As I mentioned in my earlier review, I have a few more thoughts about The Big Short.

The first reflection is on the title. The reason it refers to a short is because the three groups who were able to make money from the crisis found a way to “short” the entire American housing market, which they felt was overpriced, in other words, that a bubble was forming.

Short selling originally referred to a specific way of making money from the stock market by borrowing stocks, selling them, and then buying the stocks back at a cheaper price, and giving them back to the original owner. One would make money from this transaction when stock prices dropped, but stood to lose significantly if prices rose. It has become a more general term that refers to betting that the price or value of some item will drop, and finding a way to make money from that price drop. (I should state here that I am giving you my best understanding of these products. Feel free to correct any errors or fill in any deficiencies.)

The base product behind the story of  The Big Short is the mortgage bond. A mortgage bond is a collection of mortgages together in one container that were sold on the financial markets. The bond holder would receive income from the collective mortgage payments. A purchaser of a mortgage bond is purchasing an income stream. If a high percentage of the mortgage holders in a mortgage bond were to default on their mortgages, the bond would produce significantly less income. Therefore they would be worth a lot less on the open market. In addition, the income stream would decrease significantly, hurting the investor.

Around 2005, several individuals and small groups researched the nature of mortgage bonds in the USA. They concluded that the mortgage holders that made up the mortgage bonds were far less able to pay their mortgages than the rating agencies (for example, Standard and Poor’s or Moody’s) believed they were. Investors purchased bonds based on the ratings given. If the ratings were wrong, the bonds were far more likely to fail than the rating agencies and the investors believed they were.

When these researchers discovered this, they wanted to find or create a product that would allow them to short the mortgage bond market, i.e., to create a payout when the housing market dropped. They wanted to be able to bet against the housing market, believing that it would collapse, bringing down the mortgage bonds with it. The product they found was the credit default swap (CDS).

A credit default swap (CDS) is a form of insurance on a mortgage bond. Like any insurance, it is a bet with the insurance company about whether a certain event is going to happen. In this case, the insurance company is betting that the mortgage bond will not fail. When you purchase the CDS, you pay a series of annual payments, hoping that the bond will fail, at which time you will receive your payout. Credit default swaps were available for annual payments of less than half a percent of the value of the bond. So you could pay $1 million dollars per year for a potential payout of over $200 million.

These individuals and groups were completely convinced that their research was correct. The question in their mind was not if the bonds would fail, but when.

Now, in my mind, there are some ethical questions about this strategy. In effect, the people who were shorting the mortgage bonds were shorting the entire US economy. They would win when everyone else lost. Is it ethical to purchase a product knowing the purchase is guaranteed to cause the party across the table from you to lose money?

Let’s imagine you have a friend, Peter Scholtens, who is a very sick man. He has cancer, and has only a 20% chance of surviving 5 years. What if could find an insurance company willing to sell life insurance for Peter Scholtens at the same price as a healthy man. Would it be unethical to buy the life insurance, knowing that you would win when Peter died, and that the insurance company would lose, and that the company may collapse if enough people followed your strategy? Is this a scam? Is it fraud? Or is it being wise and astute?

Before you decide, consider the fact that we are all happy to purchase goods at a significant discount at a store closing sale, even if the company is losing money hand over fist during the sale.

I’m not sure what to decide. Is it only in an ideal world where every transaction results in two winners?

Let me know what you think.

Peter Scholtens