In the movie The Big Short, how does Dr. Burry buy credit default swaps?
In the beginning of the movie, Dr. Burry walks into the bank and wants to buy credit default swaps on the banks mortgage bonds. I'm trying to understand the process. Dr. Burry states he wants to purchase $100 million in default swaps at the first bank for example. I understood the transaction like this:
He pays $100 million up front for mortgage bonds, and has them insured by paying additional fees if the bonds increase in value over time.
I became confused with the process when Dr. Burry stated he wanted to buy "Credit Default Swaps on the Mortgage Bonds." Wouldn't he need to purchase ownership of the bonds before he could have them insured? Or do credit default swaps work in a way where you can bet against these bonds without having to take ownership of them and just pay the premium fees, which is whatever the bank charges?
Please explain Dr. Burry's $1.3 billion short position. Did he pay all of that at once, or is that the amount over time he'll pay on the premium fees? Or is it the amount he paid for the mortgage bonds all together, which doesn't count the premium fees that will be paid down the line?
The financial instrument he used is called a credit default swap. The size of the short position you are referencing is called the notional value of the swap. The reason he needed to speak to the bank up front about doing this transaction is that trading swaps requires an ISDA agreement, which is a document executed between a large bank and a hedge fund that wishes to speculate using complex financial instruments.
The way credit default swaps (CDS) trade is the following: There is an effective life of the contract, usually around 5 years, over which the swap buyer pays a fixed premium every year to the swap seller. The swap seller collects this premium free and clear if the underlying debt obligation does not default; however, in the event of a default, the buyer has the right to swap out defaulted bonds for the full original par value. Like an insurance contract, the buyer is paying the premium for the possibility that the debt defaults, while the seller collects the premium and hopes nothing bad happens.
CDS is quoted in basis points per annum. If a debt obligation is deemed very safe, the CDS on that debt obligation will trade at a low premium, i.e. not a high cost to protect against its default. In 2005-2006, CDS were trading with very low premiums because of a perception that underlying debt obligations, such as mortgages, were very safe and unlikely to default. Because of the low premium, a speculator who wanted to bet on a default could pay a small amount to make a huge multiple of his/her money.
Say Dr. Burry wanted to buy a CDS contract on a basket of mortgages. And say the CDS contract was a 5-year, quoted at 50 basis points (0.50%). And say Dr. Burry wanted to transact $100 million notional. Every year for 5 years, Dr. Burry would be obligated to pay 0.50% of $100 million, i.e. $500k. If nothing happened, the CDS seller would collect $2.5 million in total over the 5-year life. But, if a default happened, and the bonds crashed to 10 cents on the dollar in a bankruptcy proceeding, Dr. Burry would be entitled to a windfall profit of $90 million: $100mm * (100% - 10%), i.e. the notional value times the difference between par and the recovery.
The losses that Dr. Burry incurred initially were due to the fact that he was paying premium for these CDS contracts but no defaults were happening. This can be very painful as a CDS buyer because you have to time it right to win. If nothing had happened until after the life of the contract, or until he ran out of money to make the premium payments, he would have lost it all.
So, if he had a $1.3 billion short position all in all, that was merely the notional value. If the average price of the CDS were 100 basis points (1%), his annual premium obligation would have been around $13 million. That is a lot of leverage - to control $1.3 billion of bonds in a bankruptcy with only $13 million in annual premium. When the bonds went belly-up, he made a mint.
This is not something you can do in your brokerage account. To reiterate, trading swaps with a bank like Goldman Sachs requires an ISDA agreement, which is typically only granted to institutions with at least a few hundred million dollars. Hope this explanation helps.
A Credit Default Swap (CDS) can be purchased as a hedge for owners of the debt instrument being insured. However, the reference obligation (and/or its equivalent) does not have to be owned to buy credit protection in the form of a CDS. Under either scenario, the buyer would pay a contractually agreed upon periodic premium to the seller until a negative credit event occurs or the contract expires.
I apologize that I don’t remember the terms of the contracts purchased in the movie, but, frequently, a CDS is referred to in terms of the amount of protection being purchased, known as the “notional amount.” The notional amount of the contracts – or the amount of coverage being purchased – could have been $1.3 billion dollars.
The notional amount would be a factor in determining payouts in the event of a negative credit event, and would have to be taken into consideration when determining the buyer’s periodic premiums, but it would not necessarily directly determine the amount that a buyer pays in upfront or periodic premiums. The determination of premium amounts can be nuanced, depending on the type of CDS being purchased, among other factors.
It can probably be assumed, however, that, if the notional amount was $1.3 billion dollars, the premiums would have been in the tens of millions of dollars a year.