How four outsiders took on the banks (and won)

The Big Short (out now) tells the story of how four outsiders on Wall Street took on the banks during the financial crisis - and won.

Not many people saw the financial crash of 2008 coming, and those who did saw it in a "oh holy hell, we're all going to die" kind of way. Not so for four Wall Street outsiders, who saw the crash coming long before everyone else did, and managed to make a killing by betting against the banks.

The Big Short isn't just the story of people who took money from the banks. It's the story of the very few people who saw the financial collapse coming and began waving their arms and shouting about it, trying to warn everybody, whilst looting at the same time. They aren't just the nice guys who stood at the side of a beach yelling shark, they reached into the rich guy's pocket at the same time and took it whilst he was distracted.

How did they do it?

In the film, Margot Robbie (Harley Quinn from the upcoming Suicide Squad) pops up to explain subprime mortgages, whilst sipping champagne in a bubble bath in order to keep your attention. Without the advantages of a bubble bath or Margot Robbie's face, here is our explanation of how they made their money. First, the background...

The background

In the early 2000s, banks started giving mortgages to people who couldn't afford them. They then sold off these mortgages (traditionally a solid investment) to financial investors. This is a sensible move for the banks and for the investors when it the people who own the mortgages could afford to pay them back.

It was sensible for the mortgage holder - they could afford to buy a house, and pay it back over a number of years. It was sensible for the banks - they would get a return on their investment. And it was sensible for the investor. By buying the mortgage off the bank they thought they were buying a commitment from the house buyer, who would pay them back over a number of years.

Only in the lead up to 2008 when the financial world came to a crash, this wasn't what was happening. The banks weren't giving mortgages to people who could afford them. They were giving them to pretty much anybody. People who wouldn't be able to pay them back. And they were still selling the mortgages on to financial investors as if they were a safe investor, when really they were just massive IOUs that the IOUer had no hope of paying back.

What is a "short"?

Financial planner Tony Sandercock explains...

"If your neighbour is open to lending their car to you for a week, with the promise of course that you'd return it, you could immediately sell it at the current market price (say, $50,000) then use the cash to purchase the same car in the local dealer's sale (for $25,000). You can then return the new car to your neighbour and pocket the difference as your profit (in this case, $25,000).

Well, you can actually do this with shares and many other financial products.

By borrowing shares and paying the lender interest and the dividends, these shares can be sold (known as "shorting selling") with the aim to re-purchase them at lower prices at some time in the future, for return to the lender.

Short selling creates profits when prices fall. Short selling is also a gamble. History has shown that, in general, shares move upward. What this means is that shorting is betting against the long-term direction of the market.

So, if the direction is generally upward, keeping a short position open for a long period can become very risky as the losses are infinite.

A short sale loses when a share price rises and a share is (theoretically, at least) not limited in how high it can go. For example, if you short a share at $30 but the share increases to $90, you end up losing $60. And every dollar that share increases in value, it increases your losses by a dollar, as eventually, you'll have to repurchase that share at the market price so you can return it to the lender. On the other hand, a share can't go below zero, so the most you can make is $30.

In the movie, they are short selling mortgage products, which is the same concept. To you, it may sound crazy that something has to go down in value to make a profit. But yes, this really happens. If you can understand this concept, 'The Big Short' will make a lot more sense to you."

Enter the four outsiders...

Most people at the time didn't realise that the financial world was on the brink of collapse. Greg Lippman, Steve Eisman, Michael Burry and others at Cornwall Captal (played by Bale, Carrell, Gosling and Pitt) however, did see it coming. And they realised that if they were willing to bet that "safe" bonds would go bad, effectively betting that the banks would fail, they could make a killing in the process.

You'd forgive them for being quiet about this, if they realised that they could make a lot of money out of it as long as the banks didn't realise what was going on, but they didn't. They warned anyone who would listen about the upcoming collapse. Steve Eisman regularly told everyone he saw that the subprime mortgage machine was headed off a cliff, but it largely fell on deaf ears.

They began selling mortgage bonds short to investors, over $1billion worth, knowing that they would have to buy them back at some point. These looked like safe investments to financial investors, as they thought house prices would likely grow, and mortgages were safe pieces of real-estate. But the four knew that mortgages were about to become effectively worthless, and so they'd have to buy back their bonds (as they were "shorts") but at a fraction of the price they'd sold them at.

The four ended up making a hell of a lot of money using this method, and felt awful guilt at profiting at the expense of all the losses going on at the time. But, in the end, they were now multi-millionaires with feelings of guilt.

As Brad Pitt's character sums it up:

“You just bet against the American economy. And if you win, hardworking people will suffer. so try not to celebrate.”

This article was sponsored by The Big Short - in cinemas now. We're giving you a chance to win a luxury hi tech bundle worth £2,000 to celebrate the release of The Big Short.

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Plus, five runners up will receive The Big Short merchandise.