Definitely the Big Short! Sad, but brilliant movie!
If you’re interested in investing in bonds, it’s worth watching this movie! They also explain what happened in really simple/relatable terms, so it’s easy to understand if you’re a newbie investor
Let’s delve into this movie - I find this a great example of how risky subprime home loans are and in turn how risky bonds can be.
For others reading this that aren’t sure what they are, subprime home loans are home loans that are given to borrowers that often have a bad credit history or credit rating, meaning they have a higher chance of defaulting based on their repayment/credit history.
From a lenders perspective, a lender wants to offset this risk so they offer a home loan with a very high interest rate, so if the borrower does default, they’ve made more money in the short term.
In my opinion, giving someone new debt with very high interest rates (which makes it harder to service/repay the debt) that already has a history of struggling with repaying debt, is a recipe for disaster! I find it questionable how this could be deemed ‘responsible lending’ under the credit act in most jurisdictions.
What does this have to do with the stock market?
If you’re not sure what a bond is, it’s like modern day peer to peer lending. Bonds are where you lend money to a company (corporate bonds) or a government (government securities, government bonds or treasury bonds). This money is lent for a set period of time and you receive interest payments at regular intervals, known as coupons, in return. You can read more about them in ‘The Library’.
Bonds come with different quality ratings, basically from good to bad, with bad being junk bonds. However, if you invest in a Bank bond, as an example, often they will have a AAA rating, because the Bank has a good credit history. However these Bank bonds may be full of subprime loans. Even though property is considered a less risky investment (because everyone on the planet needs a home to live in), if you have rising interest rates and borrowers with bad credit ratings already paying high interest rates that then can’t repay their loans, then you have a problem.
In parts of America, where the housing and bond market crash took place, they have non-recourse borrowing arrangements. This means that in some parts of America, if you default on your home loan the bank can’t take legal action against you and claim your other assets, they can only take ownership over the property they gave you the loan to buy.
So lots of borrowers that couldn’t meet their repayments just left their houses and gave the keys back to the Bank. So the Bank had a lot of houses, with a lot of debt and no market to sell them in and no way to repay the debt, this in turn effected the bonds that were made up of these subprime loans.
The movie is named ‘The Big Short’, because one savvy investor saw this happening and ‘shorted’ (bet against) the housing market by investing in credit default swaps (CDS). A credit default swap, in simple terms, means the person buying the swap makes payments to the person selling the swap until the maturity date of the contract. In return, the seller agrees that in the event the borrower defaults (like on their home loan), the seller of the swap will pay the buyer of the swap the total value of the swap, as well as all payments that would have been paid between that time and the maturity date. - A CDS is like buying insurance, you make regular payments but when you have to claim on your insurance you get a pay out.
So while some people were losing a significant amount of money, there were some savvy investors that made a fortune!
Definitely add this movie to your Netflix watchlist!