The Big Short case study. For value investors and portfolio managers.
For portfolio management and fixed income students the 2008 – 2009 financial crisis represents a terrific learning opportunity. As I teach portfolio management to Executive MBA students I have started to use a class room screening of The Big Short case study. At 130 minutes the film is a handful for a 3 hour class but the learning impact is worth the effort. Growing up and taking investment management exams we inevitably would read about the great depression and wonder what they were thinking in the 30’s but we could never really relate to a time 70 years in the past. The Big Short fixes the relevance problem for students of value, fixed income, trading and risk by taking a different perspective on a crisis that was much more closer to home and touched all of us in ways the great depression never could.
The 2008-2009 crisis and its media coverage illustrates a few core themes that are essential for both traders and risk managers. From the damage done by collective group think to battling inherent biases and status quo to investigating trade ideas and the stress testing models – studying the crisis is worth a semester long course in investing and financial risk management.
While a film is an easy way out, the best way to approach studying the crisis is to dig a little deeper. If you are the reading type there are three books that you should explore to better understand the sequence of events and timeline – The Big Short, the original book by Michael Lewis, The end of Wall Street by Roger Lowenstein and Fooled by Randomness by Nicholas Nassim Taleb.
The first two are related directly to the sequence of events that led to the crisis while the third will help you understand why Wall Street valuation and risk models backed by hundreds of millions of dollars in technology, talent, expertise and data failed.
If you are not a reader you can still get a sense of what happened and the sequence of events that led to the crisis by watching three separate films.
The first – Too big to fail – is the documentary drama based on Andew Ross Sorkin’s best seller of the same name. The film lays out the timeline of the crisis and the drama that played out behind the scenes in Washington DC and New York and the pressure wave created by the failure of Lehman Brothers.
The second is Margin Call, a pseudo fictional depiction of a bulge bracket Wall Street Bank’s attempt to unload toxic securities off its balance sheet. While the world agrees that the film may be based on actual events there is no agreement on the bank depicted in the film. The most likely candidate is often quoted as Goldman given their last minute exit from the subprime market just before the crisis but there has been no corroboration of the claim by the team that wrote the script or produced the film. Still the 90 minute feature provides important supplementary context to the events leading to and occurring in the first film – Too big to fail.
However the most powerful and important film of the three is the Big short. While the first two provide context to the financial crisis and help us better understand the condition of the subprime market and trading desk for portfolio managers and students of value, Big short is where the real learning happens in this class. Based on Michael Lewis’ international best seller, the book and film share five parallel stories. Three that inspire us to become better portfolio managers and investors by focusing on things that we should do; and two that focus on things we shouldn’t.
The Big short tells the story of three individual led institutions that took the bet that the subprime market was bound to fail, significantly before the financial world realized that there was a problem.
As the film revolves around characters, to appreciate the context you have to get familiar with two exotic financial products. Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO). CDS and CDOs for short. We address the actual trade and its motivation in our next post.
As we watched the film with my students this week a number of questions popped up in the class. Some from students who had already seen the film once and were still not sure about aspects of the timeline. If my students had questions, there is a good chance you do too. As we review the film we will try and answer some of these queries.
A quick note before we begin. The comments below are based on the treatment of the story as presented in the book and the film. There are some areas where there is contention or divergence in how the sequence of events actually transpired. While we have always respected Michael Lewis, with the Big Short there have been a few question marks. Lewis, always a professional, has indicated most of the instances where his version of events may be different from the one being used by some of the other counter parties.
Given its length our case study has been broken into three parts. Part I focuses on the characters. Part II reviews the takeaway and lessons. Part III covers the trade.
Big Short case study. The three central characters
We begin our review by first taking a look at the three central characters. Focus on the timelines and the trade.
Dr. Burry and Scion Capital. 2005
The first of the three stories is that of Dr. Mike Burry. A neurologist turned value investor who has a track record of identifying contrarian opportunities in the equity trading world. By the time the book and the film find him Mike has already translated that expertise in growing Scion capital his hedge fund to US$ 600 million in assets under management.
Mike develops a thesis that leads him to believe that as teaser rates on subprime mortgages expire, the rate of default on these high risk mortgage securities will shoot up. Home buyers will have a challenge financing rising monthly payments as rates rise on their mortgages. As default rates shoot up on mortgaged homes the securities linked to the same loans will also default.
Mike doesn’t like shorting securities. But when it comes to the housing market his investment thesis is very simple. The financial market doesn’t really understand the odds of a subprime mortgage pool melt down. The odds the market is willing to pay for issuing insurance to protect against that collapse are hopelessly optimistic. The bill when it comes due is going to significantly higher.
He creates the specification for a credit default swap that would synthetically allow him to short a select group of mortgage bonds. Dr. Burry goes shopping on Wall Street to book the trade and between May 2005 and October 2005 buys US$ 1.3 billion worth of credit default swaps from a group of large banks that in his opinion are likely to survive the coming storm. The list includes Goldman, Bank of America, Deutsche Bank and J P Morgan among others. Mike is the original patient zero. Mike discloses the trade to his investors through his newsletter in October 2005.
Mike’s trade with Deutsche Bank makes the round within the bank till Greg Lippmann, a bond salesman hears about it. Greg gets the trade and builds a pitch that he runs by his institutional customers which is essentially how the market gets to hear about the trade. That is the simplified version that the film portrays, the actual motivation is a little different.
Steve Eisman and Front Point Partners LLC 2006
Steve Eisman and team take a call meant for another hedge fund housed at Front Point Partners and get to hear the Greg Lippmann pitch based on the original Mike Burry trade. The pitch is intriguing enough for Steve to investigate the issue further. He already has prior background with the subprime industry because of his work covering mortgage issuers and originators earlier in his career as a research analyst.
The Eisman trade is a great example of luck, showing up at work and answering the phone. Greg Lippmann original presentation is met with some skepticism – not on the trade idea, everyone gets it; but the structure, the incentives for the counterparty (Lippmann) and the payoff. Eisman’s team needs some time to figure out if there really is a bubble; if the numbers are really that bad and most importantly what is in the trade for Gregg Lippmann.
Front Point Partners starts with placing a USD 50 million notional CDS order with DB in the summer of 2006. By the time we are done with the book and the film that bet has grown to over 500 million. But in addition to doing the CDS Trade once Steve figures out how much the market is rigged to blow he goes after and shorts financial institutions linked and likely to suffer during the looming crisis.
This is a key difference between Burry and Eisman. The Eisman trades go beyond just the CDS.
Charles Ledley and Jamie Mai at Cornwall Capital – October 2016
Charles Ledly and Jamie Mai get to hear about the Mike Burry trade and the Greg Lippmann pitch and decide to investigate. The Cornwall capital team has bigger challenges compared to Scion and Front Point Partners. They are significantly smaller in size, and unlike the first two really not sure if they understand what they are doing. By the time they get to execute the trade the market has moved. Which leads them to a different and more interesting trade. Rather than buying CDS on the now significantly more expensive B rated CDO tranches, Cornwall decides to short the higher rated AAA tranches.
They execute their first trade on 16th October 2006 with DB CDS desk run by Greg Lippmann. Cornwall’s primary exposure on the CDS front is to Bear Stearns. 80% of their positions are against Bear. Once again luck favors the bold and they exit and sell their 205 million in CDS exposure through their chief trader Ben Rickett in August 2008, a few weeks before Bear goes under.
The Big Short case study – Other players
While the first three characters lead inspirational and charmed lives, there are two more timelines in the book that don’t make it to the film the same way
Howard Hubler III – Howie Hubler – 2005 – 2008 – Morgan Stanley.
The first is Howie Hubler, the Morgan Stanley head of Fixed Income Arbitrage who gets the privilege to book a US$ 9 billion dollars loss on a short CDS portfolio of US$ 13 billion.
Like Mike Burry, Hubler is one of the first few traders to realize that the not all subprime mortgage pools are created equal. He actually beats Burry to the trade and has a CDS portfolio against his own pool of subprime reference securities worth US$ 2 billion in place by early 2005. Bury at that point is still negotiating the paperwork with Goldman Sachs.
Hubler’s undoing however is the periodic pay as you go payments he has to fork out to pay for the CDS. As a trader looking to cover expenses he decides to sell CDS on the AAA tranches to offset that cost. His take is that while the B rated tranches would most likely default, the AAA rated tranches are unlikely to go under. His assumption about the correlation between the tranches get thrown under the bus as correlation actually goes to one. While the theory behind the original trade is sound unlike Burry, Eisman and Cornwall Capital Hubler doesn’t run or test the thesis beyond the standard limits of his internal models. Given the mismatch in payment size he ends up selling US$ 16 billion in CDS on the AAA rated tranches to cover the annual cost of his US$ 2 billion long CDS position.
The books talks about multiple opportunities for Hubler to reduce the exposure and exit his trades. Opportunities that could have potentially saved Morgan Stanley US$ 6 billion in eventual capital losses. But Hubler is unfortunately so close to the portfolio that he can’t get his valuation models to reconcile with what the market and his counterparties are telling him.
And here lies the ultimate irony of fate. Four trades make it to the limelight in Lewis’ book. All four are based on the same theme. Of the three underdogs, two (Scion and Front Point) understand the trade, one (Cornwall) is consistently unsure of the drivers and the transaction. Of all the traders it’s the fourth (Hubler) that should have had the biggest advantage because this was his market – a market that he owned. Unfortunately rather than insight, that closeness only created myopia. Hubler committed the original sin in financial markets – he drank his own cool aid.
Joseph Cassano at AIG FP, the group issuing the AAA backed guarantees on the subprime CDO is the other gentleman who doesn’t make the cut to the film. Possibly because the AIG story and Joe’s role in AIG’s fall from grace and the collapse of the subprime mortgage industry is a film in itself.
To be continued… at Part II – Lessons for value investors and traders from Big Short.