Three lessons from the movie “The Big Short”
If you haven’t seen this film, it’s a look at the great recession from the perspective of three groups who, unlike many others, saw what was actually happening in the mortgage bond market. They essentially bet against the housing market, to enormous profit. The movie explains some of the complicated products in an easy to understand way, and it’s pretty entertaining. I saw it in the theatre when it came out and really enjoyed it.
The instrument that the main characters use to “short” (bet against) the housing market is a credit default swap. Quick explainer: the way these work is the person who thinks companies or debtors will default pays the other side of the swap periodically. If defaults do happen, the person receives a payoff, which is generally much larger than the periodic payments made.
One: There is no free lunch in investing
Upon learning of the credit default swap trade and the reasons behind it, one hedge fund decides to enter into it. But before they sign off on the deal, the numbers guy on the team calls their salesman and asks him a simple question.
“How are you f**ing us?”
The numbers guy knows that there’s a price to be paid, and he wants to know what it is.
The salesman says, “When you come for the payday, I’m going to rip your eyes out… [but] you’re not going to care because you’re gonna make so much money.” And so they make the deal, because both of them understand the price.
In investing, you always need to know the price. Sometimes it’s an actual price or fee, sometimes it’s a string attached, but you need to know what the other side is getting from the deal. And if they won’t tell you, that’s a red flag and you should walk away.
Two: False Consensus Effect
The first person to move against the housing market (in the movie) was a California hedge fund investor named Michael Burry. He initiated the credit default swaps. No one else ever bothered to read through the offering documents of all the mortgage bonds, but he did, and determined that many of them had mortgages inside that were likely to default.
The mortgages that were likely to fall apart would start defaulting in 2007. The movie’s timeline isn’t clear, but it’s implied that Burry set up the swaps a couple of years before 2007, so that the periodic payments would have to be made for a couple of years before any payoff would occur.
This may seem silly — why make all those payments years before you think the first payoff will even appear?
He’s assuming that other people will see what he sees and make the same trade, so he wants to get in while the prices (the periodic payments) are still relatively low. Later in the movie another character tells his partner they need to get in it before everyone else does. But in fact, at the time, no one thought mortgages would default in any significant fashion, and betting against the housing market was unheard of.
This is the false consensus effect: believing that because you think something is true, so does everyone else.
In other words, don’t assume everyone else thinks the same way you do.
Three: Opportunity Cost
Burry, after using his fund’s money to make these payments, had to face an investor. He defended himself by saying, “I’m not wrong. I may be early, but I’m not wrong.”
The investor replied, “It’s the same thing!”
Because Burry got in early, no one else was making the trade, and everyone thought he was nuts. He still had to make the periodic payments while he waited for the defaults to begin. Had he waited to get into the swaps, those funds could have been invested elsewhere. They could have been making money for the investors, instead of being paid out to the banks who were on the other side of the swap.
I had an early-but-not-wrong situation myself where I began investing more heavily in international funds but it took several more years for the non-US market to take off. Had I stayed with US funds, I could have made more money in the intervening years. (I am not unhappy with the decision though, because no one could have predicted when the international markets would come back.)
When investing, it’s a good idea to think about opportunity cost: what else could be done with this money?
I encourage those of you who haven’t seen “The Big Short” yet to stream it. The movie is fun, and you can also learn a lot from it.
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Originally published on www.fabfemfinance.com.