Based on the book of the same name by Michael Lewis, the Big Short is a movie about several hedge fund managers who identified cracks in the mortgage market in 2005-2007 and attempted to bet on a collapse in the market for mortgage-backed securities (MBS). In particular these managers noted that underwriting standards on mortgage loans had weakened dramatically and so-called “private label” securities, i.e., those not insured by an agency of the federal government, were highly susceptible to failure.

The main character in the movie is a former physician, Dr. Michael Burry (played by Christian Bale), who is afflicted with Asperger’s Syndrome and, while incapable of social interaction, has massive powers of concentration. He becomes obsessed with these uninsured securities and carefully reads through thousands of pages of documentation to dig into the specific underwriting standards for the tens of thousands of loans underlying the securities. In 2005 he becomes convinced that a certain subset of these loans will fail in 2007 when the so-called “teaser rates” are scheduled to reset (teaser rates are low introductory rates on Adjustable Rate Mortgages (ARMs) that are scheduled to move sharply higher, unless market interest rates fall a lot).

Dr. Burry goes to several Wall Street firms, starting with Goldman Sachs, and announces that he wants to “short” (sell) the securities backing these risky loans. These firms comply with his request by entering into so-called Credit Default Swaps (CDS) whereby Dr. Burry, the insurance buyer, pays a fee each year to the insurance seller, Goldman Sachs in this instance, in return for a massive payoff from Goldman in the event that the market value of the underlying MBS falls. Burry entered into such an enormous quantity of CDS that the annual fees he had to pay constituted nearly 20% of his entire $500 million fund. A side issue is that prior to this transaction, Burry had specialized in finding value in obscure individual stocks. His investors had no reason to believe, and did not believe, that he had any ability to identify “macro-economic” trends (like housing price declines or mortgage defaults). Thus, they were very unhappy that he was spending nearly $100 million a year on this macro bet. Indeed, they attempted to withdraw their money and thereby shut down his fund, but Burry closed the fund to redemptions and immediately became the subject of numerous investor lawsuits.

Ultimately, Burry was proven right, not because the ARM note rates rose, but rather because housing prices topped out in 2006 and began falling in 2007. Mortgage borrowers who were stretched to the limit (like the case of the female stripper in the movie who owned five houses and had ten mortgages) were unable to refinance their loans or sell their homes at a profit, so they walked away from the mortgages, and the value of at least some of the mortgage securities plummeted. In fact, some tranches (pieces) of MBS fell 100%, to zero.

How can the value of MBS go to zero when the value of the underlying collateral, the individual homes, did not fall to zero? Well, the way that private-label MBS worked is through a process of “credit tranching” whereby lower rated tranches supported higher rated tranches. For example, suppose a $100 million MBS is divided into three tranches: a senior tranche of $80 million that is rated AAA (highest possible rating), a mezzanine tranche of $15 million that is rated BBB, and an equity tranche of $5 million that is unrated. All the losses on the entire $100 million pool of loans are absorbed first by the owner of the equity tranche, up to $5 million. Additional losses are absorbed by the mezzanine tranche, up to another $15 million. The senior tranche absorbs losses only when pool losses exceed $20 million or 20% of the pool. Wall Street firms had no trouble finding buyers for AAA tranches, so the key issue in creating the security is how much protection or “subordination” did they have to put up in terms of the sizes of the mezzanine and equity pieces in order to secure the coveted AAA rating for the senior piece.

It gets even better. Wall Street financial engineers figured out a clever way to get much of the mezzanine pieces rated AAA as well. The trick was to combine a number of mezzanine pieces into another security, called a Collateralized Debt Offering (CDO), and create senior, mezzanine and equity pieces of the CDO. Once you put up what the ratings agencies (Standard and Poor’s and Moody’s) considered to be sufficient subordination, the senior pieces of the CDO were rated AAA as well. Supposing 20% subordination was required, 92% of the original loan pool is now rated AAA (the original 80% senior piece plus 80% of the 15% mezzanine piece). Sometimes there was even a third level, where issuers combined a bunch of CDOs together to form a new security (called a “CDO squared”), which again had AAA senior tranches.   Thanks to all this layering, if total losses on a package of loans should turn out to be even 10%, then it is possible, indeed likely, that the value of certain tranches of CDO or CDO squared could go to zero, even though they were once rated AAA.

Anyway, what happened was that housing prices started falling in 2007, over-extended mortgage borrowers stopped paying their mortgages, mortgage defaults skyrocketed, numerous financial institutions and portfolio managers that owned the MBS, CDO and CDO squared experienced enormous losses, many huge financial institutions failed or came very close to failure, and the overall economy cratered resulting in the “Great Recession” from which we are still recovering.

On the flip side, Dr. Burry and the other hedge fund managers highlighted in the movie and the book, had terrific returns and made a ton of money for themselves and their investors. Well, at least they did on paper. One major issue is that the other side to Dr. Burry’s transactions was one or another large bank or Wall Street firm. If these companies had failed, then Dr. Burry would have become a creditor of a bankrupt company and things would not have turned out so great. Effectively, the bailouts of the creditors of the big banks also bailed out Dr. Burry and the other brilliant investors.

There was a lot missing in the movie. There was no mention of the massive governmental effort to promote home ownership rates by weakening mortgage underwriting standards, nor the aggressive legal and PR campaigns against lenders who did not lower their standards for minority and low-income applicants. But the movie is entertaining and does highlight the fact that despite widespread awareness of elevated housing prices and weak underwriting standards, only a relatively few “crackpots” saw a debacle coming and attempted to act upon that belief. And even they had to be bailed out.