How 'The Big Short' Investors Made Money from Selling Credit Default Swaps (CDS)

In the movie The Big Short, characters such as Michael Burry, John Coffee, and Charlie_VOICE_Allison successfully predicted the collapse of the housing market and made millions by betting on the subprime mortgage crisis using Credit Default Swaps (CDS). This article will delve into the intricacies of CDS, the strategies used by these investors, and the general oversight in the financial markets.

Understanding Credit Default Swaps (CDS)

A Credit Default Swap (CDS) is a type of financial derivative that allows an investor to transfer the credit risk of a borrower or a bond to another party, known as the protection provider. The investor pays a premium to the protection provider on a regular basis in exchange for the protection provider's obligation to pay the investor if the bond goes into default or the borrower stops making payments.

While CDS can be compared to insurance, it is important to note that it is not insurance and thus does not require ownership of the underlying asset or contract. This distinction is crucial because it allows investors to speculate on the creditworthiness of a borrower without having to invest in the actual asset.

Identifying Risk

Investors in CDS identify risk by analyzing the creditworthiness of the underlying borrowers, typically mortgage-backed securities. By understanding the likelihood of defaults, these investors can either purchase protection against default (buy CDS) or sell protection (short CDS) based on their prediction of market movements.

Buying CDS Protection

In the early days of CDS, there was a lot of confusion regarding the use of terms like 'buy' and 'sell.' When buying a bond, the investor wants the price to go up, which means they want the outlook to improve. However, when buying a spread, the investor wants the spread to widen, which usually means a negative outlook for the underlying asset. This ambiguity can lead to misinterpretations and strategies going awry.

However, for the 'Big Short' investors, correctly identifying the risk and predicting the increasing defaults on subprime mortgages was the key to their success. They bought CDS protection on mortgage-backed securities, betting that the value of these securities would decline due to rising defaults.

Triggering the Payout

When the housing market collapsed and defaults on subprime mortgages surged, the value of the mortgage-backed securities plummeted. As a result, the CDS contracts held by 'The Big Short' investors became highly valuable because the protection providers (banks) had to pay out on these contracts due to the defaults.

Realizing Profits

The investors profited in two ways. First, they could turn a profit by selling their CDS contracts at a much higher value than they paid for them. Secondly, they could collect the payouts from the sellers of the CDS when the securities defaulted, which indeed they did.

The substantial profits were a result of the underlying assets losing significant value during the financial crisis. For 'The Big Short,' this was a sound strategy based on the correct prediction of the housing market crash and the resultant defaults.

Challenges and Confusions

The key to the success of 'The Big Short' investors was not just in understanding CDS but also in navigating the complex language and terms used in the financial markets. Terms like 'buy' and 'sell' can mean different things in different financial contexts, often leading to substantial confusion.

For example, when someone sells a stock, they are going short. Similarly, when someone sells a bond, they are also going short. However, when selling a CDS, the investors are buying protection, not going short. This causes a major confusion as it means people are using the word 'short' to mean both 'I want things to be good' and 'I want things to be bad.'

Fortunately, after a few years of market participants making trades incorrectly, the financial markets agreed on the terminology. A buy/go short means 'buy protection,' while sell/go long means the opposite. This has led to greater clarity and confidence in the market, reducing the risk of systemic financial collapse.

However, it is still important to understand the terminology correctly. For instance, in The Big Short, the investors expected things to be bad, so they bought protection against the housing market collapse and went short the market. They closed the trade by selling protection, which worked much like going short in the equity market.

One of the key points of CDS is the ability to trade the credit of the underlying asset without needing to own the asset itself. This can be advantageous for investors who can analyze credit risk and speculate without needing to hold the actual assets, provided they understand the intricacies of the derivatives market.