How Did The Big Short Work? Breaking Down the Financial Strategy

The 2008 financial crisis was one of the most devastating economic events in modern history, and a small group of investors saw it coming. Their strategy, famously depicted in The Big Short, involved betting against the housing market when almost everyone else believed it was stable. This move, known as “shorting,” allowed them to profit from the collapse while major financial institutions suffered massive losses.

To understand how this worked, it’s important to break down the key financial instruments they used and the mechanics behind their trades.

Mortgage-Backed Securities

Banks issue home loans to borrowers but don’t always keep them. Instead, they bundle these loans and sell them to investors as mortgage-backed securities (MBS). Investors receive payments as homeowners make their mortgage payments, making MBS an attractive option for steady returns.

The appeal of these securities relied on the assumption that housing prices would continue rising and borrowers would make their payments. To attract investors, financial institutions categorized MBS into different risk levels, with higher-rated tranches offering lower returns but greater stability. Ratings agencies, such as Moody’s and Standard & Poor’s, played a critical role in assigning these ratings, often inflating them beyond what was warranted.

As demand for MBS grew, lenders issued more loans, including to borrowers with poor credit histories. These subprime mortgages carried higher interest rates but were far more likely to default. Many had adjustable rates, meaning borrowers initially paid low interest before facing sharp increases. When homeowners could no longer afford their payments, defaults surged, undermining the value of the securities tied to them.

Collateralized Debt Obligations

To further package and distribute risk, financial institutions created collateralized debt obligations (CDOs), which pooled various fixed-income assets, including MBS and corporate bonds. CDOs were divided into tranches, allowing investors to choose between safer senior tranches with lower yields or riskier junior tranches with higher potential returns.

CDOs were structured under the assumption that defaults would remain isolated. Issuers argued that diversification reduced risk, but many CDOs were heavily weighted with subprime mortgage securities, making them highly vulnerable to a housing downturn. Rating agencies often assigned AAA ratings to senior tranches despite the underlying assets being far riskier than advertised. This misrepresentation led to increased demand and further inflated the housing bubble.

Investment banks played a central role in creating and selling CDOs, often holding onto the riskiest portions themselves to maximize returns. Meanwhile, the relentless demand for CDOs encouraged banks to issue more subprime loans, creating a cycle that fueled the crisis.

Credit Default Swaps

To manage risk, financial markets turned to credit default swaps (CDS), which functioned like insurance policies on debt securities. A party purchasing a CDS paid regular premiums to a seller, who agreed to compensate them if the underlying debt defaulted. Unlike traditional insurance, CDS contracts didn’t require ownership of the insured asset, enabling investors to speculate on default risks.

The widespread use of CDS contracts amplified risks within the financial system. Many institutions selling these swaps, such as AIG, assumed defaults would remain minimal and didn’t hold adequate reserves to cover potential payouts. This overconfidence led to an explosion in CDS issuance, with the total market reaching an estimated $62 trillion at its peak. As defaults surged, firms that had sold large volumes of swaps faced mounting liabilities, triggering liquidity crises that forced government interventions to prevent systemic collapse.

Short Position Execution

Identifying weaknesses in the housing market was only the first step. To profit from the collapse, investors needed a way to bet against securities widely believed to be safe. Traditional short selling—borrowing an asset, selling it, and repurchasing it later at a lower price—was difficult to apply directly to mortgage securities. Instead, they used synthetic financial instruments that allowed them to take short positions without owning the underlying assets.

One key method involved entering swap agreements where they paid recurring premiums in exchange for a payout if certain securities collapsed. These contracts mirrored the function of shorting stocks but were tailored to the structured finance market. Pricing was influenced by credit spreads, which widened as market confidence eroded. Investors who initiated these trades early secured lower costs, while latecomers faced significantly higher premiums as risk perception grew.

Realizing Returns from Market Decline

As the housing market unraveled, those who had taken short positions saw their trades move in their favor. Defaults surged, driving down the value of mortgage-backed securities and CDOs. This made credit default swaps increasingly valuable. The widening credit spreads signaled growing distress, allowing investors holding these swaps to either sell their contracts at a premium or wait for full payouts when securities officially defaulted.

Liquidity constraints worsened the situation, as financial institutions that had sold swaps were forced to cover mounting losses. Firms like AIG, which had issued billions in CDS contracts without sufficient reserves, required government bailouts to prevent total collapse. As panic spread, banks rushed to offload toxic assets, further depressing prices. Investors like Michael Burry and Steve Eisman, who had positioned themselves correctly, closed out their positions at massive profits, securing billions as the broader financial system teetered on the brink.