Question

Could you describe and explain how Michael Burry using the credit default swap in "The Big Short" film to profit from the collapsing house market? What is the underlying asset of credit default swap in "The Big Short" film? Why Michael Burry and the others sell the credit default swap to close their position before the maturity date? Why they don’t wait until maturity to receive a payoff if they are sure most mortgage contracts will be default triggered by the housing bubble?

Answer 1

Before understanding shorting, one needs to understand how CDS (credit default swaps) works.

3 terms are important for clarity of CDS —

• Asset : House or property is an asset. Any volatility in asset prices is called 'market risk’

Rise (or fall) of property markets cause rise (or fall) of the asset class.

• Credit : any loan taken against a property is called mortgage or credit. The probability of default on these loans (by the borrowers) is called 'credit risk’.

If the underlying asset class (i.e. property) increases in value, the credit risk reduces; however if the underlying asset class is expected to fall, the credit risk increases.

• Credit derivative : it's a hedging instrument against the above credit risk of a loan/mortgage. It's called CDS (credit default swaps).

Just as the underlying basis for a ‘credit’ instrument is the ‘asset’ class, similarly the underlying basis for a ‘credit derivative' instrument is ‘credit’ or mortgage — all of which is explained above.

CDS payoff increases if credit risk increases, and payoff reduces if credit risk decreases.

Now, moving over to shorting —

Smart shorters who could anticipate a coming collapse in property markets, went and shorted the mortgage/credit by buying CDS. It works like this —

• Any fall in property prices → would increase the probability of default on credit/mortgage
• Increase in credit risk → increases the payoff to the holder of CDS

Hence, as house market was collapsing, the shorters were profiteering (by holding CDS).

Credit Default Swaps are essentially financial derivatives that act as insurance on the default of an obligation. However, in the Big Short, these swaps were purchased by Michael from the big banks as a financial investment that would pay off if the mortgage-backed securities defaulted.

The Credit Default Swap diagram below goes into a bit more detail (Thanks Google!). I've also described a few of the parties:

Default Protection Buyer: The party purchasing the protection (or using the CDP as a bet) In the Big Short, Michael's hedge fund is in this role.

Default Protection Seller: The party that promises to insure (or pay) the Default Protection Buyer the default of the bond. If the bond defaults, then this party will pay the Default Protection Buyer the full amount of the bond. In The Big Short, these are the big banks who are betting that the MBSs will not default because of their conviction that the housing market will continue to go up. In real life AIG [Financial Products] was the biggest Default Protection Seller, and lost $99 billion serving as the Default Protection Seller to various parties.

Bond: Mortgage-backed securities. These particular bonds basically promised to pay the cash flows from a bunch of different mortgages bundled up - mortgages that many people defaulted during the financial crisis.

Premium: Amount paid by Michael's hedge fund to bet that MBSs would fail and earn a payout from the banks.

Scenarios of Default (The Big Short)

What would have happened if there was no default?

The bank wins - since it gets the premiums, and didn't have to pay out any money.

What happens if there is a default?

The bank would had to pay the full amount of the bond to Michael. This isn't really a big problem...except if you are a bank with billons and billions of similar CDP obligations on your books.

Overall, Michael got rich by purchasing Credit Default Swaps from the banks that would pay him the full amount of the bond if the MBS's defaulted.