Why Product Managers Love Mortgage-Backed Securities
Explaining short-selling and product strategy with… CLICK BAIT!
If you haven’t watched The Big Short, you might be asking “what the hell are mortage-backed securities?” This is a question that I had to once grapple with myself. Indulge me with a brief personal prologue…
Career Choices
My first job as a university graduate was as a recruitment consultant in London’s financial district, often referred to as ‘The City’. I should stress that I was perhaps the WORST recruitment consultant this particular firm EVER hired.
Despite my degree in American Studies (which, SPOILER alert, made me qualified for pretty much nothing) and zero knowledge of the financial services industry, this recruitment firm thought it would be a good idea for me to focus exclusively on hiring ‘credit risk analysts’ for investment banks.
This forced me to learn trending industry terms such as ‘Securitisation’ ‘Mortgage-Backed Securities (MBS)’ and ‘Collateralised Debt Obligations (CDO)’. After a few months I quit sad and dejected with still little to no understanding of the investment debt industry.
The one solace I now take from my brief experience on the periphery of the financial services industry, is that as much I didn’t understand how MBS and CDO markets worked, it would appear that none of the analysts or the banks, funds and ratings agencies I was hiring for understood them either!
As we learn in 2015’s The Big Short, directed by Adam McKay, these investment products tied to reckless mortgage lending were responsible for the 2008 crash of the US housing market and in turn the global economy!
However, as The Big Short explains, some of its characters did understand how the mortgage-back securities market worked. And today we’ll take some product management lessons from them!
NB: The Big Short, is based on real events and characters based on real people, some of which have had their names changed in the movie. For simplicity I’ve referred to characters as named in the movie.
WARNING: the video clips below contain strong language which will not be suitable for all.
Curiosity and Data Analysis
The central thread of The Big Short follows a group of investors who bet against or ‘short’ the market for mortgage-backed securities (MBS), bonds made from thousands of mortgage loans sold on from mortgage lenders to investment banks to repackage and resell to investment funds.
This group were in effect betting against the US housing market, and by implication predicting a catastrophic worldwide economic crash. Spoiler alert: this happened!
Leading the pack is Michael Bury, an independent fund manager with an awkward social manner and if Christian Bale’s depiction is to believed, highly questionable personal hygiene habits!
Bury reflects that it is curious that despite the Dot-Com crash in the early 2000s, that the San Jose housing market, the epicenter of Silicon Valley increased in value, rather than decreasing as you might reasonably expect.
Taking this observation, Bury then proceeds to painstakingly analyse the reliability and credit worthiness of each the thousands of mortgages in a range of top selling MBS products provided by investment banks.
He uncovers that many of these loans are doomed to default, granted to would-be homeowners without dependable income or induced by low initial interest rates, which are due to spike making repayments unaffordable. The MBS products are effectively worthless from a investment perspective, so Bury decides to short them, to the disbelief of the banks he trades with and the chagrin of his investors.
The product management lesson here is turning an observation into insight. Be curious and question the status quo and commonly held opinions. This type of questioning is the opening premise of many successful start-ups; “Why is it so expensive or inconvenient to… [transfer money / book a taxi / find somewhere to stay]”
Then, you may have to REALLY dig into some data…
Quantitative AND Qualitative
Now, as important as sound data analysis is, there is a danger in being what many organisations now describe as being ‘data-led’. It is far too easy to focus on the wrong data points.
As a prudent product manager you should avoid, as poet Andrew Lang is reported to have said, using “statistics as a drunken man uses lampposts – for support rather than for illumination.”
To avoid this situation, when Mark Baum and his team at Front Point Investors learn of Michael Bury’s trade from Deutsche Bank’s Jared Vennet, Baum takes his team to Florida to validate the statistics presented to them, with some field research.
Although told as part of a grimly humourous narrative, the team are in fact meticulously researching all sides of the housing market; rental tenants and their (absent) buy-to-let landlords, real estate agents and mortgage brokers.
When Baum and team interview two witless mortgage brokers, they learn that no matter how recklessly or even fraudulently they complete mortgage applications on behalf of their customers, that banks will buy these ‘debt assets’ from them almost immediately, no questions asked!
One goes on to concede that a significant number of their customers are exotic dancers, “strippers” who are cash rich, but as independent contractors, lack good credit scores. This leads to one of the most teeth-grindingly awkward scenes in the movie, as Baum sternly interviews a barely-dressed female dancer on her mortgage loans as she ‘performs’ in front of him. He learns that she has “five houses… and a condo” all bought with ‘teaser’ introductory low rate mortgages that will soon switch to unaffordable repayment schedules.
“There’s a bubble!”
Zig-ing and Zag-ing
There are plenty of start-ups and business strategy pivots which demonstrate the power of doing the opposite of your competitors… or at least doing it first. See more on this in an earliest post on McDonalds.
Jamie Shipley and Charlie Gellar of Brownfield Fund takes this idea and runs with it. As other investors scramble to bet on the failure of B and BB trenches of the MBS market, the riskiest mortgage loans, Jamie and Charlie jump on the idea of betting against the AA trenches, those that in theory are the lowest risk and most reliable.
Brownfield’s inspired insight was that the AA trenches were sold misleadingly (fraudulently?) as full of reliable mortgage loans. However, in reality they were likely to be filled with precarious loans and thus doomed to fail alongside all the lower graded trenches. And so it proved, with profitable results for the pair of young investors, albeit with disastrous implications for the global economy…
As a product manager, ask yourself, “What does this industry do/assume which may not be true?”
Be prepared though, just like the ‘Big Short’ investors, to have a LOT of tenacity in order to stick with your evidence in the face of incredulity and derision from colleagues and competitors alike. TEASER ALERT: I’ll explore this more in my next post…
To help give you some added confidence here, let’s play a game. Here are some FALSE assumptions that when challenged led to incredibly disruptive and successful products. You should be able to guess what they became…
“Nobody wants to rent DVDs via the mail (or watch movies on their computer).”
“Nobody will pay to stay in a stranger’s home.”
“Nobody will get a ride in a stranger’s car.”
“Nobody will put 1,000s of personal photos/videos of themselves on the public internet” *
*If ONLY this last one was TRUE!
Our Great Depression
As well as telling the inside story of the 2008 financial crash with wit, intelligence and a splash of dark humour, The Big Short also gives us poignant depictions of characters enduring grief, depression, stress and anxiety.
It also features a bevy of charming cameos not least from one of my heroes, the great but very sadly departed Anthony Bourdain.
Talk to someone.
