Before I get to what I don’t understand, I will try to summarize the 2008 financial crisis as simply and briefly as I can. If I’m wrong, please leave a comment and help me be less wrong.

A summary of the 2008 financial crisis

Banks were making money by collecting a bunch of mortgages into packages (bonds) and selling them. Whoever buys those bonds stands to make a profit as the mortgages are paid off. Those bonds have to get rated by credit rating agencies that give the bonds (or parts of the bonds) ratings (e.g., AAA, AA, A, BBB, etc.) which indicate the riskiness of the bond. A riskier bond is one that has a higher chance of failing and causing its owner to lose money. It also has a higher return.

The banks were making so much money on the fees they charged to sell those bonds that the demand for more and more mortgages to bundle up into bonds was outpacing supply.

This demand meant that companies that gave people mortgages to buy homes could make a lot of money selling these mortgages to banks that wanted the mortgages to sell in bonds.

This led to companies giving loans to people who should not have been loaned so much money, people with really low credit scores, for example. It also meant that people agreed to mortgages that had terms they didn’t understand. For example, mortgages with “teaser rates” that started pretty low, but then jumped up several hundred per cent a few years later.

Bonds that contained these “bad” loans (loans that were likely to not be paid off by the people who were loaned the money) should have been rated as very risky by the rating agencies. Somehow, they were not. This led to a situation in which a bond that was AAA rated (the highest and safest rating) contained loans that should have been rated way less than that.

This all came to a head in 2007 and 2008 as mortgage default rates (i.e., the rates of people who were not paying off their mortgages or were “defaulting” on them) rose sharply. The default rates reached levels that made many of the bonds that contained them fail, causing losses to those who held them (or were betting on them, but that’s another story).

The losses and failures caused a huge cascade or domino effect that caused trillions of dollars to “disappear” from the market.

The Big Short and what I do not understand

If you read The Big Short or watched the movie then you know the story.

“shorting” means to bet against something happening.

“The Big Short” refers to a bet that a few people made against the housing market, a market which is made up – to a large extent – of the bonds I described above.

Someone called Michael Burry looked into the details of the top-selling mortgage bonds and realized that the loans were much worse, or much riskier than people thought.

He decided that, based on the quality of the loans, large numbers of people were going to default on their mortgages, and the failure of the bonds was inevitable. He then decided that he would use money from a private investment fund he ran to bet against those bonds. In the end, those bets made him a lot of money.

The reason he made an unusually large amount of money is that the banks thought the chances of the bonds failing were so small that they gave him very good odds (from his perspective). Everyone thought the housing market was going nowhere but up. It was such a sure thing that, if I understand things correctly, no one had bet against it until Mr. (Dr.!) Burry did. This allowed him to make the bets cheap, and get paid big if he won. The banks gave him good rates because they thought there was no chance they would lose.

Here’s what I don’t understand

If I am the bank, and a fund manager walks into the building and asks to bet a very large sum of money that something I am very confident would never happen, would, how can I just agree to make the bet for the manager without ever scrutinizing the thing he just bet on afterwards?

It’s not like Dr. Burry was out of his mind. The book says he was eccentric, but he had a medical degree and ran an extremely successful fund that made huge and above-average returns.

If he walks into the bank and bets hundreds of millions of dollars that certain bonds were going to fail, how could the bank not have wondered what the hell was going on, and then read the bonds and the mortgages they contained and scrutinized them?

At some point another fund called Cornwall Capital (Brownfield Capital in the movie) made bets against the AA segments of some those bonds. How could banks take bets that questioned the very fabric of financial reality and risk-assessment at the time and not read and check every single word in the bonds?

I understand that the banks were making a lot of money selling these bonds to other financial institutions. This provides an incentive to not look too hard at the thing they were selling and discover that it was rotten. But still…

These are the possibilities I see:

  1. They thought people betting against the bonds were crazy and were happy to take their money (this is the image the movie presents).
  2. They did look into the bonds and discover how bad they were, but decided to continue selling them anyway because they were making a lot of money and didn’t think they would be hurt when the bonds failed.
  3. Something else, but I don’t know what.

To clarify: at some point the banks did start realizing how bad the bonds were and they started trying to short the bonds themselves. However, it seems like this realization came way too late. At that point it was years after Dr. Burry (and others) had made their bets against the bonds; mortgage default rates were high, and the bonds were already failing.

I just don’t understand how the people who took those bets didn’t run to their desks after Dr. Burry left the building and double-, triple-, and quadruple-check those bonds.

I know both incompetence and fraud are involved. I just don’t know the ratios.