What The Big Short teaches you about the downside of leverage

Matthew Partridge looks at what 2015 film The Big Short can teach investors about the pros and cons of leverage.

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The Big Short is a 2015 film based on the non-fiction book of the same name by Michael Lewis. It looks at the US housing-market bubble (and subsequent financial crisis) through the prism of three groups of investors: Michael Burry, Front Point Partners and Brownfield Capital. Each of them decides to short the housing market by buying CDOs (insurance on the risk of bunches of mortgages defaulting). It performed solidly at the box office, making $133m, and was nominated for five Academy Awards (including Best Picture), winning one (Best Adapted Screenplay).

The key moment

To investigate what is really happening with the mortgage market Mark Baum (Steve Carell), the head of Front Point Partners, decides to go on a road trip to Florida, the epicentre of the boom. He speaks to several investors, including an exotic dancer, who have taken out mortgages on multiple properties that they cannot afford, in the hope that prices will keep going up, enabling them to sell at a large profit. Towards the end of the film we see some of these characters desperately searching for work.

Lesson for investors

Although leverage can magnify your gains if things go well, it does the same to your losses if the market turns down. Indeed, even if the price of the assets you are investing in rises, you may end up losing money if the price gain is less than the cost of borrowing money. The film shows that the problem was exacerbated by people taking out "teaser" loans where the interest rate charged would dramatically increase after a few years. While the idea was that people would avoid these higher rates by refinancing, this turned out to be impossible during the panic.

Other financial wisdom

Many people who gambled on the US housing market lost everything, and millions ended up in negative equity. However, as most US mortgages were only secured against the property (unlike in Britain), underwater homeowners often could (and did) wipe the slate clean by walking away; banks couldn't pursue them. That tended to prompt the banks to sell the property to recoup some money, pushing prices down further.

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