THE BIG SHORT

In Partial Fulfilment for the Subject ACC 222

Financial Management

Submitted to: Ma’am Lolita Apatan

Submitted by: Jerah Y. Torrejos

March 14, 2020

List of Terminologies within the Movie

a. Mortgaged-backed Security

Before Lewis Ranieri introduced MBS, banking was “boring” as what the narrator of
the movie had described. Banks only cater to regular mortgage loans from individuals who
wanted to own houses. This greatly restricted the capital and resources of the bank. This
also has perceived risk that customers will default on their loans.

At some point, banks began to pool together thousands of mortgage loans into a
single bond which is known as Mortgaged-backed security (MBS). MBS were divided into
tranches and were sold off to investors. Banks choose to do this as a way to free up their
resources and took away the risk they don’t want to take on. They also profited from
associated costs of selling and origination these loans. 1

b. AAA Credit rating

Standard & Poor’s and Moody’s were mentioned in the movie for a couple of times.
They were the agencies that gave credit ratings to bond issuers (companies and countries)
and debt instruments and securities. Credit ratings are based on the creditworthiness or the
capability of borrowers to pay off their debts based on their income and past repayment
history. Usually agencies use letter grades for their ratings, AAA (S&P) or Aaa (Moody’s) as
the highest rate.

In the movie, these credit agencies gave Mortgaged-backed securities AAA ratings
despite being backed by subprime mortgages. They were being paid to mislead the
investors into thinking that these securities had minimal risk. The financial crisis of 2007
showed how important these credit ratings are and how important that it should truthfully
reflect the likelihood of default in a bond. 2

c. FICO Score

Just like letter grades, FICO scores created by the Fair Isaac Corporation is an
assessment of the creditworthiness of borrowers. It helps investors to decide whether to lend
credit or not. The score ranges from 300 to 850, the highest being 850 which means that this
has the lower risk posed to lenders. 3

d. Subprime adjustable-rate loans

Usually banks were strict in lending credit to homebuyers, but to create more
demand for houses, they started to freely accept just anyone including those people with
poor credit scores. These loans are called subprime loans which according to Margot Robbie
are “shit”. Since the borrowers had poor credit ratings, there’s a big possibility that they will
default on their debts. This posed a greater risk to investors as compared to prime loans. To
compensate the risk, the interest rates are also higher as compared to those less risky
loans. Credit rating agencies should have rated those tranches as C, but banks piled the
bonds into a portfolio that rating agencies deemed to be diversified and rated it AAA.

Subprime adjustable-rate loan is a type of subprime mortgage with interest rate that
started as fixed for several years and then become a floating rate- a rate that moves with the
market or an index- throughout the duration of the loan.4

1
Kagan, J. (2020, March 2). Understanding Mortgage-Backed Securities (MBS). Retrieved from
https://www.investopedia.com/terms/m/mbs.asp
2
Finney, D. (2020, February 5). A Brief History Of Credit Rating Agencies.
https://www.investopedia.com/articles/bonds/09/history-credit-rating-agencies.asp
3
What is a Credit Score? (n.d.). https://www.myfico.com/credit-education/credit-scores
e. Tranches

The French word tranche means “slice”. Securities such as Collateralized Debt
(CDO) are divided into pieces to increase their marketability and suitability to investors.
These portions are called tranches. Since it is a pool of thousands of mortgage loans, MBS
are also divided into tranches. They could be grouped according to maturities or interest
rates. 5

f. Collateralized Debt Obligation (CDO)

Collateralized Debt Obligation is a derivative which value is dependent on the

underlying asset which in the movie was the thousand of mortgage loans. These assets
serve as collateral in case of default on loans. CDOs are divided into tranches to be sold to
institutional investors. 6

g. Short the Bonds – “to bet against”

After concluding that there is a housing bubble in the US, Michael Burry went to
different banks and borrowed a billion dollars in mortgage bonds with a short position, which
means that he believes that it will decline in value. At that time everyone thought that the
housing market is stable, so the banks agreed to lend him the mortgage bonds.

Shorting bonds is borrowing bonds and selling it immediately into the market. An
investor is expected to return the borrowed bonds by repurchasing it in the future. If the price
declined, the investor can keep the difference between the selling and repurchase price.
This way, investors got to gain money without really owning the bonds.7

h. Credit default Swaps

Credit default Swaps is a contract to hedge risk with another investor. Credit default
swap is like insurance in case of default on particular loans. There was no existing credit
default swap on mortgage loans at that time, so Dr. Burry created one as part of his deal
with the bank. If the housing market continues to be strong, he needs to pay premiums to the
bank. If it declines as what he expected, the bank will pay him instead. When millions of
Americans defaulted on their loans, payments on tranches also defaulted. When the housing
bubble burst in 2007, he made a lot of money for his investors and himself. 8

i. ISDA Agreement

ISDA Agreement is a document published by International Swaps and Derivatives

Association (ISDA) that is used internationally to administer over-the-counter transactions. It
is a standard agreement between parties which also gives them certain legal and credit
protection. 9

j. Synthetic CDOs

4
Heyford, S. C. (2020, February 5). The Risk of Subprime Mortgages by a New Name.
https://www.investopedia.com/ask/answers/07/subprime-mortgage.asp
5
Chen, J. (2020, January 29). Tranches. https://www.investopedia.com/terms/t/tranches.asp
6
Staff, M. F. (2017, June 7). What Is a Collateralized Debt Obligation? https://www.fool.com/knowledge-center/what-is-a-
collateralized-debt-obligation.aspx
7
Staff, I. (2020, January 29). Is it possible to short sell a bond? https://www.investopedia.com/ask/answers/04/070904.asp
8
Morrissey, J. (2008, March 17). Credit Default Swaps: The Next Crisis?
http://content.time.com/time/business/article/0,8599,1723152,00.html
9
What is an ISDA Master Agreement? (n.d.). https://www.derivsdocu.com/services/consultancy/What-is-an-ISDA-Master-
Agreement/
 Synthetic CDOs are like CDOs but yields higher by investing on non-cash derivatives
like credit default swaps. In the movie, it was said to be a CDO of CDO. If a CDO is a bet,
synthetic CDO is a side bet which was surprisingly has a bigger market than CDOs. 10

k. Bespoke tranche opportunity

Bespoke tranche Opportunity (BTO) is said to be the new Bespoke CDO. Bespoke
CDO is also a synthetic CDO tailored specifically for investors needs. It disappeared after
the crisis but made a comeback in 2016 as a BTO. Although BTO is linked to the crisis, but it
has a huge role in hedging risk and freeing up capital which are important to investors and
this is one of the reason it made a comeback. 11

2) What is/are the greatest lesson/s you have learned from this movie and how this/these
impacted you as a financial management student and as a future finance head?

The Big Short is an eye-opener which showed me the importance of decision making
and how different choices have varying degree of consequences. While watching the movie,
the pressure and the anxiety of the characters transcend beyond my computer screen and
the feelings suddenly became real to me. I realized that this is not simply what I imagined it
to be. They were talking about millions and billions of dollars and here I am having a difficult
time thinking what to spend my lunch money on. I learned that finance head should be
decisive to take on opportunity for their investors.

Although I’m aware of the weight of the decisions of finance heads and the impact it
brought to the company, it doesn’t prepare me for the effect it has on a country’s economy.
When I saw the man and his family being homeless again after settling in their new home, I
was upset and the 9 million homeless people during the Great Recession ceased to be just
numbers. They become living and breathing people. But this doesn’t stop me from becoming
a finance head in the future, but instead this encouraged me to take Finance seriously and
be among the best to help the economy and the ordinary people.

3) If you will be one of the characters, who do you think would fit you most based on your
attitude and decision-making today? And based on your answer in number 2, would you still
want to be that person someday?

I feel for Mark Baum. I can relate to his pain, his anger, his pessimism, and his
distrust for the system. Mark Baum wasn’t wrong to become a pessimist. He wasn’t wrong
either about the broken system we’re living in. A broken system plus greedy people at the
helm makes a great recipe for disaster. He knew that it’s always the ordinary people who will
take the brunt of the financial crisis. This made him hesitate during the last part of the movie.
It made him conflicted between morality and taking opportunity from what happened.

I guess I will be like him when I become a finance head. I know that being decisive is
very important and creating value for investors is my responsibility, but I can never totally
ignore my conscience. It is an ethical dilemma that I cannot answer not until I’m put in the
same situation as he was.

4) What are our lessons that were vital in your process of understanding the movie?

10
Chen, J. (2020, January 29). How Synthetic Collateralized Debt Obligations (CDO) Work.
https://www.investopedia.com/terms/s/syntheticcdo.asp
11
Chen, J. (2020, January 29). Is a Bespoke CDO a Good Fit for Your Portfolio?
https://www.investopedia.com/terms/b/bespoke-cdo.asp
 In the movie, Michael Burry a hedge fund manager had a conflict with his investors. I
learned from our lessons that many investors are risk averse and it was portrayed well in the
Big Short. The investors thought that the credit default swap against MBS was a very bad
investment. This belief created a dispute between Dr. Burry and his investors, some even
want to sue him when he send them a letter that restricted their access to the funds. But Dr.
Burry was firm on his belief and he knew his role as a manager is to create value for his
investors.

My knowledge about financial institutions also helped me to understand the movie.

Investments banks were an integral part of the movie. They function as underwriters and
distributors of subprime MBS to investors. They also sell credit default swap as insurance to
those loans. Bear Stearns, in particular, was hit hard when homebuyers started to default on
those loans. In 2007, they suffered heavy losses and their market value dropped significantly
and was eventually sold off.

I learned portfolio diversification in Financial Management. I was sad when I learned

that they used this method to somehow defraud investors. Banks lumped up unsellable
bonds into a portfolio. Credit agencies thought it was diversified enough and rated it AAA
instead of what it really was.

Interest rate is also a topic that I learned from the discussions in Financial
Management. Low interest rate on mortgage loans was one of the reasons which spurred
the home-buying frenzy in the US. Low interest rates drove up house prices. As what I’ve
learned, interest rates and prices have indirect relationship. Banks also lifted their strict
restrictions on borrowers to create more demand. As the demand grew, interest rate began
to increase and prices began to fall. It reached a point where homeowners cannot pay the
interest on their loans. Many people defaulted and the rest was history.

5) What are aspects of finance and financial management do you want to learn more?

Finance book authors are mostly foreigners. As a Filipino, I feel distant when they
start to give examples from foreign economies. I want to learn more about the Philippine
Financial system. I want to know how the global crisis impacted the Philippines and how
Filipino fund managers cope up with it. I also like to know how investors view the current
situation of our economy.

I want to understand more about derivatives and banking. Derivatives seem so

complicated, but at the same time it is interesting to study. My knowledge about banking is
superficial. I need to learn more about it to help me if I become a finance head in the future.

I also want to learn more about investing particularly on how to start investing and
where to invest as a beginner. I want to apply my learning in school in the real world.