2. MAIN FACTS
* In the early 2000s Michael Burry discovers that the U.S. housing market is about to collapse. Why? Over the past two decades, the big
banks have made it a habit to bundle together Americans' home mortgages into bonds known as "CDOs,“. The quality of those loans has
been declining, making it likely that many CDOs will go bad.
* These bad loans are known as "subprime mortgages.“ The problem is that banks are targeting immigrants and other members of the
working class and suckering them in with low interest rates, only to jack up the prices after a two-year grace period. And that these people
can't actually pay them back once the price gets jacked.
* As Burry is convinced that the CDO market is about to crash, he buys a "credit default swap" on a bunch of CDOs. This means that he pays
the bank each month that the CDOs retain their value, while the bank pays him each month they drop. It's like making a bet. Burry buys a
ton of credit default swaps and predicts that they should start paying off in 2007.
* This deal is monitored by Greg Lippmann, a bond trader with Deutsche Bank. After confirming Burry's claims, he creates a sales pitch to
persuade others into buying credit default swaps from him. It doesn't work very well until he meets FrontPoint Partners. Led by Steve
Eisman, FrontPoint buys a nice grip for themselves, and there are high fives all around.
3. * Another group enters the game: Cornwall Capital, fund operated by Charles Ledley and Jamie Mai. They managed to make millions
working the stock market, but now they've set their sights on subprime mortgages. With the help of Ben Hockett the fellas buy credit default
swaps on the highest rated portions of CDOs.
* In early 2007, FrontPoint Partners and Cornwall Capital go to Las Vegas, convincing themselves even further that a massive collapse is
imminent.
And they're right: over the next few months, subprime mortgages start going bad all over the country. Oddly, however, the bonds
that contain those mortgages are retaining their value. Huh? Michael Burry suspects that the banks are inflating CDO prices so they can sell
their own CDOs to unsuspecting victims before it's too late.
* By the end of the year, the bubble has exploded. A bunch of major banks and financial firms go bankrupt. On the flip-side, the good guys
make a bunch of money: Ben Hockett sells Cornwall's swaps, while Burry sells his to silence from his investors. Eisman, on the other hand,
decides to hold on to his credit default swaps until 2008.
* Stocks really hit the fan. When even more banks and financial firms fail, the US government steps in and bails them out.
4. Financial instruments are assets that can
be traded. They can also be seen as
packages of capital that may be traded.
Most types of financial instruments
provide an efficient flow and transfer of
capital all throughout the world's
investors
A debt instrument is a paper or electronic obligation that
enables the issuing party to raise funds by promising to repay
a lender in accordance with terms of a contract. Types
of debt instruments include notes, bonds, debentures,
certificates, mortgages, leases or other agreements between
a lender and a borrower.
A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is
obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses to
make large real estate purchases without paying the entire value of the purchase up front. The borrower repays
the loan, plus interest, until he/she eventually owns the property free and clear. If the borrower stops paying the
mortgage, the bank can foreclose.
TERMS TO BE TAKEN INTO ACCOUNT
5. A bubble is an economic cycle characterized by
rapid escalation of asset prices followed by a
contraction. It is created by a surge in asset
prices unwarranted by the fundamentals of the
asset and driven by exuberant market behavior.
When no more investors are willing to buy at
the elevated price, a massive selloff occurs,
causing the bubble to deflate.
Hedge funds are alternative investments using pooled
funds that employ numerous different strategies to
earn active return for their investors. Hedge funds may
be aggressively managed or make use
of derivatives and leverage in both domestic and
international markets with the goal of generating
high returns.
Credit default swaps (CDS) are the most
widely used type of credit
derivative and a powerful force in the
world markets. These were first
launched by J. P. Morgan.
A CDO is a structured financial product that pools together cash
flow-generating assets and repackages this asset pool into
discrete tranches that can be sold to investors. A collateralized debt
obligation (CDO) is so-called because the pooled assets – such
as mortgages, bonds and loans – are essentially debt obligations that
serve as collateral for the CDO.
6. HOW DO CREDIT DEFAULTS SWAPS WORK?
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-
backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of
the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or
another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to
shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a
negative credit event occurs. The bond involved in the transaction is called the "reference obligation."
Therefore, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction,
when the reference entity (the issuer) has a negative credit event. If such an event occurs, the party that sold the
credit protection, and who has assumed the credit risk, must deliver the value of principal and interest payments
that the reference bond would have paid to the protection buyer.
The contract seller is taking the risk of big losses if a credit event occurs.
