Ryan Gosling does his very best to explain how a collateralized debt obligation works.
Ryan Gosling does his very best to explain how a collateralized debt obligation works. Paramount Pictures

Three groups of experts saw the crash of 2008 coming. There were the Marxists (for example, the writers at the NYC-based Monthly Review—yes, they have very kind things to say about my work in the current issue); then the heterodox economists (such as the Australian Steve Keen, whose work and ideas is promoted by the locally based website IDEA Economics); and, finally, investment managers who saw that many of the collateralized debt obligations (CDOs) sold by investment banks were actually worthless and so bought credit default swaps (CDS) on those CDOs.

What this CDO and CDS business means: A CDO is a financial product that's complexly packed with debt obligations (in the case of The Big Short, home mortgages of all kinds) and sold to an investor, who in turn can buy a CDS as an insurance policy on the CDO. If payments from the CDO stop for some reason or another, the CDS pays the investor the money he/she expected from the CDO. Many believed CDSs made the world a safer place.

But there was one big problem to this happy picture: A CDS is not really an insurance policy, because the ownership of a CDO and a CDS is not strictly correlated. You can buy the latter without owning the former. This is like allowing strangers to buy insurance policies on my life.

The result of this absurdity is obvious: All of those strangers will want me dead. Meaning, they would be shorting my life. If people happen to see me smoking a cigarette, they can stop whatever they are doing, rush to AIG, and buy my life insurance policy. This is what perceptive investment managers did to the US economy. They wanted to make money on its death. The fact that CDSs were mostly regulated as actual insurance policies shows the kind of power Wall Street has in American politics.

Hollywood has made a very good movie about the years leading up to the crash (I highly recommend The Big Short, and so does Alan Harvey at IDEA Economics—more about this in another post). But because the filmmakers could never (and probably did not desire to) sell to the studios a movie about the Marxists or heterodox economists who predicted the crash (both have motives that are regarded with great suspicion in our society), they picked the investment managers.

Why? Though they came to the same conclusions as the Marxists and heterodox economists, the investment managers, like good American individualists, transformed these conclusions into a lot of money in their bank accounts. They did not help the public, they helped themselves. The Big Short is a comedy.