The Big Short is a star-studded movie that follows the story of a number of finance professionals and hedge fund managers who identified that the 2006 US housing market was in a price bubble that would soon burst. The story that the plot follows could hardly be called glamorous – the protagonists identified that the securities bundled together to create Mortgage Backed Securities (MBS) and Collateral Debt Obligations (CDO) were at high risk of default and set off to make squillions from the anticipated crash.

The movie is a cautionary tale of the impact that short-sighted greed can have on the global economy and it is important to understand the lessons regarding securitisation that the picture skillfully highlights.

What is an MBS?

An MBS is a type of financial instrument called an asset-backed security that was traded on a huge scale before the 2007-08 Global Financial Crisis (GFC). As the name suggests, an MBS is a slice of a bundle of loans, in this case, real estate mortgages. The loans are ‘asset-backed’ because they are secured by the real property purchased with the loaned funds.

The way it works legally is as follows. The institution that created the bundle holds the security in trust. Units in the trust are sold to investors. The notes return a sum determined by the repayments made by the original borrowers (the ones that bought the real property). The repayments made on the mortgages by the homeowner are collected and paid back to the investor (same principle as the payment of a bond’s coupon rate). This means that, in the event of the borrower defaulting on the loan, the property subject to the mortgage is foreclosed by the institution who then sells the property in an attempt to reclaim the outstanding sum.

This financial derivative of a standard household mortgage has two benefits to investors and institutions. The sale of the MBS means that the lenders have more money to create more loans. Investors have access to a steady stream of income from a quality investment with good returns that are secured by the property the loan was used to purchase. One of the big selling points of this security was that it is supposed to be one of the safest investments rated by accredited rating agencies (i.e. Moody’s, Standard & Poor’s) and a licensed financial institution had to create it. This led to MBSs advertised as very low risk.

What is a CDO?

A CDO is also based on similar securities to the MBS (collateralised = security). Instead, the mortgages that make up the security are graded into categories called ‘tranches’ which are divided into groups based on the likelihood that the borrowers will default. An investor chooses which tranche they’d like to buy into and that determines their place in the queue to receive the proceeds from the sale of the securities in the event that the borrowers are unable to repay the loan. CDOs became infamous when financial institutions started to fill them with loans that were so terrible, an already high-risk MBS couldn’t include them.

The lower down the pyramid, and the further from receiving the benefit of the securities backing the loans, the greater the returns. As long as the debt repayments are made, then all of the investors in each tranche are happy. However, when people start to default on their loans, those lower down the priority list begin to lose out.

The Benefits of Diversification

By pooling together a large number of mortgages from across the US, the securities outlined above were supposed to be a lower risk due to greater diversification. In theory, factors that don’t impact the whole economy are less likely to affect a large number of mortgages. For example, an increase in unemployment in one particular town or the decline of one particular industry is less likely to affect negatively a pool of thousands of mortgages drawn from across the US. However, a number of the securities were not truly diversified in the same way they were advertised – especially when the market began to crash and the global job market was affected.

If There Are All These Benefits, Then How’d They Cause the GFC?

The GFC was brought about due to a large number of factors. Chiefly, it was because the institutions creating the securities had little incentive to work out the quality of the borrowers who made up each of the MBSs and CDOs. There was a short-term incentive for financial institutions to pump out as many new loans as possible. Cash bonuses the staff received for each approved loan exacerbated this problem and led to a fast and loose style of employees arranging finance for customers who were obviously unable to repay their debt. And all to boast about having the most expensive watch/holiday/car/house/holiday home or whatever else was the flavour of the month.

There was also little consequence for the financial institution creating the securities as selling them on to a third party meant that the risk of default was transferred to these new investors. This drop in lending standards and the push to bring as many new homebuyers onboard resulted in an influx of new people with the funds to purchase or build a home, consequently increasing property values.

This value kept climbing until the market realised that more and more borrowers were defaulting on their debt. Once the borrowers started to default, the creditors would foreclose the mortgaged property and recoup their investment by putting it on the market. As more and more houses were foreclosed, the value of property began to fall and resulted in the bursting of the property bubble. This realisation resulted in a panic that gripped the market once the real quality of MBSs and CDOs was realised.

The Big Short focuses on each character’s discovery that the underlying securities in many of the MBSs and CDOs were not as secure as they were made out to be. You’d think that with the level of devastation caused and still felt around the world, greater controls would be placed on securities. But the movie ends with the warning that many of these securities are still being created and sold today, with few meaningful attempts made to address the factors that prompted financial institutions to drop their lending standards to offload more securities to other investors.

The issues the movie covers could have added relevance in Australia as some predict that we’re headed for a similar burst to our housing market. Whether it’ll be to the same extent as the 2009 crash in the US, or occur at all, is hotly debated.

What do you think? Tag us on Twitter @legalvision_au and let us know.

Thomas Richman

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