The Big Short

I’m not a fan of Michael Lewis, so I didn’t have high hopes for this movie.  As it turns out, Lewis’ glib, superficial take on complex subjects was precisely right for explaining the market crash of 2008.  It’s a bit oversimplified (the role of AIG in backstopping the AAA ratings of mortgage portfolios full of junk is virtually ignored).  But for the most part, the descriptions of the investment industry seem exactly right.  In particular, the depictions of self-styled masters of the universe sneeringly confident that their understanding of the market was absolutely correct was spot on.  The movie uses cameos from famous people to explain complex financial instruments, which sounds like a gimmick but works surprisingly well.  The little segment set in a Las Vegas casino, explaining synthetic CDOs as a cascading series of side bets all ultimately relying on the same blackjack hand, is particularly good.  If nothing else, this movie will make you feel the Bern that none of these jokers wound up in jail.

I do have a question that some of you more well-versed in derivatives than I might be able to answer.  The story follows a few outlier investment professionals who become convinced that the received wisdom of the financial community was wrong, and that the housing market was heading for a big fall.  Seeking to bet against the housing market, they found that no such instrument exists.  So they prevailed on a few bankers to write one — the “Big Short.”

Later on, when housing defaults begin to rise, the Shorts are surprised to find that the market value of their specially-created security remained unchanged (at least until the banks who sold them the securities were able to hedge their position by laying off their bets on unsuspecting third parties).  The movie describes this as a “fraud,” but I wonder if that’s correct.  The market value of exchange traded securities change with each trade, and mutual funds are marked to market every day by law.  But privately-traded securities, especially unusual ones like these for which had no pre-existing trading market, are subject to no such law.  Wouldn’t the rules about when the securities had to be re-valued be set by the individual securities contract?   In other words, the bankers’ delay on re-valuing the securities might have been reprehensible, but not actually illegal.

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