A Real-Life Trader Talks About ďThe Big ShortĒ


Posted By Brian Gallagher on Dec 23, 2015
http://nautil.us/blog/a-real_life-trader-talks-about-the-big-short

After watching The Big Short, I felt I had a decent grasp on the causes of the 2008 financial crisis. The film, which is being released across the United States today, is based on the book by Michael Lewis, and describes how a few prescient financiers bet against the debt bubble and made millions.

Still, nothing can replace the insight of someone who worked in the industry during the crisis. Bob Henderson, a physics PhD turned Wall Street trader, lost $200 million in a single month in 2008 (before ultimately recovering from the loss and making a profit), while working at a major investment bank in New York. He details his story tomorrow, the 24th, in an exclusive Nautilus feature. (Hendersonís article is now available to read.)

Before we publish his feature, we wanted to get his opinion on The Big Short. What he had to say was illuminating, not only because of how he related with the characters — played by Ryan Gosling, Brad Pitt, Steve Carrell, and others — but also because of the context he gave.

What surprised you the most in the movieís portrayal of the impending financial collapse?

It was surprising to me that some people, portrayed by Ryan Gosling and Christian Bale and others, actually got to the bottom of some of those mortgage products — figuring out that they were being fundamentally mispriced — when so many others didnít. We had lots of quants — quantitative experts — and very smart people at the banks who presumably didnít see it, or somehow it didnít reach the right people. Alan Greenspan didnít see it, Ben Bernanke didnít see it, and neither did the head of the Treasury — super smart people who did have their fingers on the pulse of a million different things. Working at my bank, I talked to some of those high level people towards the end of 2007, when the first real cracks were happening in subprime loans, but it hadnít spread to everything else yet and the big crisis came a year later. They really thought, Oh itís just a subprime thing; itíll be contained. So a big part of the debate about the recession — and this is simplifying a bit — is whether the banks were stupid or criminal in this. Iíll go on the side of stupid, not criminal. The fact that an organization can act stupidly even though it has a bunch of smart people in it, thatís interesting.

Did The Big Short change your perspective on the collapse in any way?

Absolutely. The Big Short helped me understand the incentives of the guys who saw the collapse coming. It also helped me understand — if research bears it out, which I think it probably will — that these products themselves helped inflate the bubble. And not only did the bubble infect these products and make them bad, there was also a feedback loop so that the more these products had sold, the more demand there was for loans, which then drove banks to be more willing to buy these crappy loans, which then meant the mortgage brokers made more crappy loans, which meant more people could buy houses, which pushed the market up more. That whole feedback loop is really systematic and itís interesting, and I donít know that anybody at the time couldíve really seen that.

If you had the information that made Christian Baleís character, Michael Burry, bet against the economy, would you have been as confident as he was?

I would not have been confident. This is a beautiful part of the story. As one character says to Burry, being early in a bet on the market is the same as being wrong. So itís not enough to be right. You have to be right at the right time. In this case, the right time corresponded to housing prices peaking, which I donít believe anyone could know for sure. I thought the movie did this very well, because he knew he was right, and he was right in a sense. He bought a specific product, a swap on mortgage backed securities, which is basically like insurance on a bond. If you buy one, you get paid if the bond defaults. Before Michael Burry, there was no convenient, efficient way to bet on the default happening; You could just bet bullishly that a borrower would fulfill the bond. This added some symmetry to the market, so you could go either way. Nobody had any interest in betting against them — since they were backed by housing, which was supposedly solid — but he did. So he had banks create a credit default swap on mortgage bonds. He actually looked at what the details were, all that public information inside these packaged bonds, and could see that the borrowers would not be able to pay off their loans. He was confident because of that.

Why were Michael Burryís colleagues so opposed to him betting against the economy?

Because he had no background in the product he bought, so I completely sympathize with his skeptical colleagues. If you just go in there as an amateur, youíre probably going to lose, and he was effectively going into the mortgage market as an amateur. He trained himself and really looked into these products in a way nobody else had, but his older colleagues — with decades of experience — thought he was betting against basically the whole world, bidding against what everyone thought was a perpetually solid housing economy and all the experts. So I have to admit, unless I had the time and the inclination to do all the same work that Burry had done, I wouldnít have trusted him.

One of things I felt this really highlighted was how hard it is to completely go against conventional wisdom. People who have faith in you, who liked you, who gave you money — the guy said he was Burryís mentor — they want to disown you. Iíve seen it happen. Itís so hard to withstand that and to hold onto what you believe. Thatís why so few people end up doing it. Iíd like to say I wouldíve been Michael Burry too, and I wouldíve made billions of dollars, but I donít think I wouldíve. I could easily imagine, having seen all the details he saw, and still not having the guts to hang on the way he hung on — because even if he was right in the long run, in the long run weíre all dead. If the housing bubble had gone on another year, he mightíve lost all his money.

Why was Wall Street so blindsided by the meltdown?

Almost nobody had the incentive to really look for the causes. The few that ended up finding the problems with these products were the ones that had the most incentive to, because they could make a huge amount of money. A couple of guys in the banks did. One was the guy whoís played by Ryan Gosling — real name Greg Lippman, a banker at Deutsche Bank. The other, named Howie Hubler, at Morgan Stanley, wasnít in the movie; he lost $9 billion, even though he thought the housing market was going to crash. He bet on it, but the bet was costing him a lot of money day to day, so he tried to fund that bet with another trade that he thought wasnít as risky. That ended up blowing up even more than the thing that he was originally betting on. So he made the bet too complicated, trying to finesse it. He lost more money than anybody in the crisis, the biggest loss in Wall Street history, even though he was fundamentally sort of right. That just shows you how complicated those products were.

Do you think the collapse could have been stopped before it started?

Sure. A bunch of a different things happened that all came together to create this crash. I could list eight or ten different contributors. Some of it is the incentives of all the major actors: the mortgage brokers, the banks, the rating agencies, the regulators, the investors. If you altered any one or two of them, then you could see how the whole thing couldíve been avoided. If the rating agencies, for example, had just said weíre not giving this product a good rating because weíve looked really closely at it, then the whole thing wouldíve been shut down. Same thing with the investors. And if the bankers stood up and said, well, we donít want to do this because weíve looked at it too, and weíre going to be more thorough about it and not make as much money, that couldíve stopped it. So many people couldíve stopped this, so many different kinds of entities couldíve interfered with this whole thing, and they didnít.

The investors had a lot of incentive to buy mortgage bonds not only because interest rates were low and those products gave higher returns, but also because the ratings of the products were high. The investors who bought these things assumed that the rating agencies knew what they were doing. But the system gave ratings agencies every incentive to just give good ratings to these things because the banks were the ones who paid them. This was a flawed setup.

Why was the financial systemís incentive structure flawed to begin with?

Itís a complicated question, because when you think about it, nobody really sets up the financial system — the financial system grows, right? It grows under restrictions and laws that the government makes, but nobody is sitting on top of the whole thing thinking, How do I create all the right incentives for everybody? I think that would be an amazing thing for regulators to do, theyíve never really done that. Instead, itís done at much smaller levels, like within a bank you try to do that with your people, you incentivize your traders to behave a certain way by paying them with certain formulas. Within the government they may do the same thing, you know, within little pockets. Itís a big complicated system and nobody is overseeing the whole thing and designing it. But I know that, for example, one of the things that came out of Dodd-Frank and other regulation since was that, if you make loans, now you canít sell the whole thing, you have to hold a piece of it to retain some risk. So thatís at least one example of the government paying attention to incentives.

Brian Gallagher is an assistant editor at Nautilus.