Case Study: Analysis on the Economy and Financial System of Financial Crisis

(The Big Short Movie)

Roque, Maricar S.

BSA-2A

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 Introduction

The Big Short is a 2015 Oscar-winning film adaptation of author Michael Lewis’s best-selling
book of the same name. The movie, directed by Adam McKay, focuses on the lives of several
American financial professionals who predicted and profited from the build-up and subsequent
collapse of the housing and credit bubble in 2007 and 2008.

Published in 2010, The Big Short: Inside the Doomsday Machine was a loose sequel to
Lewis' best-selling book Liar's Poker, a chronicle of his work experiences at Solomon Brothers
in the 1980s. Both non-fiction works offer a deep dive into the lives, workplaces and
psychology of several Wall Street professionals and the financial world.

This article explores The Big Short, its main characters, and the stylistic tools used by McKay
to explain complex financial instruments engineered by the banks during the run-up to
the subprime mortgage meltdown.

The Big Short Movie

The Big Short refer to the fact that the position they took was looking to have the entire
financial market and related economy fail to have a gain. They were betting against the NINJA
loans that had entered the collateralized mortgage bond market. The various players took a
position that was NOT to a hedge to a position they held in the collateralized mortgage bond
markets. So they where simply via a contract selling something they did not own or creating a
"short position" The reason the banks and financial players allowed the bet was they where
effectively betting on an event that had never occurred before in the mortgage market or the
economy it was the first time the mortgage market and USA economy took such a hit.

The cause of the 2007-09 crisis was the fact that, when banks make loans, money is created
and that money has to be found a home. That situation has not changed. Banks create money
when they make loans, and the rate at which they lend exceeds the rate at which the loans are
repaid, so the stock of money in circulation is constantly increasing. This stock is greater than
the amount that needs to be held to buy goods and services and the surplus ends up in the
financial sector looking for safe investments which will provide a good return. If it were the
case, say, that all bills for the provision of goods and services were settled quarterly, then the

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money needed to pay these bills would only amount to 25% of annual GDP, as the money used
each quarter could then be reused the following quarter. According to World Bank figures, the
global stock of broad money grew from 50% of global annual GDP in 1963 to 100% of GDP
in 2000. As a rule of thumb, then, it could be said that in 1963 half of the money in circulation
was chasing goods and services and the other half chasing investment opportunities. By 2000,
75% of the money was chasing investments. As a consequence, there was a constantly growing
worldwide unmet need for tradeable securities with a low risk of default. This demand came
primarily from pension funds, whose regulations restricted the levels of risk they were
permitted to incur, and from hedge funds and securities dealers who needed low-risk securities
to serve as high-quality collateral for their operations.

Securities are contracts granting the holders the rights to future payments. Banks, who were
expecting future payments of interest and principal from the loans they were extending, found
that if they packaged the rights to these future payments into securities, they could sell as many
of these securities as they could generate from new mortgages, credit card, automobile and
other loans and make a substantial profit in the process. They switched from their traditional
business of holding loans to maturity and collecting the payments themselves, to an "originate
to distribute" business model of extending as many new loans as fast as they could, turning
them into securities and selling them at a profit to investors, who were supposed to understand
and accept the risks that the banks were also transferring to them.

Securitization allowed many different loans to be lumped together and then divided up again
in a form which could be easily traded. "Tranching" allowed some of these securities to be
given preference over others from the same pool in the allocation of revenues from the
underlying loans, reducing the risk of default for those securities, and mathematical algorithms
allowed the level of risk of default for each tranche to be tailored to the needs of the prospective
purchaser.

But the mathematical algorithms used to rate these securities were wrong and risks were
miscalculated. Instead of default risk being randomly distributed between mortgages as the
algorithms assumed (and as had been largely the case previously under the "hold to maturity"
practice) the new "originate to distribute" model generated blocks of mortgages and other loans
with an increased tendency to default as a group. If conditions were such that one of the loans
in the block defaulted, then it was more likely that those conditions would cause all the other
loans to default also.

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In 2004, the Federal Reserve started increasing US interest rates rapidly, making loans more
difficult to service, and by 2007 this had triggered a wave of defaults which rendered many of
these securities worthless. Financial Crisis has a negative impact in the economy and in the
financial system which has been more or less manifested. First is loss of value of currency: The
country in a financial crisis loses the investors' confidence in its currency. The FDI/FII starts
to flee the country at the first sign of such crisis. For countries like India, China and many other
developing countries who have banked their growth on foreign investments, this is the most
relevant aftermath of the crisis. Second is Fiscal pressures, Due to the withdrawals of private
investors from the market, the government is now responsible for increasing their public
spending and building infrastructure for industries and public at large. This is all the more
relevant in case of India and fiscally dangerous, given perpetual budgetary constraints and
deficits. Third is Staggered consumption, The consumption of goods and services takes a deep
hit. As was seen during US crisis (2007-2012), the demand for consumer and industrial goods
and services went record low because of fears and shocks the crisis generated. The demand
reduces. The economy shrinks. The next point is the direct fallout of this phenomenon. Fourth
is Massive unemployment: This is one chilling outcome of any financial crisis. Due to reduced
growth opportunities, the industries sack number of personnel, leading to massive
unemployment countrywide. US is struggling with this problem since the crisis unfolded. This
again, as discussed in point 2, puts immense pressure on government and its social obligations
of providing quality education and healthcare to the masses along with a meaningful
employment. Lastly is Introduction of Macroprudential tools: The economies in the backdrop
of such crises develop and introduce various mechanisms to push their countries back on the
growth trajectory. The QE (Quantitative Easing) program of US Fed is one shining example of
this. This was largely meant to increase the dollar supply in the domestic and world economy
and thereby re-install the faith in dollar. It attempts to make credit easily available and cheaper
in the market. Although the benefits of such unprecedented monetary decisions are globally
debatable, it seems to have worked for US economy to some extent and similar steps now have
been taken by ECB (European Central Bank) and Bank of Japan to push their respective
currencies.

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 Conclusion

The crisis could be avoided if the banks didn’t just lend money out to people and not checking
if they would get the money back from the people. If the bankers would of played it smart this
wouldn’t of happened. Also, since they wanted the money all to themselves the chances of this
being avoided might be slim. If people were smart where they put their money and how they
spent in it would be more helpful. Another thing that could have prevented the crisis would be
how the brokers regulated things such as loans, and hedge funds. There was too much freedom
on them and not enough focus on the issue. Also, if new financial products weren’t established
yet then more people would be aware of what was actually happening around them.

References

https://www.gradesaver.com/the-big-short/study-guide/summary

https://www.ecnmy.org/engage/the-big-short/