What The Big Short Gets Right (and What Politico Gets Wrong)

January 17, 2016

Imagine there was no financial crisis. Lehman Brothers went into bankruptcy and the only sound was crickets chirping. No panic, no bailouts, no TARP. There’d be nothing to be mad about, right?

Actually there’s everything to be mad about. We’d still have six million foreclosures destroying communities and people’s lives. The Great Recession would have happened almost exactly as it did, throwing millions of people out of work and scarring their productive lives. And there still would have been a wave of individuals who profited enormously through bad mortgage instruments, leaving everyone else on the hook.

One of the many things I like about the new movie The Big Short is that it doesn’t focus on the financial crisis, which normally dominates all the stories about what happened. Instead it focuses on how the housing bubble was created and sustained while previewing the destruction it would take on the people whose homes were in those mortgages bonds.

Most of the review from the finance and economics community of The Big Short have a “yes, but” quality, where they like the movie but then go on at length how it doesn’t cover their particular financial bugaboos. But we are now getting the counter-narratives, arguing that the film is entirely wrong with its message. First came the crazytown bananapants stuff from the American Enterprise Institute, arguing that the whole film is a lie. [1]

But now we have Michael Grunwald at Politico, arguing that the movie “whiffs on the big message of the crisis.” The crisis is just a story about a general housing mania, which all the attention the movie pays to the complicated mess of mortgage-backed securities and collateralized debt obligations (MBS, CDOs) needlessly complicates. The real problem was short-term leverage and the panics that ensued in the financial crisis. However those problems were handled well enough during the bailouts, and Dodd-Frank has made significant strides in fixing the problems the movie brings up.

I think these are all wrong, full-stop. And they are all wrong in a way that limits our ability to really understand the crisis, and where we are now. (Mild movie spoilers ahead.)

The Losses Weren’t Widespread, but Concentrated in Certain Instruments

Grunwald argues that you don’t need to know about MBS and CDOs. “As with the tulips and most financial crises, the basic cause was a highly leveraged investment mania”, and MBS and CDOs “were just fancy ways for financial players to place bets on the housing market.”

But if it was a general mania, you’d expect to see widespread losses among all kinds of mortgage players. But those losses were concentrated in subprime and especially CDOs. From the FCIC report:

Simply speaking, banks holding their own mortgages and government-backed credit (implicitly or explicitly) experienced nothing like the losses that financial securities saw. The bubble also wasn’t driven by consumers. As Adam Levitin and Susan Wachter found, the price of mortgages fell as the quantity increased, pointing to a supply-side movement rather than one driven by higher demand from housing-crazed individuals.

And rather than “bets on the housing market,” what the people who bought MBS wanted was “safe assets.” This might seem like a minor difference but it has serious consequences. Investors thought they were abstracting away from housing, and instead investing in something that was engineered to be as safe as cash. This is why so much of the subsequent academic focus has been on the “informationally-insensitive” aspect of the housing bonds.

This is why securitization matters. It is way of investors to outsource the creation and management of these bonds in such a way that investors didn’t have to look at the specifics.

The demand was for safe assets, and securitization promised a way of generating safe assets through financial engineering. This is also why the ratings agencies matter. Their problem wasn’t that they were off a rating or two. It’s that they were necessary to secure the cash-like AAA rating investors wanted.

The Big Short Shows Why Shadow Banking Matters

It becomes clearer when the movie walks us through how securities were created. Grunwald brings up shadow banking to note that it can cause bank-run-like events, or that “so much of the leverage was in the form of overnight financing that could run in an instant.”

But the other part of shadow banking is the disintermediation of credit, or less jargony, the fact that many different people are involved between making the loan and holding the risk of the loan. This is crucial to shadow banking, and crucial to the massive losses we saw in these instruments.

These instruments become as deadly as they were because people’s incentives didn’t line up at all. Steve Carell’s investor character can’t tell if the slimy mortgage originator (played to perfection by New Girl’s Max Greenfield) is confessing or bragging when describing the low standards he has for mortgages. His excesses are supposed to be prevented by the ratings agencies. In one of the most arresting scenes in the film, a ratings agency executive explains she can’t accurately assess anything because they’ll lose market share to the other agencies. Both components, in turn, should be held accountable by the investment banks, who are too smug to assume this could collapse.

Only securitization, which sets the plot in motion, could align the many bad incentives necessary for the housing losses. The Big Short does a great job of showing how each of these actors’ poor decisions amplify the damage the others could cause.

The Real Crisis is Housing, not the Financial Crisis

The Big Short is significantly better than the movie Margin Call when it comes to what happened. In Margin Call, a well-acted movie, all the drama is entirely about who will eat the losses of bad trading decisions, and whether people can live with themselves afterwards.

My friend JW Mason thinks Margin Call is a commentary on the inconsequential nature of finance, as no ordinary people matter in any of this stuff. One of the few scenes with an ordinary person, a maid in an elevator, has two bankers talk about covering their asses over the ensuring financial losses over her. Yet whether these rich people or those other rich people take a loss on financial claims over real assets isn’t really important for the maid, or for any of us.

At most, there’s a crisis. But I think the 2008 panic on Wall Street is boring. It was no doubt traumatic for the people who lived through it, but the story is simple and doesn’t have many consequences. There’s a banking panic, and you decide whether to stop it and how to allocate losses. The Great Recession would have continued mostly the same without it. [1] I’m really glad The Big Short didn’t focus on it. What mattered for the real economy was the foreclosure crisis.

Instead The Big Short makes the consequences for real people an unforgettable part of the story. It shows the people who will lose their homes, the neighborhoods that will be abandoned, and has to remind its actors that, in what is structurally a caper movie where you want them to succeed, society as a whole is going to lose from them being right.

Grunwald argues that leverage matters for the financial panic. But where it really mattered was for underwater homes and the recession. What triggered the Great Recession, which started 9 months before the crisis (in December 2007), was the collapse in housing, which in turn lead to a deleveraging wave among consumers. The best research shows that underwater mortgages are what drove the decline in aggregate demand that the government struggled throughout the Great Recession to balance, not any kind of financial hiccups. Those losses are impossible to imagine without securitization.

What’s Responsible?

Grunwald notes that “Maybe it wouldn’t have succeeded as a work of art if it had ended with responsible government crisis managers making horribly unpopular decisions that stabilized the financial system and prevented a second Great Depression. But that’s what happened, and people ought to know that.”

A nice thing about The Big Short is how little that helps the people in the crosshairs. About 40 minutes into the movie you meet a family in a house where the owner isn’t paying, and the renter is worried because his kid just started school. What comfort could they, especially if they had been owners, have taken from the Obama administration’s policies?

They could have believed in Larry Summers’ early 2009 promise of “substantial resources of $50-100B to a sweeping effort to address the foreclosure crisis” as well as “reforming our bankruptcy laws,” promises made to secure liberal votes on the TARP bailout and do their stabilization. But it turned out the administration put no effort in bankruptcy reform while spending virtually none of the money set aside for relief programs.

The family could have tried to get a mortgage refinance, but the Obama administration blundered the HARP program through 2012, blunting the stimulative effects of the Federal Reserve’s record low interest rates. As former Federal Reserve official Joe Gagnon said in 2011, “the administration’s program for getting underwater borrowers to borrow didn’t work and I think that’s a true disaster that has no excuse.”

They were no doubt having trouble with their mortgage servicers, probably not knowing of the extensive documentation fraud and bad practices setting them up to fail. Grunwald argues that “The complexity of the products they invested in didn’t matter that much once the epidemic arrived.” The real epidemic was the foreclosure wave, and there the complexity matters quite a bit, because in the servicing chain there were terrible incentives to prevent getting mortgages current and limit the bleeding.

The OCC found that there were “violations of applicable federal and state law” that had “widespread consequences” in the servicer markets at 14 large banks. Again, impossible to have at this scale without securitization. Yet the investigations that did follow were a disaster, with the banks hiring their own investigators, and the Federal Reserve stonewalling inquiry into the results because of “industry secrets.” One can go on for hours along these lines.

It’s nice to think that the thought of “hey, the bailouts made money” is capable of keeping a homeless family warm at night, though that’s probably not the case. If anything, Steve Carell’s character isn’t angry enough at the end of the movie about what was going to happen.

Dodd-Frank to a Partial Rescue

Grunwald argues that because of “the Dodd-Frank legislation that President Obama signed into law….the financial system is not perfectly safe, and never will be, but it is dramatically safer.” Grunwald notes the movie says virtually nothing has been done, and points to a subsequent interview with the director saying something should be done that was in fact done on derivatives.

Of course you should read everything from me and the Roosevelt Institute about all Dodd-Frank related reforms. I think Dodd-Frank is underappreciated and people should know more about its real strengths and flaws. But I’ll say this for The Big Short and reform. Where Dodd-Frank has made the most advances are related to the crisis: more capital, more clearing of derivatives, better information and options when it comes to a crisis.

But The Big Short isn’t about the crisis, and the flaws it points out are still with us. What kind of mortgages can go into a mortgage bond, central to The Big Short, is something Dodd-Frank calls a “qualified residential mortgage” and something regulators have punted. Nobody is happy with where the ratings agencies are. The main effort is to deregulate who can qualify as a ratings agency, but if the problem the movie showed is that you can simply take your ratings elsewhere, it’s not clear how more agencies help. Derivatives now go through clearing and exchanges, but the way they can be abused to set up instruments to fail, like the infamous Magentar trade, is still around. How we can either fix housing securitization or move beyond it is simply not settled.

All these differences matter. They matter for understanding the past and preparing the future. Ignoring them to try and make our situation look better does a disservice to what we’ve been through, and where we need to go.

UPDATE: Check out housing expert David Fiderer response to the Grunwald review too, which includes two things I should have mentioned here. First, the FCIC’s conclusion that of “all the CDOs issued in the second half of 2006, more than half of the equity tranches were purchased by hedge funds that also shorted other tranches.” Examples of people creating securities designed to fail were widespread, and is another reason CDOs mattered. Second, the “damning evidence of securities violations by 18 banks, set forth in the lawsuits and litigation by FHFA.” It’s worth familiarizing yourself with that if you don’t know, to show how much fraud, as opposed to naivety, was really there.

Alas, there was simply too much wrong with the Politico piece to get it in one take.

[1] I’m debating a response to that column, but that argument has been debunked so many times over the years it’s exhausting doing it again. Is that how they win, they just never get tired in repeating a wrong thing? I wrote something here that gives a first pass on the Wallison stuff a few years ago. It’s worth noting even GSE critic Joshua Rosner is writing that Wallison has gone off the deep end with his “fiction or fantasy” arguments on this.

[2] See Appendix A of JW Mason’s Disgorge the Cash for a list of reasons to think the fall in corporate investment wasn’t related to the financial panic. Estimates that try and tease out an the relationship between the panic and unemployment, such as those by Gabriel Chodorow-Reich, show it is very small one that is relatively clustered. Economists tend to overemphasize such “financial frictions” because it’s the one of the only ways the current ethereal macroeconomic models even allow for a recession.