“The Big Short“: Finimized For You

Here’s what a few key scenes from The Big Short can teach you about finance – and this stuff is still relevant years after the financial crisis.

The introduction of Lewis Ranieri and
Mortgage-Backed Securities

Lewis Ranieri - The Big Short
Source: http://therealdeal.com/

The Big Short opens with a brief introduction of Lewis Ranieri – the man who “invented mortgage bonds”. In the 1970s he took thousands of individual mortgages and combined them into one large mortgage. Investors could buy, essentially, shares in that large mortgage and they would be entitled to their share of the interest payments.

Back then, hardly any investor could buy mortgages and the innovation gave bond investors (e.g. those seeking an income producing asset – one that paid interest) a new alternative. Statistically, only a small percentage of homeowners would default on their mortgage – and any losses that occurred would be more than made up for by the interest paid by other homeowners who had taken out mortgages. Without “subprime borrowers” and layers upon layers of complicated financial products on top (see below), these things actually worked. And still work today: $1.7 trillion was issued in 2015 in the US alone. Your pension fund, if you have one, probably owns some.

Derivatives, Leverage & Selena Gomez

One of the best explanations in the movie was Selena Gomez showing how the whole casino was betting on her Blackjack hand. When she lost her $50, everybody else lost their bets – so the total impact of Selena’s $50 loss was more like $100,000. That’s how derivatives work: they derive their value from some reference investment (in this case, Selena’s Blackjack hand). And derivatives still exist on virtually everything, not just mortgage-backed securities.

What’s perhaps even crazier is that, in the real world, all those people betting on Selena’s Blackjack hand don’t need to poney-up very much of their bet. For a $50 bet, they probably only have to deposit $5 with the dealer. If they win, it’s a huge return on their investment – but if they lose, they have to cover their losses, which are much larger than the stake they initially had to deposit. So, in this example, if the value of the bet (a.k.a. a stock) halves in price, then the investor has lost $25 – or 5x their initial stake. That’s why, from time to time, you hear about derivative losses causing huge damage.

We’re not saying this good or bad – but hopefully it’s helpful to know that this is how the entire financial system works.

Bubbles… and we don’t mean Champagne

When watching the movie, we all know how this story ends: with the biggest financial crisis since the 1930s. But that was so far from obvious to the vast, vast majority of people in the years leading up to 2007. Yes, a few people made a ton of money betting their money on it being a bubble – but they were literally “a few.” In the whole world.

Michael Burry - The Big Short
Source: Paramount Pictures, Getty

Michael Burry (the death metal listening, sandal clad hedge fund manager portrayed by Christian Bale) is told by his main investor: “You can’t spot a bubble, that’s what makes it a bubble.”

“That’s stupid,” says Burry.

But then we then witness his extreme mental anguish as he struggles to maintain his contrarian position amidst an investor revolt.

What that tells you is that it’s really tough to identify when something is a bubble – and even tougher to profit from spotting it. The average investor is much more likely to make a healthy return by exposing themselves to overall economic growth by owning a balanced portfolio of stocks, bonds, real estate and, perhaps, some other assets – and trying to ignore timing bubbles.

And lastly ; )

P.S. You can sign up for our quick, jargon-free daily financial news at www.finimize.com. Join thousands of other young professionals who read 3-minutes of financial news every day to understand why the news is personally important to them!
Sign Up Now!

Here’s what a few key scenes from The Big Short can teach you about finance – and this stuff is still relevant years after the financial crisis.

The introduction of Lewis Ranieri and
Mortgage-Backed Securities

Lewis Ranieri - The Big Short

Source: http://therealdeal.com/

The Big Short opens with a brief introduction of Lewis Ranieri – the man who “invented mortgage bonds”. In the 1970s he took thousands of individual mortgages and combined them into one large mortgage. Investors could buy, essentially, shares in that large mortgage and they would be entitled to their share of the interest payments.

Back then, hardly any investor could buy mortgages and the innovation gave bond investors (e.g. those seeking an income producing asset – one that paid interest) a new alternative. Statistically, only a small percentage of homeowners would default on their mortgage – and any losses that occurred would be more than made up for by the interest paid by other homeowners who had taken out mortgages. Without “subprime borrowers” and layers upon layers of complicated financial products on top (see below), these things actually worked. And still work today: $1.7 trillion was issued in 2015 in the US alone. Your pension fund, if you have one, probably owns some.

Derivatives, Leverage & Selena Gomez

One of the best explanations in the movie was Selena Gomez showing how the whole casino was betting on her Blackjack hand. When she lost her $50, everybody else lost their bets – so the total impact of Selena’s $50 loss was more like $100,000. That’s how derivatives work: they derive their value from some reference investment (in this case, Selena’s Blackjack hand). And derivatives still exist on virtually everything, not just mortgage-backed securities.

What’s perhaps even crazier is that, in the real world, all those people betting on Selena’s Blackjack hand don’t need to poney-up very much of their bet. For a $50 bet, they probably only have to deposit $5 with the dealer. If they win, it’s a huge return on their investment – but if they lose, they have to cover their losses, which are much larger than the stake they initially had to deposit. So, in this example, if the value of the bet (a.k.a. a stock) halves in price, then the investor has lost $25 – or 5x their initial stake. That’s why, from time to time, you hear about derivative losses causing huge damage.

We’re not saying this good or bad – but hopefully it’s helpful to know that this is how the entire financial system works.

Bubbles… and we don’t mean Champagne

When watching the movie, we all know how this story ends: with the biggest financial crisis since the 1930s. But that was so far from obvious to the vast, vast majority of people in the years leading up to 2007. Yes, a few people made a ton of money betting their money on it being a bubble – but they were literally “a few.” In the whole world.

Michael Burry - The Big Short

Source: Paramount Pictures, Getty

Michael Burry (the death metal listening, sandal clad hedge fund manager portrayed by Christian Bale) is told by his main investor: “You can’t spot a bubble, that’s what makes it a bubble.”

“That’s stupid,” says Burry.

But then we then witness his extreme mental anguish as he struggles to maintain his contrarian position amidst an investor revolt.

What that tells you is that it’s really tough to identify when something is a bubble – and even tougher to profit from spotting it. The average investor is much more likely to make a healthy return by exposing themselves to overall economic growth by owning a balanced portfolio of stocks, bonds, real estate and, perhaps, some other assets – and trying to ignore timing bubbles.

And lastly ; )

P.S. You can sign up for our quick, jargon-free daily financial news at www.finimize.com. Join thousands of other young professionals who read 3-minutes of financial news every day to understand why the news is personally important to them!

Sign Up Now!

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