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The Big Short,
a 2015 film directed by Adam McKay, follows three parallel stories of the US
mortgage housing crisis.  The first story
follows Michael Burry, a capital hedge fund manager, who accurately predicts
the housing bubble and decides to short the housing market. 

The
film begins by explaining what would eventually become one of the foundations
of the US banking industry, the mortgage backed security, or MBS.  A mortgage backed security is an asset backed
security where the asset is a typical home mortgage.  Mortgage backed securities were authorized in
1968, when President Lyndon Johnson authorized the Charter Act.  In addition to creating Fannie Mae, the
Charter Act gave banks the ability to sell mortgages to non-bank investment institutions. 

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Typically
after a bank or mortgage company makes a home loan, they then sell the loan to an
investment bank who bundles the loan with other mortgages of similar interest
rates.  This bundle is placed into a
shell corporation called a Special Purpose Vehicle, which is specifically
designed to insulate the mortgage backed security from the bank’s other
services. (Amadeo, 2017) 

The
Charter Act was not intended to remove good lending practices.  However, banks began to realize that as
mortgage backed securities became more popular, they were able to sell their
mortgages and recoup the cost of the loan with little or no risk to them.  This lead to banks approving variable
interest loans to customers that were normally considered ‘at-risk’, also known
as a subprime loan.  “While subprime
rates vary from lender to lender, the Federal Reserve defines a subprime loan
as one that carries an interest rate at least three percentage points higher
than the rate on a US Treasury bond that has the same term as the loan.  Subprime loans may provide credit to
responsible people who may not have a strong credit history. However, subprime
lending practices can be abusive or predatory, trapping unsophisticated
borrowers in a cycle of debt while providing initially large profits for the
lender.”  (“Subprime Loan”,
2008)

In
the film, hedge fund millionaire Michael Burry, played by Christian Bale, comes
to the realization that the housing market is backed by subprime loans, where
the majority of them have variable rate interests that will rise in second
quarter of 2007.  Betting on the fact
that the high risk subprime loans will default when their rates rise, he begins
to engage the large Wall Street institutions, expressing the idea that the mortgage
backed securities will fail, and creating a credit default swap market.  A credit default swap is a “contract between
two parties where the buyer makes periodic payments (over the maturity period
of the CDS) to the seller in exchange for a commitment to a payoff if a third
party defaults.” (“Credit Default Swap”, 2011)  In other words, the CDS is insurance against
the failure of specific mortgage backed securities.  To further compound the issue, investment
banks were creating Collateralized Debt Obligations, or CDOs, that were made up
of the lowest tier of mortgage backed securities. 

The film ends in 2008
with the collapse of the US housing market. 
As predicted by Burry, customers began to default on their loans due to
higher interest rates and mortgage backed securities began to fail.  Therefore since the flow of cash to the CDOs
dried up, the CDO managers could no longer make payments to their bondholders, resulting
in millions of dollars paid to the holders of credit default swaps.  

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