3 ms·

As I understood it in the Big Short: Christian Bale's character's hedge fund wanted to make a big bet that mortgage backed securities would fail. So he shoppe

As I understood it in the Big Short: Christian Bale's character's hedge fund wanted to make a big bet that mortgage backed securities would fail. So he shopped the banks for those that would take that bet. The ones that agreed to take the bet, he paid them a negotiated monthly amount (basically rent) to keep the bet in effect. If he stopped paying rent, the bet was off. The banks thought it would never happen and it was free money coming in. Since they thought the risk was 0% it was free money coming in. ... basically, the banks thought he was crazy, but would take his money to keep the bet going. In the movie, Bale's fund gradually loses money paying "rent" on this bet / option / contract. Things get dicey when conditions that should result in the bet paying off get covered up by the banks and government, and the investors in his fund get pissed they aren't getting any return on their money as promised.

infinite8s 10y ago
It wasn't a bet - it was insurance, and his payment was the premium to underwrite that insurance. Of course the banks who wrote him the CDS failed to price the risk appropriately... It's like you are arguing that life insurance is a bet.
- iofj 10y ago
  Isn't that the same as is happening today with bonds ? The government is pushing bond prices down. So companies are using short-term loans to pay all their costs, while paying everything out to investors (clouding the issue is that a lot of this is happening through buybacks). What happens when interest rates go up, even a little ? It seems to me obvious consequences would be: 1) monthly payments go up. Either directly (variable interest) or when you refinance (companies have running debt. Almost always taking out new loan when old one comes due). In that case, interest rates go up slower than the benchmark rate, but they still go up. 2) creditworthiness of all debtors goes down (same as with individuals: you are "approved" for a monthly payment, e.g. 100 dollars/month. At 0% interest that covers 12000 dollars for a 10-year loan. At 1% that covers 11400, or about 5% less. Next time you ask for a loan you're not going to be able to loan 12000, so you can't just roll over the debt. So your ability to get new loans is going to be worse) Also, can someone explain to me why this doesn't result in moral hazard for management of large companies ? If you can loan at, say, 0.25% why wouldn't you just loan the next 60 year's profits now (investment time horizon "until the investors are expected to be dead"), pay it out to investors, and leave, content that you have done far better than you could have done by managing the firm well ?

infinite8s 10y ago

It wasn't a bet - it was insurance, and his payment was the premium to underwrite that insurance. Of course the banks who wrote him the CDS failed to price the risk appropriately... It's like you are arguing that life insurance is a bet.

iofj 10y ago
Isn't that the same as is happening today with bonds ? The government is pushing bond prices down. So companies are using short-term loans to pay all their costs, while paying everything out to investors (clouding the issue is that a lot of this is happening through buybacks). What happens when interest rates go up, even a little ? It seems to me obvious consequences would be: 1) monthly payments go up. Either directly (variable interest) or when you refinance (companies have running debt. Almost always taking out new loan when old one comes due). In that case, interest rates go up slower than the benchmark rate, but they still go up. 2) creditworthiness of all debtors goes down (same as with individuals: you are "approved" for a monthly payment, e.g. 100 dollars/month. At 0% interest that covers 12000 dollars for a 10-year loan. At 1% that covers 11400, or about 5% less. Next time you ask for a loan you're not going to be able to loan 12000, so you can't just roll over the debt. So your ability to get new loans is going to be worse) Also, can someone explain to me why this doesn't result in moral hazard for management of large companies ? If you can loan at, say, 0.25% why wouldn't you just loan the next 60 year's profits now (investment time horizon "until the investors are expected to be dead"), pay it out to investors, and leave, content that you have done far better than you could have done by managing the firm well ?