Let it be known, we had to look up how to review a movie. Remember, we are not professional spellers (if you recall the last LBW INSI”G”HTS) nor professional movie critics, although we try our best!
“In 2008, Wall Street guru Michael Burry realizes that a number of subprime home loans are in danger of defaulting. Burry bets against the housing market by throwing more than $1 billion of his investors’ money into credit default swaps. His actions attract the attention of banker Jared Vennett (Ryan Gosling), hedge-fund specialist Mark Baum (Steve Carell) and other greedy opportunists. Together, these men make a fortune by taking full advantage of the impending economic collapse in America.”
LBW’s thoughts on the movie:
Having read THE BIG SHORT written by Michael Lewis in 2010, I (Dan) personally wondered how a book, littered with complexities and industry jargon, could be made into a movie let alone reach the general population, be informative, and entertaining all in one package. Needless to say, they did it! I shouldn’t have underestimated Lewis as he also wrote Moneyball and The Blind Side, both great books and movies.
If the purpose of the movie was to unveil the immense amount of misconduct orchestrated by many, causing one of the worst recessions since the Great Depression in the United States’ history, then the producers accomplished their goals. The film drove this theme home by interjecting humor combined with creative ways to educate the viewers on concepts that can be difficult to comprehend.
The subject matter is fresh in many of our minds as we all have felt the impact of the financial crisis, brought on by the collapse of the housing market, in one way or another from individuals delaying retirement due to their retirement nest eggs collapsing, to new college graduates unable to find employment. Some felt it significantly more than others, but we all had exposure.
History tends to, in some degree, repeat itself. If you haven’t seen the movie, we strongly encourage you to do so. It is helpful to understand the past, in order to better grasp the future.
Below are a few frequently asked questions that people have asked us for further clarification on:
1. What is a CDO?
- Let’s first break down what CDO stands for – Collateralized Debt Obligation. To break it down even further, lets explain each word. First, Collateralized – to provide an asset, as collateral for, such as a loan. For example, when you are at a bar and want to play pool, the bartender may ask for your ID as collateral so you will not steal his equipment. The next two words are quiet common, Debt– something, typically, money that is owed or due and Obligation – an act or course of action to which a person is morally or legally bound; a duty or commitment. So, to put this into context, a CDO is a type of structured asset-backed security. The collateral used to back this product is usually a pool of assets that generate income or cash flow, such as mortgages. For example, when an individual buys a CDO that is backed by a pool of mortgages, the income is generated via the mortgage payments. If the pool of mortgages that make up to the CDO stop making payments, then the CDO owner has an economic right to the house, because the debt security is backed by the house’s equity. To further complicate the product, there are tranches. As explained previously, if the mortgages ceased payments, the CDO owner has an economic right to the underlying houses; however, tranches allow investors to purchase their place in line to receive their economic interest. For example, tranche A may be first in line, followed by B and C. If all the mortgages default, tranche A will get its collateral first and whatever is left will go to B and so on and so forth.
- What is a Synthetic CDO?
- As we did in question one, lets break down the definition of synthetic as it pertains to financial instruments. Synthetic – a financial instrument that is created artificially by simulating another instrument with the combined features of a collection or other assets. Even the definition sounds risky. The best way to explain how this relates to an investment product is to give an example.
There are two people: Joe and Jane.
Joe has a pen and Jane wants to buy it.
During their conversation of what price Joe is willing to sell the pen to Jane for, Bob and Brandy show up and begin to listen to their conversation.
From the discussion, Bob believes that Joe will sell his pen for at least $15.
However, Brandy thinks there is no way Joe gets more than $13.50.
So, Bob and Brandy enter into a bet: if Joe sells his pen for $15 or more, Brandy will give him $10, and if Joe sells it for less than $15, Bob will give Brandy $15.
What has transpired here is Bob and Brandy have created a synthetic agreement. The result of one of them winning the bet is based on the transaction between Joe and Jane, while Joe and Jane’s transaction is based on the pen. So, in this example Bob and Brandy’s bet is based on the pen, but it is one-step removed. To take this another step further, if Sean and Sally came along and overheard Bob and Brandy and subsequently bet on their (Bob’s and Brandy’s) transaction, they have now created another synthetic transaction and are two-steps removed from the underlying asset, the pen. A Synthetic CDO is no different than our example, except instead of a pen, insert a CDO. I hope this was helpful, we are not nearly as good at explaining this as Selena Gomez!
- What is a Credit Default Swap?
- Credit Default Swaps or CDS’s are another complicated investment product. In order to explain, we will first need to understand the individuals involved in the transaction. To create a CDS you need three parties 1) the buyer of the CDS; 2) the bond holder who will issue the CDS and 3) the entity that will guarantee the payment to the buyer if the CDS works out in his favor. What role does each party play?
- Buyer of the CDS – this individual buys the CDS and pays premiums to the seller of the CDS. The buyer is paying premiums because he is essentially buying insurance that if the bonds, which comprise the CDS, default he will get paid all of the premiums of the bond in addition to the interest and principal due.
- The holder of the bonds – this party holds the bonds in which the CDS is based on.
- The institution that guarantees payment – this party guarantees the payment if the bonds that the CDS is based upon default. They will pay all of the interest and principal to the buyer of the CDS.
- In essence, a CDS allow an investor to buy insurance on bonds, while paying a premium, and if that bond defaults, they win. If it does not default, then they lose. Michael Burry happened to be on the right side of that bet.
- I don’t quite understand Gosling’s character role. Please explain?
- Ryan Gosling played the character of Jared Vennett, a portrayal of Wall Street bond trader Greg Lippmann. To understand his character, you first need to understand what a bond broker or salesman is and does. Well, you may have guessed it – a bond broker or salesman, sells bonds to institutions or professional money managers. In doing so, if the bond makes money then in turn Vennett would too. Vennett, throughout the movie, sells Credit Default Swaps, and at the end of the movie he walks away with plenty of retirement money.
- Why is Wall Street involved with Home Mortgages in the first place?
- Wall Street is a broad term, but for simplistic purposes, it includes investment banks, traditional banks, and other investment-related companies. Wall Street’s involvement with mortgages was inevitable as investment professionals have always sought ways to create a profit. These professionals saw an opportunity in mortgages, bundled them up, and sold them to institutions. Why? These institutions are compensated via commissions or transactional fees. Now this could be right or wrong, but in the end investment professionals can bundle and sell anything they think they can make money on. Mortgages were attractive because the common consensus was that a consumer would never default on their mortgage as they would lose their home. Mortgages were assumed to be “risk free” (an excellent selling point), but as we all know there is risk to every investment.
- How does short selling work?
- Short selling is the opposite of buying a security long. When an individual short sells a security, they anticipate that the stock price will decline. To maximize their profit, they hope the price falls to $0. On the other hand, when an individual buys a security long, they hope that the price goes to $1,000 per share or even higher. In conclusion, when an individual sells short, they make money when things go wrong such as default, fraud, or other negative events, and the share’s price declines as a result. In THE BIG SHORT, the investors chronicled went short on CDO’s by utilizing CDS’s. These investments paid “big dividends” as the CDO’s went into default.
- How was that stripper able to get all those mortgages for her multiple homes?
- Typically, in strong economies lending requirements tend to loosen. Those requirements tighten in poor economic conditions. Real estate, like any other kind of investment, needs to be assessed within the proper perspective. However, there seems to be more of a consensus that real estate is likely to be a good investment versus other opportunities. For all intents and purposes, real estate is equivalent to owning a private stock. As a result, added risks come with the ownership of such an entity. During the time period leading up to the great recession, lending rules and restrictions were EXTERMLEY lenient. A number of lenders were not verifying borrowers’ incomes. Credit reports were not scrutinized to the level they should have been. Institutions pre-approved people for loan amounts above what they should have. Programs were designed to get people into homes as quickly and easily as possible. Accordingly, we had zero down payment programs, and speculative mortgages that offered interest-only loans. We also saw a large increase in adjustable rate mortgages (or ARMS’s). Lenders and borrowers were betting on increased incomes over time, and were thus reliant on an economy growing at unstable rates. In other words, people became lazy. Generally, a mortgage is, or was, considered a long-term investment…however, people started to flip their homes as mortgages became easier to come by and house prices increased, which thereby convinced others to view mortgages and home ownership as short term investments. If we had continued to live by the principles of paying 20% down on a home and living within our means, would this crash have happened?
- How does this movie relate to LBW?
- In many ways. First, some of the characters who took advantage of betting against the system were value investors like us. Value investors are taught not to invest in a security unless they have done their due diligence. We are encouraged to act as contrarian investors. Since we look at possible investments from a micro perspective, we are more likely to discover risk factors in the general market place. If we do our jobs correctly, we are more likely to detect and avoid future bubbles as well as take advantage of opportunities that others may have not yet uncovered. Much of the financial crisis was created due to a lack of education as consumers did not know what they owned. A key ingredient in risk management is knowing what you own. Professionals didn’t do their research and/or challenge their or other’s line of thinking. Many professionals recognized the risk to their clients, yet only saw potential profit for themselves. This is yet another example of how the fiduciary standard (written about in last month’s blog post) is so very important to consumers.
Who are we kidding? We’re not touching this subject with a ten-foot pole.
Summing It Up:
We hope you enjoyed the review. Please know, it was fun, but we will be keeping our day jobs!
Oh, and before we forget, we give the movie’s subject matter two thumbs down due to the events leading to the worst financial crisis’ since the Great Depression, but the movie itself, two thumbs up!
As always, please call with any comments or questions!
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