COMMENTARY: “The Big Short” – DVD bonus features I’d like to see

January 21, 2016

Lawrence Hsieh, Practical Law

The Big Short is a thoroughly entertaining film about the lead-up to the financial crisis. One of the slickest devices employed in the movie is when celebrities and experts, such as the University of Chicago’s Richard Thaler, break through the theater’s “4th wall” to directly address the audience with explanations of complex instruments like synthetic collateralized debt obligations.

By now, the basic plot is well-known. The anti-heroes, outsiders who are part of the system, “bet against the housing bubble” by buying credit default swaps (CDSs) against mortgage bonds and derivatives backed by mortgage receivables. They would profit when enough of the mortgagors defaulted to trigger either a “credit event” under the swaps (and therefore payment by the presumably solvent counterparties), or a correlating increase in market value (and therefore the opportunity to sell high). Without giving away too much, the film exploits the initial lack of apparent correlation to great dramatic effect before the movie ended like we all knew it would.

In anticipation of the March DVD release, here are two of my predictions for what might, hopefully, show up in the bonus features.

A more balanced view

The film sustains the popular narrative of the crisis – of corporate greed gone amok, fueled by deregulation. This greed is personified strikingly by smug composite-character retail mortgage brokers, and an equally smug based-on-real-life CDO bond manager. Probably nobody associated with the film would endorse the disputed view that aggressive federal government programs to encourage homeownership caused the bubble in the first place. Even so, the film would benefit from a more balanced view. A bonus feature could help to rectify that.

The film of course depicts borrowers sympathetically, as the victims of the crisis. The camera lingers on the past-due notices and artifacts strewn about abandoned, financially underwater homes. Borrowers are mostly invisible, save for an aspiring real estate mogul who likely will no longer be able support her multiple mortgages. There is also, curiously, an earnest but oblivious tenant who is worried that his family will be evicted by the absentee landlord’s bank.

A major disappointment is that the film absolves borrowers from responsibility for their own predicament. A bonus feature, echoing the “4th wall” style, could explore the possibility that a big subset of the borrowers abdicated personal responsibility and were just as greedy, negligent, reckless and clueless (and in some cases, unscrupulous) as the bankers who gave them undeserved credit.

Predicted 4th wall sequence – Actor Christopher Walken, whose catch phrase from the movie “Suicide Kings” was “everybody lies,” makes a public service announcement about combating predatory lending practices with common sense skepticism and 5th grade math skills, which are demonstrated on a free Internet calculator.

Are credit default swaps insurance?

The characters in the film casually refer to the swaps as “insurance.” A bonus feature could explore the issues more deeply. To be sure, the instruments have insurance-like characteristics. The protection seller – typically a bank (like movie punch line Wachovia, even though that bank refused to do a deal with fund manager Charlie Geller) or an insurance company affiliate – promises to make payment to the protection buyer, such as the movie protagonists, if the underlying alphabet soup of bonds or derivatives default. The protection buyer pays premiums for the protection.

This is similar to how a life insurer might promise, in exchange for premiums, to make payment to my beneficiaries when I die. But as much as you might be provoked to buy a policy on my life after reading this article, life insurers will not sell you that policy. You do not have what state insurance regulators call an “insurable interest” in my life.

The protagonists were similarly “naked” (presumably the reason for the movie’s R rating) because they did not own the underlying bonds. But the film punted on whether the protagonists had an insurable interest that would make the swaps “insurance” subject to state insurance law and its strict capital requirements, rather than swap contracts governed by the ISDA. Some critics say that the crisis would never have happened had the swaps been deemed insurance from the get-go. But insurers are just as savvy as banks at off-loading risk through financial innovation –transformers, captives and insurance-linked securities.

State insurance regulators, led by the National Conference of Insurance Legislators (NCOIL) and the New York Insurance Department, were worried after the crisis that the federal government would not move quickly enough to regulate swaps, so they launched a preemptive strike. The states asserted jurisdiction over “covered” CDSs, but ceded oversight of “naked” CDSs to the federal government. Covered CDSs are swaps bought by investors who also own the referenced credit for routine hedging purposes – a massive and beneficial market ignored by the movie.

All kinds of confusion erupted, including whether the states might inadvertently snatch jurisdiction over other kinds of swaps such as interest rate swaps. State regulators ultimately suspended their quest, and today CDSs are regulated by the SEC (single names, loans and narrow-based security indexes) or the CFTC (broad-based security indexes). Rather than setting aside reserves from premiums, which is what state insurance regulation would have required, swap writers must post margin to account for risk spreads.

Predicted 4th wall sequence – Ron Swanson, the libertarian character from “Parks and Recreation,” explains that any vendor who sells goods to his City of Pawnee can legitimately hedge its exposure to non-payment by purchasing credit default swaps written by Wachovia against the city’s municipal bond obligations, even if the vendor does not own any of the bonds.

Cue ending credits song, “Once in a Lifetime”…

Fade to black…

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Jan. 14. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @RiskMgment)

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters. The views expressed here are his own. Lawrence is a graduate of the University of Chicago Law School and holds an engineering degree from Cornell University. Lawrence is the author of the Corporate Transactions Handbook.)

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