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The Big Short

The Big Short

The “elevator pitch” is the stuff of movie folklore. It comes from the early days of Hollywood, when an aspiring screenwriter would catch an unsuspecting mogul in a lift and pitch his idea to the captive executive before he reached his destination.

One can only imagine the pitch for The Big Short. “It’s about derivatives. Specifically, it’s about residential mortgage-backed securities, collateralised debt obligations and credit default swaps.” Not exactly Jaws, is it?

Yet as a movie it works well. It has a big name cast (Christian Bale, Ryan Gosling, Steve Carell and Brad Pitt). It’s based on a best-seller by former Salomon Brothers trader Michael Lewis, with a screenplay by Adam Mackay (Anchorman, Talladega Nights). And it tells the story of how events in the US housing market brought the world economy to its knees.

It’s undoubtedly a difficult story to translate to the big screen, given the subject matter. Derivatives – products whose value derives from the value of an underlying asset – come in all shapes and sizes, and some of them can be bewildering in their complexity.

I’ve invested in these varieties of derivatives for a number of years. I’m used to explaining the concepts to potential investors.  But I’m usually talking to the more financially sophisticated investor.

Dealing with the mass market requires a different approach. So the screenwriter has attempted to illustrate these concepts by way of celebrity cameo appearances. These include singer Selena Gomez in a casino explaining collateralised debt obligations, chef Anthony Bourdain in a kitchen untangling securitisations, and actress/model Margot Robbie explaining mortgage bonds. In a bubble bath. 

I started watching the film thinking: “I hope after seeing this, my mum might have a sense of what I do for a job.” But I’m not sure: if you’ve not got a sound grasp of the concepts to begin with, I don’t think it will improve your understanding.

The film pulls no punches in allocating blame. From real estate salesmen to mortgage lenders to investment bankers to credit ratings agencies – all come into the firing line. There is some justification for this. But The Big Short is important if it can go some way to explaining how the world’s financial system got in the mess that it did.

Modern residential mortgage-backed securities (RMBS) have been around since the mid-sixties, sponsored by US government agencies. But it wasn’t until the late 1970s that US bankers created the first non-government-backed RMBS.

As derivatives go, the idea was straightforward; take a bundle of home loans, pool the monthly principal and interest payments, and use the monthly cash flows as backing for the bond. The newly-created securities could then be sold off to investors. Nothing wrong there, in principle. But by the early days of this century, as US house prices rocketed, lending standards had begun to slip.

To simplify, the story reveals how it was possible for investment bankers to package up a number of home loans including loans with a high risk of default, and still manage to obtain a triple-A rating from the agencies. The repercussions? Mortgage lenders relaxed their lending criteria, realising they could back off any default risk to external investors. Meanwhile, the bankers could construct these securities artfully, such that the ratings agencies would confer the prized Triple-A rating on the product.

It was an accident waiting to happen. The prospect of mass defaults moved from possibility to likelihood to near-certainty, without most people noticing.

It was an accident waiting to happen. The prospect of mass defaults moved from possibility to likelihood to near-certainty, without most people noticing. Millions of ordinary Americans were encouraged to borrow heavily to take advantage of the relentless increase in house prices. One cameo scene within the movie reveals how a Las Vegas “exotic dancer” with an irregular income managed easily to borrow to acquire seven separate homes.

This state of affairs was eventually spotted by a tiny number of investment managers. They’re not heroes in the traditional Hollywood style, in that they weren’t crusaders, trying to right a wrong. They were simply doing their jobs –  trying to make money out of what they saw as a market anomaly.

The movie lays the blame at cynical investment bankers who set out to “game” the system, constructing deliberately arcane investment products with the aim of disguising the poor quality of the underlying assets. It’s also made clear that mortgage lenders felt no care of duty to their clients, merrily extending loans to anyone who asked. “Ninja” loans – issued to borrowers with no income, no job and no assets – were rife. It’s alleged that the credit ratings agencies were irresponsible – indeed, it’s even suggested that they were compromised by the bankers into “selling” AAA ratings.

Much of this may have been the case, and many people in the financial services industry skipped a lot of the work they should have done,

Nowadays, I believe it’s different. The financial services industry is much better regulated now than it was then. The knowledge base has increased considerably. I remember selling bond funds back in the early noughties, and found myself having to explain what a buy-to-let, a semi-prime mortgage or a prime mortgage was. You don’t now - people know what they are.

And ever since the financial crisis, a good IFA will question what’s in your fund, why you are buying RMBS, and what kind of RMBS you are buying. People rightly go through everything.

But there is a danger that the main message people will take from The Big Short is that bankers are evil, and the financial services industry is rotten to the core.

In my opinion, that’s a simplistic approach to take. It’s like suggesting that individuals have no obligation to take responsibility for their own financial decisions. Instead, it was all the banks’ fault for selling it to them.

Of course, the reality is quite different. Individuals also have responsibility for their own financial decisions. The message is clear: if you don’t understand the product, don’t buy it. Also, society needs to improve financial education generally.

Lastly, I should point out that it was the investment community that spotted that something was wrong. Not the banks. After watching The Big Short, if people separate the two of them in their minds, I think we – as investment managers – actually came out of that quite well.

Image credit: © David Bro/ZUMA Press/Corbis

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