The Big Short: A Case Study on Greed, Irrational Exuberance, and Human Nature

By AAwosika07 | Entrepreneurship

Dec 09

“Investing is not the study of finance. It’s the study of how people behave with money. And behavior is hard to teach, even to really smart people. You can’t sum up behavior with formulas to memorize or spreadsheet models to follow. Behavior is inborn, varies by person, is hard to measure, changes over time, and people are prone to deny its existence, especially when describing themselves.” – Morgan Housel

It’s amazing how logic, reason, and even sanity go right out the window when you involve money. I’ve always argued that the ‘lizard brain’ and emotions drive human behavior more than logic.

Nothing captures this more clearly than finance.

As I’ve started to grow my income, I’ve become more interested in finance and investing.

When it comes to money, two primary emotions drive our behavior — fear and greed. You can see how these two emotions drive financial markets, even to the brink of total economic meltdown.

The Other Night, I re-watched The Big Short — a movie about the housing market collapse and the handful of investors who not only saw it coming but profited from it.

I don’t know much about the technicalities of finance, but I’ve spent a bunch of time studying human nature, our biases, and the ways our emotions get in the way of rationality.

The movie captured a bunch of them. Take a look at my observations and see how they not only affect your relationship with money, but life in general.


Again, I’m no expert, but here’s how the movie portrays the financial collapse

Back in the ’70s, Lewis Rainared creates ‘mortgage bonds.’ As explained in this summary:

He took thousands of individual mortgages and combined them into one large mortgage. Investors could buy, essentially, shares in that large mortgage and they would be entitled to their share of the interest payments.

Back then, hardly any investor could buy mortgages and the innovation gave bond investors (e.g. those seeking an income-producing asset – one that paid interest) a new alternative. Statistically, only a small percentage of homeowners would default on their mortgage – and any losses that occurred would be more than made up for by the interest paid by other homeowners who had taken out mortgages.

The details don’t matter much, but people believed the securities were stable and profitable. And they were stable and secure for a time.

Where profit goes, people go. Mortgage bonds and other ‘Mortgage-backed securities’ become insanely popular. At a certain point, the banks ran out of high-quality mortgages to put in these mortgage bonds, so they started to fill them with lower quality mortgages.

They continued to add lower and lower quality mortgages into these securities. When they had a pile of mortgages so bad they couldn’t put them in the bonds, they created an entirely new security called a CDO.

Per Investopedia:

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

These CDO’s contained mostly garbage quality mortgages. But, they put lipstick on a pig and made them appear to be solid investments. Other people created derivatives to sell to people who wanted to bet on all these MBS’s.

Others placed bets on top of the bets of those securities, creating a massive connected web of people looking to make money from the ‘untouchable’ housing market. To keep the charade going, rating agencies would rubber stamp pretty much every mortgage in these securities.

A handful of investors realized the mortgages in these securities were garbage, so they placed bets against the bonds and against the housing market as a whole.

You know the gist of how the housing market crashed, but what’s more interesting at the different little elements of human nature that led to the crash. I’m going to rattle off a bunch of observations I got from the movie.

Irrational Exuberance

If you follow finance Twitter at all, you’ve seen memes that say “stocks only go up.”

It’s a tongue in cheek phrase, but this is the way we feel emotionally. This is how financial bubbles form. People see the prices of assets go up. They think they can buy in and watch the assets rise higher. Nobody thinks they’re going to lose money.

You can see the levels of irrational exuberance in many parties involved in the crash:

  • The banks who sold the securities
  • The investors who placed bets on them going up
  • The investors who placed bets on top of those bets
  • People who bought expensive homes with no money down and crazy mortgage terms
  • Real estate professionals making hand over fist selling homes to unqualified lenders in a rapidly growing market

Bubbles pop because, eventually, the fundamentals of the market will win.

That irrational exuberance quickly turns into fear. Once the prices fall sharply, people want to get out and sell their assets, even at a loss. They ‘buy high’ and ‘sell low.’

The Principle Agent Problem

Humans are self-interested, to a fault. People will look out for number one, first, and if their goals aren’t aligned with the people they’re supposed to help, the people they’re supposed to help will get screwed.

You can see this many times throughout the film and the real-life events:

  • The bankers had the incentive to make short-term profits and their interests weren’t aligned with many of the people who suffered — taxpayers, regular people with pensions and 401ks, and everyone who lost jobs due to the crash
  • The real estate agents who sold homes to people who couldn’t afford them had the incentive to make more money, even if it meant putting the people who bought the homes in a risky situation
  • People who participated in creating and selling the financial instruments that grew the bubble in the first place

I have no sympathy for bankers and Wallstreet types, but the incentives and principal-agent problem made for this type of outcome to occur due to the phenomenon I’m going to about next.

Skin in the Game

Skin in the game is the idea that you should pay for the consequences of your actions. Lack of skin in the game played a role in the collapse of the housing market:

  • Many Wallstreet and banker types collect fees regardless of how well the assets they manage perform. They’d behave differently if they were investing their own money.
  • Skin in the game was transferred from the bankers to the taxpayers who had to fund the bailout. Nothing has been done about this lack of skin in the game at all and you can see this effect reaccuring right now when huge companies got bailouts from the taxpayers due to the co-vid pandemic. When someone else pays for your mistakes, you have no incentive to be cautious.
  • Skin in the game might also explain why so few people profited from the collapse of the market. If you wanted to make that bet, you’d have to fork up your own cash, or the cash of your investors, to do it. A huge payoff, yes, but a catastrophic loss if you’re wrong.

The Madness of Crowds and the Loneliness of Being Right

There were many times in the film where the ‘shorters’ had to go through a bunch of emotional turmoil to follow through with their decision.

Michael Burray staked 1.3 billion of his investor’s money into the bet.

Of course, all of his investors wanted to pull out. Some threatened him. There’s a scene in the movie where the main stakeholder barges into his office and tells him to ‘give him his fucking money back.’

Before the collapses ensued, the ‘shorters’ had to watch their money bleed away in the form of premiums. Even when the market started to fail, the prices of the MBS’s didn’t drop. All of the ‘shorters’ caught onto the fact that the market was totally fraudulent. They could’ve ended up being technically right yet still losing everything.

Peter Thiel explains why it’s so difficult to be a contrarian:

“If your goal is to never make a mistake in your life, you shouldn’t look for secrets. The prospect of being lonely but right—dedicating your life to something that no one else believes in—is already hard. The prospect of being lonely and wrong can be unbearable.”

Then, the madness of crowds explains why the vast majority of people believed the housing market would never fail.

Nietzsche put it well:

“Madness is rare in individuals – but in groups, parties, nations, and ages it is the rule.”

Selling somebody a $700,000 home with no job, no money down, and a 450 fico score seems insane if you’re the only person doing it. But if every real estate agent in your city is doing it, it seems not only rational but the obvious thing to do.

In retrospect, making all of these crazy financial bets based on the myth of the market’s stability was insane for one person to do, but obvious when everyone was doing it.

The Power of Incentives

Warren Buffet’s business partner, Charlie Munger, says: “If you know the incentive, you know the outcome.”

Munger himself says that he’s still shocked, constantly, by the power incentive has to drive behavior. Personally, seeing the world through the lens of incentives changed the way I saw everything.

I stopped being as judgmental about people and their nature, especially the dark parts of it. When you cook up a set of incentives, people have almost no choice.

There’s a scene where Michael Baum has a meeting at the Standards and Poor Ratings Agency — a company that gives ratings to the loans that went into the financial instruments banks sold. By this time, the market is already failing and he’s curious as to why the prices of the securities haven’t fallen yet.

When talking to an employee of the company who rubber-stamped a bunch of garbage mortgages, he presses her for information as to why they would give such high ratings to obviously garbage quality loans.

She said, “If we didn’t approve them, they’d just go next door and get an approval.”

All of these concepts overlap. But perhaps incentives is the umbrella that covers them all. The main incentive for a bunch of people involved was the fact that they had to do things a certain way in order to get by, make a living, or make a killing.

Pure Stupidity

There’s a scene between one of the ‘shorters’ Michael Baum and Jared Vennet — the person who brought the idea of shorting the housing market to Baum in the first place.

They’re discussing how it could even be possible for such rampant fraud to occur, fraud even too insane for an already fraudulent industry.

Baum tries to think logically and comes up for all of these nefarious and calculated reasons. Venett responds with a simple answer.

People are greedy and stupid.

First, as the greed train goes faster more people want to get on it. Happened during the tech bubble, happened during the housing bubble, some argue it’s happening right now with a stock market that keeps going up even though the real economy is in the gutter.

Second, people underestimate just how stupid people in positions of authority are.

Many people suffer from authority bias:

This is the idea that people follow the lead of credible, knowledgeable experts.

They discount their own intelligence and outsource it to ‘credible’ and ‘knowledgable’ ‘experts’. The only problem? Many of these people have little to no credibility, knowledge, or expertise.

They throw on a nice suit, work for an organization or a department with an acronym for a name, and use big words and jargon to confuse you into thinking they’re smart.

So, most people throw their money into 401ks without knowing what’s in them because they trust the ‘knowledgeable experts.’ They sign the adjustable-rate mortgage agreements because it got handed to them across from a fancy desk. We think a title like ‘chairman of the fed’ means you know everything about the macroeconomy.

And we end up with the results we got in 2007. Results which will inevitably occur in the future.

People Fail to Learn From The Past

The movie ended with a caption that basically said that banks are creating the same financial instruments that played in role in the collapse. None of the bankers who mismanaged the funds of their investors got fired or went to jail. Most walked away with giant bonuses. Many of the people responsible for the crisis were placed in government positions to oversee it. That’s wild but true.

Let’s not place all the blame on the government, the bankers, the federal reserve bank, etc. We all play a part in the problem, too.

What problem?

Human beings have a hard time learning from their mistakes. They feel the pain when the collapse happens, but irrational exuberance always comes roaring back.

Do you think people as a whole got more fiscally conservative and avoided debt after the crisis? Hell no. To this day, the vast majority of people still believe real estate is an untouchable investment, even though tons of people went underwater on their mortgages just a decade ago.

We continue to play the game the societal overlords want us to play. Instead of realizing that they’re the problem, we fight with each other over who’s team is going to win and which authority figure gets to make all of our decisions for us.

There is no moral to this story or a bunch of pieces of advice to give you. Human nature dies hard. Irrationality almost always wins. Greed and stupidity will reign supreme as long as humans exist. We’re doomed to repeatedly learn the lessons of history.

In your case, the best thing you can do is try to fight the battle against your biases as hard as it may be. Getting a slight edge, a bit of a handle of your emotions can pay huge dividends, both literally and figuratively.

I definitely wouldn’t put my faith in the system if I were you. Due to all the problems and biases, I listed above, asking the creators of the system who benefit from it, to change it, makes absolutely no sense.

Create your own system. Take as much ownership over your own life so that you’re not susceptible to the whims of others. Love people, interact with them in good faith, enjoy them, but never forget who they really are.


About the Author

Ayodeji is the Author of Real Help: An Honest Guide to Self-Improvement and two other Amazon best-selling titles. When he's not writing, he enjoys reading, exercising, eating chicken wings, and occasionally drinking old-fashioned's.