have simplified and explained this movie, so even dummies can understand it easily.
Contents
The American Dream and Greedy Banks: A Recipe for Disaster
The two important factors in this financial crash were the American dream and the greediness of the big banks. The American dream we all know is the idea that everyone is hardworking, has a good job, and owns a home. Every immigrant who comes to America has this American dream, and they strive to buy a home by working hard.
Now let’s start from the beginning. The important aspect of the 2008 crash is that everyone wants to own a home. To buy the home, banks provide loans. When a borrower goes to the bank to get a loan. Banks cross-verify whether that person is capable of paying back the loan. If the person is not capable of paying them, banks usually rejects the loan. If the person is capable of paying back the loan, then the bank gives him the loan and earns interest. That’s how a commercial banks make money by giving out loans.
The Mortgage Machine: From Loans to Securities
But what happens after banks gives out these loans?
Let’s say 10 people have taken a loan from ABC Bank to buy a house, and they owe money to ABC Bank. Now, what ABC Bank does is sell these loans to an investment bank. Now people owe the money to the investment bank.
The investment bank combines these loans and creates new products known as mortgage-backed securities. The term for this process is securitization. It allows investment banks to transform a portfolio of individual loans into a tradable security. Investors then purchase this product. As everyone pays their home loans to own a house, so investors consider these mortgage-backed securities as the safest investments. The home loans were the fundamental part of these mortgage-backed securities.
The Deceptive Ratings Game
In mortgage-backed securities, these loans given ratings by rating agencies like Moody’s. They rate the loans according to the behaviour of the borrower. It is called a tranche. For example, if a borrower pays the premium on time and never misses any premium. The probability of such a borrower paying back the loan is higher. So, typically, such loans receive higher ratings. These loans are rated AAA.
Another type of borrower might miss some of the premium here and there, but at the end, he will pay back his loan. He may pay it a little late, but in the end, he pays it back, and this type of borrower is slightly riskier than the previous type of borrower. So, typically, such loans receive slightly lower ratings. These loans are rated BBB.
The third type of borrower might default on his payments and not be able to pay back his loan. Such loans are rated lower, and they are rated as CCC loans.
Now, when investors invest in such mortgage-backed securities, they first check the overall ratings given by the credit rating agencies to these mortgage-backed securities. Investors considered a mortgage-backed security safe if it contained a higher proportion of AAA-rated loans.
But there was another problem because investment banks and credit rating agencies were hand in hand. The credit rating agencies never gave the true rating to these loans. For example, if the loan actually had a rating of CCC but the credit rating agencies ignored that and gave it a rating of AAA. So, all these mortgage-backed securities given higher because of these fraud ratings by credit rating agencies.
Because of this, investors thought these mortgage-backed securities had the majority of AAA rated loans. But instead they all were filled with the majority of CCC rated riskier loans. Which made these mortgage-backed securities much riskier than investors thought.
The Rise of Risky Lending by Greedy Banks
This whole process was very beneficial for the banks. Banks would just give out loans, and then they would just sell these loans to the investment bank. The investment banks would then just create mortgage-backed securities with these loans, and credit rating agencies would rate them higher. Then investors bought it as a safe investment.
But all of this was going on the assumption that everyone paid their loans. Which, in the majority of cases, is true. But the number of loans a bank can give, is limited to people who have a good income. So, banks started to give ARM loans, which means adjustable-rate mortgages. An adjustable-rate mortgage is a type of home loan that has an interest rate that can change periodically over the life of the loan.
Before the 2008 financial crisis, lenders and banks were offering ARMs with very low initial rates to entice borrowers, but those interest rates would increase after the initial period, often causing payments to become unaffordable for borrowers. This attracted many borrowers who were not responsible with their finances. Ultimately leading to many bad loans. This led to more triple-C types of loans in the MBS product.
To entice more borrowers, banks started giving interest-only adjustable-rate mortgage (IO ARM) loans. It is a type of mortgage loan that allows borrowers to pay only the interest portion of the mortgage payment for a certain period of time, typically the first few years of the loan. After the interest-only period ends, the borrower must begin making payments that include both principal and interest.
This type of loan became popular in the years leading up to the 2008 financial crisis, as it allowed borrowers to make smaller monthly payments during the interest-only period, which could make homeownership more affordable. This attracted even more risky borrowers to take out loans.
However, these loans were also associated with higher risk, as borrowers were not paying down any principal during the interest-only period. But when the interest only payment period was over, they were often unable to pay the higher payments that included both principal and interest.
If interest-only adjustable-rate mortgages were not enough, the banks wanted to entice even more people to take loans. So later, the situation got even crazier, and banks started giving an interest-only negatively amortizing adjustable-rate subprime mortgage (IO-NA-ARM). This was the worst type of loan. In which the borrower could pay almost nothing or a very small amount of the premium every month. And their remaining premium amount would get added to the principal amount of the loan.
This type of loan attracted even more risky investors. Who just borrowed money and then eventually defaulted. These loans were then added to the mortgage-backed security product. The credit rating agencies gave triple-A ratings to MBS bonds which had majority of such loans.
Because of this, mortgage-backed securities had mostly such worthless loans. Which was nothing but a ticking time bomb. All of this craziness was going on the assumption that demand for houses would keep increasing and the price of the houses would continuously go up. Also, the interest rates were lower when giving out these loans.
Borrowers Defaults
When interest rates started to go up or were re-adjusted for the loan amount. Many of these borrowers were not able to pay any of these loans, and they started defaulting on their loans.
So, banks took their homes to resell them. This started to happen with all the loans that were given, and eventually everyone was defaulting on their loan. So, this created a huge supply of homes in the market where there are not enough buyers. This resulted in home prices starting to go down and resulted in a wave of foreclosures when home prices declined. But the banks were not even able to get 50% of the original value of the house.
Once the borrowers started defaulting, the cascading effects started, and the investors who bought the mortgage-backed securities of these loans also started losing money. So, it was a chain reaction that started from the bottom and ended at the top.
Wiped out Pension Funds and Big investors
In the 1980s, the US government passed the Secondary Mortgage Enhancement Act, which allowed pension funds and insurance companies to invest in these private MBS. As the credit rating agencies gave these MBS good ratings. The pension funds and insurance companies had invested billions of dollars in these MBS. But these pension funds and insurance companies lost those billions of dollars during the crash, wiping out the pensions of the hardworking common people.
The Genius Michael Burry watching all the drama
Now all of this chaos was happening while everybody was unaware of what was going on. There was one guy, Michael Burry, who was carefully observing what exactly was happening. As all the loans given out by the banks had to be reported to the SEC. All this loan data was in the public domain, and nobody cared to read it except Michael Burry.
When he read all the details of these MBS bonds. He understood that a large portion of all these bonds had interest-only adjustable-rate mortgages. Which he found very shady. He further studied the housing market and figured out that the growth in the housing market is a bubble. At some point, this bubble in the housing market is going to burst and crash the market. This was around the year 2004–2005.
Michael Burry correctly predicted that the crash would begin in second quarter of the 2007. In second quarter of 2007 the interest rates of all these adjustable-rate mortgages reset or changed.
Michael Burry, at the time, was managing a hedge fund. As the manager of a hedge fund, it was his job to find investments where his investors would make the most profit. If you want to learn more about hedge funds and how they work, check out this article.
Burry Bought Credit Default Swaps
At the time, there was no method or instrument with which you could bet against the housing market. Michael Burry went to those investment banks and asked them to create a new instrument called credit default swaps.
With credit default swaps, he bet the money on these mortgage-backed securities that they would fail. He also paid the monthly premium for those swaps. Basically, he shorted the housing market. That’s why the movie is named as The Big Short.
It was very unusual at the time because everyone assumed that everybody paid their loans. Everyone thought he was crazy and wrong. But Michael Burry was sure the housing market would crash. Even the big investment banks with big research teams were not able to figure out this ticking time bomb. Once people started defaulting on their loans, the domino effect started, resulting in a global recession.
Making huge money
When the housing market crashed, Michael Burry received all the premium amounts he paid for those credit default swaps and the value of the contract they fixed. Michael Burry’s bet made him $100 million personally and a total of $700 million for his investors.
This is how the greediness of the big banks caused one of the biggest financial crashes in history. The story of Michael Burry tells us that not to blindly believe anything that is going on in the market. You need to do your own due diligence before making any kind of investment to make real money through the markets.
We hope you understood everything about the big short and 2008 financial crisis and if you did, then give check out other articles on the site.
FAQs
Is Michael Burry in The Big Short?
Yes, Michael Burry is a central figure in “The Big Short.” He is portrayed as the hedge fund manager who predicted the 2008 financial market crash and profited significantly from it.
How much did Michael Burry make in The Big Short?
Michael Burry made $100 million personally and a total of $700 million for his investors by betting against the housing market through credit default swaps.
How to invest like Michael Burry?
Investing like Michael Burry require a lots of research and patience. Michael Burry usually looks for the value stocks which are cheap in price but have a great potential to grow overtime. Check out, Michael Burry’s strategy for investment.
Who predicted the 2008 crash in The Big Short?
Michael Burry, a hedge fund manager, predicted the 2008 financial crash. He closely analysed the mortgage-backed securities and foresaw the collapse of the housing market.
How did Michael Burry profit?
Michael Burry profited by purchasing credit default swaps, a financial instrument that allowed him to bet against mortgage-backed securities. When the housing market crashed, these swaps paid off significantly, earning him and his investors substantial profits.
Where did Michael Burry learn to invest?
Michael Burry learned to invest on his own. While working as a doctor he used to do trading on the side during his free time, from there he initiated and later started a Hedge Fund Scion Capital. Check out complete Back story of Michael Burry.
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