The Big Short: Inside the Doomsday Machine

Out of the ashes of the dot-com crash rose the housing bubble. Low interest rates and relaxed underwriting standards allowed anyone to buy a home. Loans were available for anybody, reagardless of their ability to pay. (In some cases, borrowers were encouraged to lie outright.) Lenders offered low teaser rates with options to limit payments further. They would gather fees when the loan was made and then securitized the loans to sell them to others. Borrowers would be expected to refinance or sell their property after the teaser rates expired. This system would work as long as home values are rising. However, once the prices start to fall (or even increase at slower rates), the house of cards would start to fall as teaser rates expired.

In the early 2000s, bankers had convinced themselves that sub-prime was where the money was. They created complex finance instruments to package them together in a seemingly "safe" manner. The highest rated securities would keep all their values if defaults continued at their "normal rates". Wall street thought they had eliminated most work. Even this risk could be eliminated by purchasing credit default instruments that would pay out if the bond payers failed. These additional layers helped to mask the true risk exposure.

While most people saw safety, a few people could see the house of cards falling. "The Big Short" focuses on these people. They saw the subprime situation as a super-complex ponzi scheme that was destined to fail. However, it was difficult to take a short position in "subprime". They would invest in Credit Default Swaps as well as short stocks of banks with heavy subprime exposure. Alas, the market for swaps were controlled by the banks that had exposure to subprime. They would continue to keep the value nearly constant, disregarding the possible exposure. Despite mounting subprime problems, the positions failed to show an increase in value until the bottom fell out of the market. However, once the bottom fell out, there was a risk that the counter parties would be able to fulfill the default swaps. Due to the complexity and massive exposure, there was a risk that the entire financial system would fail. However, the government jumped in and "saved" the financial system, allowing many to continue business as usual and continue to collect their big bonuses in spite of the fact that they nearly brought down the entire economy.

The subprime crisis hurt a lot of people. Supposedly safe mutual funds had their value greatly reduced due to exposure to "AAA" subprime instruments. Many people lost their houses and many others saw the value of their houses plummet in value. Many jobs were lost. Retirement savings were wiped out. Ironically, many of the people that caused the mess continued to do fine. They had already collected their big bonuses and had little "skin" in the game. Fund manager Michael Burry, who had correctly predicted the fall, left investing for a while after the fall. Despite predicting the crisis and making a ton of money for his investors, he was viewed as somebody "outside" and not given much credit.

With the abundant availability of information, there is little "low hanging" fruit for traders and bankers to justify their huge bonuses. Thus we end up with complex derivatives to help juice yields. We saw a near collapse of the system during the subprime collapse. Is this only a preview of the full collapse to come? At one time, gold was use to help exchange goods. The coinage had an intrinsic value. Then paper money replaced the coinage. It was valued for what it stood for. (At one time it represented a gold value. Now it is just a "Faith") Today, paper money is largely out of the picture, with most transactions merely involving numbers moving from one account to another. On top of this, there are numerous complex instruments. How stable is this system?