Why did the banks sell credit default swaps to Michael Burry in The Big Short?

Question

In The Big Short there's a scene where Michael Burry shorts the housing market by going to different banks and buying insurance from them. After he leaves, we see the bank employees making fun of him for making a terrible deal. Yet in the end it is revealed, the banks knew all along the crash was going to happen but also knew the taxpayer was going to bail them out, which is why they basically bribed the ratings agencies to fake the ratings of the mortgage bonds. So why did they sell the insurance to Micheal Burry, when they knew he was going to profit heavily of them? Just to keep the illusion going?

Answer 1

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The movie dumbed it down and made the banks look hapless. It was almost like the banks wrote the script. Only boy genius could figure out that the housing market was going to crash.

So in the movie the scenes you are referring to happened on film because:

1. Going over the exact reasoning would be even harder to understand than the other stuff they already brought up.

2. The big banks would go nuts and possibly sue the studio.

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I worked in quant and direct feeds during this time in the market, doing a lot of work for big banks (I was the guy that got them data faster so they could game the system pre-regulations). This plays out real real simple.

You have guys who are handing out loans and giving criteria for portfolios of loans being handed out. They allowed lenders to bypass PMI and basically let people buy houses with no money down.

Example: Standard is 20% down on a house. If you don't have 20% of the house you pay PMI which is a B*TCH but protects banks. Here is where it gets shady. There was this huge cross-section of people that didn't have the money to pay for their down payment + mortgage + PMI - so these people where denied or simply chose not to get loans.

But but but the big banks whispered to the direct lenders... we want more loans no matter what. So if someone buys a 200k house and they don't have 40k down let's figure something out. We make them put maybe 10k down give them a 30k loan as a second mortgage (on a house they don't have yet) and give them the home loan. Yep 5% with no PMI (PMI on a 200k loan right around $200 per month).

Pretty shady right? That was step 1. Step 2 is let's get that 2nd loan off the books and charge them for another new loan. So let's tell all of our lenders to target potential houses that they could get (maybe fake) appraisals done at a much higher estimate. Guy comes out and says the house is now worth 240k... Well now your equity stake is 20% and we will give you a loan for the 190k. Boom new loan on books.

The big banks new what they were doing. They had systems with all of these loans categorized and segmented based on loan type, customer type, and risk. So when the default rate of 3rd year borrowers went from 1.057% to 2.7% their algorithms knew what to expect down the road.

The fact is all of the jobs at these banks are bonus-able on what you did this year. These guys get a $5m bonus for giving out 10 billion in loans... They could care less what crashes in 3 years or forecasts. So all of the managers on this side of the company knows what's coming. But if they try to save the ship or reduce risks, they are mitigating their salary. So they basically hid it until the last second. This is the main point the movie should be ashamed for not portraying accurately. For such a good movie it is pathetic that they made the banks look shocked.

Why didn't the guys selling the short know? They would have no clue and would never be allowed to see the data (at least the accurate data) that the loan division heads have. So the #1 evil is the banks manipulating the market to sell loans. But in a very close 2nd place on the evil list is the idea of handing out huge bonus for short-term performance in the banking industry. Basically you get your huge bonus no matter how much you screw the company over long-term unless you broke some law/regulation.

[To understand why they were happy to sell the short, you would need a meta movie about the loan department. This movie would probably be just as intriguing as The Big Short and would go over the 3-4 year cover up of the loan portfolio books.]

Answer 2

Two reasons. First, banks do not generally have monolithic investment hypotheses. It is totally possible for different parts of the bank, or even different traders on the same desk, to have offsetting views. Note for example the relationship between Donald Trump and Deutschebank — he defaulted on their commercial lending division, sued them, and they declared they would never do business with him again. The personal banking division of the same bank was delighted to take his business, even to the point of lending him the money needed to pay off the division of their own bank that he had just defaulted on.

Second, banks act as intermediaries, selling exposure to one side and laying off the risk elsewhere (perhaps somewhat transformed, by being embedded in an indexed derivative or a structured note for example). In such cases, the bank is left with little or no principal risk and takes a spread.

Answer 3

This is to go along with Michael Stern's answer about how different arms of a bank may act differently or seemingly independently of one another.

The dialog of the scene depicting Burry discussing the purchase of the insurance swaps would clearly indicate that, at the very least, the quants he was dealing with did not know such a crisis was on the horizon. They even seem to try and convince him his request is both highly improbable and foolish:

Michael Burry: I want to buy swaps on mortgage bonds. A credit default swap that pays off if the underlying bond fails.

Goldman Sachs Sales Rep (Lucy): You want to bet against the housing market?

Michael Burry: Yes.

Goldman Sachs Quant (Deeb): Why? Those bonds only fail if millions of Americans don't pay their mortgages. That's never happened in history. If you'll forgive me, Dr. Burry, it seems like a foolish investment.

This happens around 2005, roughly two years before the housing market would start to collapse in 2007, culminating in the bankruptcy of Lehman Brothers in September 2008 depicted at the end of the film. The quants legitimately thought what Burry was betting would happen could never happen, and were all too happy to take his money.

Goldman Sachs Sales Rep (Lucy): This is Wall Street, Dr. Burry. If you offer us free money, we ARE going to take it...

I mean to be fair, they're actually being quite reasonable here in trying to warn him against the action he's seeking to take, but if he wants to do it they can certainly make it happen and won't bat an eye. They even laugh among themselves in celebration after he leaves because they legitimately believe they're going to make a small fortune of Burry and can't believe what just happened.

Leading up to this moment, even one of Burry's biggest clients thinks he's wrong.

Michael Burry: It's only a matter of time before someone else sees this investment. We have to act now.

Lawrence Fields: And how do you know these bonds are built on subprime crap? Aren't they filled with hundreds of pages of mortgages?

Michael Burry: I read them.

Lawrence Fields: You read them? No one reads them. Only the lawyers who put them together read them.

Michael Burry: I don't think they even know what they made. The whole housing market is propped up on these bad loans. It's a time bomb, and I want to short it.

The dialog is also notable for Burry's insistence at acting quickly to be the first to obtain these types of swaps, because he thinks someone else will see it as well and seek to capitalize on it.

As the movie shows at least two other groups learned of the problem and sought to capitalize on it.

Eventually the guys at Brownfield learn the SEC has zero regulations on mortgage-backed securities, and as the defaults rise but the CDOs and mortgage bonds remain the same or even go up in value, they surmise the banks are aware of the issue and are attempting to sell and short them before the looming crash. They attempt to alert the press, but no one of relevance will listen to them.

This is pretty much the central point of the film: the banks at first didn't seem to realize the impending doom, or at least didn't think it would be a big issue because, "Who doesn't pay their mortgage?"

But as the movie would show, mortgage lenders were also acting unscrupulously and lending to people that were massive risks because of the money they were making, and when things went sideways the banks acted fraudulently to protect themselves due to little to no regulations on the investments involved. Eventually they were bailed out, no one of consequence was arrested, and virtually no effective regulation was put in place because banks are now selling CDOs under a new name, "Bespoke Tranche Opportunity."

Answer 4

There's more than one bank. It's no more a contradiction to say that "the banks" knew it was coming and yet "the banks" were betting against it happening, than it's a contradiction to say "the soldiers" were trying to land on Normandy Beach, and "the soldiers" were trying to stop them. By the time of the events of movie, mortgages were being moved from one bank to another, in increasing complicated arrangements. Max Greenfield plays someone at the beginning of this chain: he gets people to take out mortgage loans, and the bank that makes the loan quickly off-loads it to another bank, who may then combine it with several other mortgages to create a CDO and sell it to another bank, who sells it to another bank, etc. He doesn't care whether the mortgages are good, because his employer doesn't care, and they don't care because they're just selling them to someone else.

And within one bank bank, there are different divisions that are often working at cross purposes. The character Jared Vennett is based on Greg Lippmann, who was betting against the CDOs while other divisions of his employer, Deutsche Bank, was investing in them.

Third, this takes place over several years. The banks didn't all start out knowing it was going to come down. As time went by, more and more banks went from selling the insurance, to getting out of the business, to trying to buy insurance themselves. It was Burry buying this insurance that tipped Vennett/Lippmann off to look more closely at the CDOs, which made him realize he should bet against them, which led him to wanting to go out and sell insurance to investors, which led him to Mark Baum (based on Steve Eisman). As Vennet sells more and more insurance, more and more people, such as Charlie Geller and Jamie Shipley, start to see the cracks in the industry.

Also, the bailouts were primarily of the underlying mortgages, which were backed to some extent by federal programs such as Fannie Mae. The bailout of entities holding derivatives based on those mortgages was more sporadic.

Answer 5

I think it's a stretch to say the banks knew the crash was coming. Yes in the closing moments of that bubble they could see the market start to wobble, but most bankers, most investors, most homeowners, were oblivious to the impending doom before that pint. The bankers who laugh at him think they are making easy money because his bet is (in their opinion) a stupid one. But he was placing his bets at least a year before the cracks became visable to the market.

In the immediate aftermath the heads of the banking industry knew the government would have to bail them out, but before the collapse begin they couldn't see it coming because it was unprecedented and they were blinded by greed.

Read the book if you'd like more detail. It's one of my favourites.