How does "selling" a credit default swap works in the Big Short?

Question

I have watched The Big Short several times, watched a bunch of clips, and searched in youtube lots of explanatory videos. I am not even close to understand all the concepts shown in the movie, but I do have some basic understanding of them.

My understanding is that the characters in the Big Short don't really "short" in the sense of "shorting" stocks (as in borrowing a stock, selling it right away, then wait for the stock to decrease in price so they can profit the difference). They short (as in, bet that something will decrease in value) mortgage bonds by "buying" Credit Default Swaps, which my understanding is that it's basically an insurance contract in case the bonds are defaulted.

As an insurance contract, they need to pay premiums on them, until the bonds fail, or until the contracts expire. If the contract expire, then the insurer keeps the money from the premiums. I think I am not far off in all these.

Now in the movie (and in real life) the bonds, did fail, so the characters of the movie gets money. Now, how does that work? Few questions below

• They constantly mention that if the bonds fail over 8%, the whole bond is worthless. why is that? to me it sounds like even decreasing 50% or 60%, there is still money being paid for that bond, so it shouldn't be completely worthless (big loss, probably yes, but worthless? maybe they just overused the word worthless?)

• How does "selling" a CDS work? for example if I have fire insurance on a house, and it burns down, I don't need to "sell" anything. I just go to the insurer and get a new house. I would expect the characters just go to their insurer and get the money stated in the contract.

• why do the characters run into the risk of "sell it all or lose it all"? to me it sounds at the point they were selling their CDS, everyone in the world knew about it. why would anyone "buy" stuff from them?

I hope my questions made sense.

Answer 1

The "short" in the Big Short is taking an insurance position that will pay out if the CDO it insures has defaults on a certain proportion of its underlying mortgages. You don't mention CDOs in your question so I'm not sure that you aren't conflating the two which might confuse you.

1. You don't just insure your house for a fire that burns the whole thing down surely? You insure it for any unforeseen damage over a certain threshold. That 8% default rate is the threshold over which the insurance pays out to make the insured person whole. It does sound like they overused the word "worthless" or devalued it, yes. Note that the bonds in question were mortgage backed so that 8% equates loosely to 8% of people who's mortgages were in the CDO defaulting on those mortgages.

2. If you have insurance on your house you buy insurance if you sell a CDS you sell insurance. I've been meaning to see the film (as I used to work with the CDS market but sometimes these films are too cringe-worthy to watch) but my belief is that they were betting against the US real estate market so would have been buying the CDS naked (without the bonds or CDOs it is insuring) as a leveraged bet on the real estate market falling. The bonds were also "over-insured" with there being more insurance contracts being traded than there was value of CDOs.

3. The banks were mispricing the CDOs, whether intentionally or not, because they were wrapping prime and sub-prime mortgages into the same CDO to reduce the risk and to make them "investment grade". Many pension companies and other investors only buy investment grade instruments either for risk or legal reasons so being of investment grade can be essential to having a market for your product. As soon as the banks discovered that the CDOs that they were holding were worth less (because they had higher risk and therefore higher chances of defaulting) than their current valuation they needed to sell them off before they became essentially worthless. Remember that we are talking about prices here and for bonds as prices fall so yields rise and yields are proportional to risk - you have to have a higher potential return to take more risk. When the miss-valuation was discovered they didn't want to be holding the downgraded assets but people who didn't know would still buy them.

3.1. The CDSs themselves might also need to be unloaded before the discovery of any overinsurance on the bonds so the profit on the CDS could be locked in before the issue was discovered leaving the holder uninsured but I think in this regard you are confusing selling CDOs and CDSs. The wikipedia article seems to confirm my suspicions but I'll watch the film some time soon for you.

personal note: I worked with these when they were coming onto lit markets in 2011-12 on the trading side rather than pricing or risk so I missed the "wild west" of 2008 and only really saw the reality of the regulators bringing order to that market.

Answer 2

I found this answer that explained it well enough for me: How did Steve Carrell make money in The Big Short?

The "shorting" in the movie context slightly differs from how you would short a stock (borrow, sell, buy it back when price drops). Instead, it is conducted via an arbitrary insurance (named credit default swap), which essentially states if more than x amount of mortgage wasn't paid, then the big bank pays people like Baum y amount. In exchange, until that threshold is reached, Baum has to pay an agreed upon fees. This insurance can be transferred (sold) to someone else.

However, waiting until the agreement comes into effect may not be desirable. For example, the whole bank might fail and cannot pay the agreed amount (i.e. lose it all), so you can transfer the agreement to someone else (sell it) and still earn a profit. For example, I have paid $10 for the past year for the agreement that would pay me back $100 if the economy fails, instead of waiting for the economy to fail and receive that $100, I can find someone that's willing to take over this agreement for $50, and take home $40 profit for myself.