The Big Short: Punditry, Historical Accuracy, and the 2008 Mortgage Meltdown Part I

What’s the Big Stink?

The Big Short (2015) is a movie about a collection of fringe investors and financial gurus who cashed in big time by accurately predicting the 2008 housing market collapse. Certainly, by now, the “Wall Street, financier, sales, greed-gone-bad” genre has been well established: Wall Street (1987), Glengarry Glen Ross (1992), Boiler Room (2000), Wall Street: Money Never Sleeps (2010), Wolf of Wall Street (2013) all come to mind. Given the rich history of the genre, it’s difficult to make a movie that tells a new story that isn’t a simple rehashing of the previously mentioned flicks. That said, what separates The Big Short from other films in its genre isn’t the star-studded cast (e.g., Christian Bale, Steve Carell, Ryan Gosling, and Brad Pitt) but that it genuinely aims to depict a macro-level economic event in United States history (the film is an adaptation from the Michael Lewis nonfiction book, The Big Short: Inside the Doomsday Machine).

Personally, I found the The Big Short to be entertaining, but some pundits weren’t pleased with the way the movie portrays the advent of the financial crisis and ensuing legislation that bailed out major banks.  This blog post is the first in a series that examines the experts’ opinions on The The Big Short and its portrayal of the 2008 mortgage meltdown.

When Worlds Collide

[Conflicting opinions on google about a year ago]

Crudely put, there are two competing narratives that aim to describe the worldview of the 2008 financial crisis:

The Wall Street Greed Narrative: The 2008 financial crisis was caused by lack of regulation and Wall Street greed.

The Government Incompetence Narrative: The 2008 financial crisis was caused by poor government stewardship that incentivized bad loans.

It should come as no surprise that these diametrically opposed narratives sound very similar to today’s contemporary discourse surrounding . . . well basically every political issue, but that’s a post for another day.

Let’s take a closer look at the arguments at play:

 The Wall Street Greed Narrative

Historian Alex von Tunzelmann explicitly grades the veracity of the The Big Short in her piece, “How historically accurate is The Big Short?”. Giving an “A-” for the film’s history grade, von Tunzelmann argues,

Markets: Quietly and separately, all these men spot that there is a problem with mortgage securities, particularly those resting on the unfettered inflation of the risky subprime market. The film is accurate about the historical trajectory of events. It is true that an astonishing number of people, including the chairman of the Federal Reserve himself, continued to ignore the housing market bubble and even to deny it could happen – though, as the Nobel Memorial Prize in Economics Laureate Paul Krugman has pointed out in his review, more people noticed there was a problem than the tiny group who are shown here. Another economist, Jeffrey A Tucker, has argued that The Big Short is “incomplete” without reference to the actions of the Federal Reserve itself. He directs viewers looking for an accurate account of the causes of the crash to Margin Call. The Big Short has a broader focus than Margin Call and a more explicitly political perspective. Historically speaking, though, its approach is equally valid: its focus is on the Wall Street personalities involved, the mind-blowing levels of denial and coverup among regulators, ratings agencies and banks, and ultimately the consequences. If its economics isn’t a full picture – well, there’s only so much you can say in two hours, and only so many celebrities the film-makers could entice into a bubble bath to explain things.

Giving the movie a final judgment, she concludes,

Verdict: Fast, funny and righteously furious, The Big Short is more gripping and less desperate to make jerks in suits seem cool than most business movies. It’s also a solid historical explanation of the subprime crisis.

Fair enough. Supporting this narrative, Nobel Peace Prize Winning Economist Paul Krugmans adds his two cents stating,

But you don’t want me to play film critic; you want to know whether the movie got the underlying economic, financial and political story right. And the answer is yes, in all the ways that matter . . . And the bubble whose existence they denied really was inflated largely via opaque financial schemes that in many cases amounted to outright fraud — and it is an outrage that basically nobody ended up being punished for those sins aside from innocent bystanders, namely the millions of workers who lost their jobs and the millions of families that lost their homes.

Pretty cut-and-dried. Both authors support the claim that “opaque financial” instruments (e.g., Credit Default Obligations – CDO’s – were specifically highlighted in The Big Short) amounted to little more than a modern-day Ponzi scheme on rocket-fueled steroids. Moreover, the authors advance that it wasn’t just financial security instruments that caused the problem, but that the entire industry (i.e., bond agencies and regulators) willfully turned a blind eye to the situation.

Having looked at the Wall Street greed narrative, let’s take a look at how opposing authors shift the blame from the private sector to Uncle Sam.

The Government Incompetence Narrative

Weighing in from the American Enterprise Institute, Peter J. Wallison is having absolutely none of the above. Wallison is quick to refute the narrative that The Big Short is remotely accurate whatsoever. Rebutting the notion that corporate greed produced the financial meltdown, he begins,

The arrival of The Big Short in theaters a few weeks ago has reignited interest in the causes of the 2008 financial crisis. If you believe that the crisis was caused by greed and recklessness on Wall Street then you’ll like this film. Paul Krugman, writing on the op-ed page of the New York Times, liked it immensely, apparently thinking a Hollywood version of reality was fact.

We can all agree that the financial crisis was caused by a “mortgage meltdown” mostly among subprime and other risky mortgages. What neither this film nor the greed narrative tells us, is why there were so many of these mortgages in the financial system to begin with. The answer: Sorry Dr. Krugman, it was not Wall Street.

Right out the gate, the gloves are off! It’s here that we find the clash between the two most popular narratives about the mortgage meltdown. Wallison develops the case that the federal government incentivized reckless lending practices which laid the foundation for financial catastrophe. Wallison explains,

In June 2008, just before the crisis, more than half of all US mortgages—31 million loans—were subprime or otherwise risky. Of these, 76 percent were on the books of government agencies, primarily the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. This shows, without question, that the government—a sophisticated buyer—created the demand for these deficient loans.

The remaining 24 percent of these loans were on the books of private sector entities, such as banks, investment banks, insurers, and investment funds of all kinds.

Because of their government backing, Fannie and Freddie were the dominant players in the US mortgage market, and had been for more than a quarter century. They did not make loans themselves, but acquired mortgages from banks and other lenders. These were held in their portfolios or sold off to investors with a GSE guarantee.

Significantly, before 1992, Fannie and Freddie accepted only prime mortgages—loans in which the borrower made a down payment of 10 to 20 percent, had a FICO credit score of at least 660, and debts that were less than 38 percent of income after the loan was closed.

You’ve probably heard of Fannie and Freddie and you’re probably aware of the fact that they’re a big bank of sorts. It’s worth noting that if you’ve ever purchased a house, it’s likely that at some point in time, Fannie Mae or Freddie Mac has probably owned your mortgage. But what does this mean, exactly? It is likely you didn’t directly purchase your mortgage from either of the two companies, and the bank or mortgage broker you worked with isn’t directly owned by Fannie or Freddie, so how did those major banks end up “owning your mortgage”?

The Mortgage Process and The Secondary Market

Well, oftentimes, here is how  (a very simplified example of) the mortgage process works:

A prospective borrower is looking to purchase a house and therefore needs to get pre-approved for a mortgage. That borrower will reach out to a mortgage loan originator (MLO) who works for a mortgage bank. A competent MLO will guide the prospective borrower through the vetting process which consists of a careful examination of credit history, income, and assets. Once all of those factors are carefully examined for qualification, the buyer is pre-approved for a mortgage and consequently, purchase a house. By now, the buyer most likely has a handful of houses in mind they would like to purchase with their mortgage. Typically, through real estate agents, the buyer and seller negotiate a price for the house that satisfies both parties. At closing, the buyer receives title to the property conveying their newfound ownership, while a check for the price of the house goes to the seller.

Here is where Fannie and Freddie come in. It is standard industry practice that the check the seller is receiving isn’t coming from the buyer’s mortgage bank. The mortgage bank works with a third party lender that is supplying the cash for the loan. If the loan is a “prime” loan, it’s highly likely that Fannie and Freddie are contenders to purchase the loan (mortgage). Lenders like Fannie and Freddie are willing to fund the deal between the seller and buyer (i.e., write the check to the seller for their house), because in return, the lender receives an interest rate on that mortgage. Simply put, the lender is trading short term cash for a long-term investment. When the mortgage bank sells the loan to a lender like Fannie or Freddie, the mortgage is being sold into what is known as “the secondary” market.

It is common practice for mortgage banks to cater their underwriting standards to the preference of Fannie and Freddie. For mortgage banks, underwriting a loan that Fannie and Freddie will purchase is one of the smoothest ways to consummate the closing process so that all parties involved get what they want (i.e., seller gets paid for their house, buyer gets a loan to purchase the house, real estate agents get paid a commission).  Fannie and Freddie are willing to offer some of the most competitive and lowest rates because they make a profit from the sheer volume of loans they purchase. Loans that do not qualify for Fannie and Freddie standards can be shopped out to wholesale lenders that may be willing to purchase the mortgage, albeit at a higher but still competitive interest rate.

Ultimately, when a mortgage banks informs you that you’ve been pre-approved, the subtext of pre-approval is that, “based on your credit and risk factors right now, there are a series of lenders that would be willing to finance your mortgage at a competitive price.”

Wallison’s argument hinges on the idea that once upon a time, Fannie and Freddie were forced by the government to relax their “prime” underwriting standards in order increase the number of homeowners in America. He explains,

The market was stable with this foundation, but despite many government subsidies the homeownership rate in the U.S. had been stalled at 64 percent for 30 years. Congress blamed this on the GSEs, particularly their refusal to relax their underwriting standards; by insisting on acquiring only prime loans—it was argued—the GSEs left a vast number of low income Americans frozen out of the American dream of homeownership.

Thus, in 1992, Congress adopted a program known as the affordable housing goals, which required Fannie and Freddie to acquire an annual quota of loans that had been made to low or moderate income borrowers. Initially, 30 percent of all loans the GSEs acquired in any year had to be made to home buyers who were at or below the median income where they lived. Various subordinate goals were also required, covering minorities and borrowers below 80 and 60 percent of median income.

The Department of Housing and Urban Development was given authority to raise the goals—and it did, aggressively. Between 1993 and 2000, HUD raised the 30 percent goals to 50 percent, and between 2001 and 2008 it raised the goals to 56 percent. Thus, by 2008, 56 percent of all mortgages the GSEs acquired had to be made to borrowers below median income. Notably, HUD’s relentlessly rising quotas occurred in both Democratic and Republican administrations.

Understandably, it was difficult for the GSEs to meet these quotas and still acquire only prime loans. Accordingly, between 1993 and 2008, they began to accept increasing numbers of subprime and other risky mortgages. These caused their insolvency in 2008 and their takeover by the government that year. Fannie later reported that in 2008 it was exposed to $878 billion in these deficient mortgages, which caused 81percent of its losses that year. Freddie’s percentage exposures and losses were proportionately the same.

Wallison concludes by connecting subprime underwriting standards to the alleged inaccuracy of The Big Short,

The connection between these numbers and the financial crisis is unavoidable. Because the GSEs dominated the mortgage market, when they reduced their underwriting standards to meet the affordable housing quotas the rest of the market followed. Soon, borrowers who could have afforded prime mortgages were getting loans with zero down payments. The result was an enormous housing price bubble, the largest in U.S. history, and when the bubble began to deflate, borrowers who could not meet their mortgage obligations were unable to refinance their loans. The number of defaults was unprecedented. This was the mortgage meltdown.

Government blunders turned it into a financial crisis. First, the government rescued Bear Stearns, a Wall Street investment bank, in March 2008, creating expectations that it would rescue other big firms if they got into trouble. But when Lehman Brothers—a firm much larger than Bear—weakened, the government suddenly reversed its policy, letting Lehman fail. This upended the market’s expectations, creating doubt about the safety and soundness of every firm. The result was an unprecedented panic that we know today as the financial crisis.

This is not the kind of story that Hollywood likes—no greed, no evildoers, not even any humor—just very bad government policy combined with serial government blunders. We should see the “greed narrative” for what it is: first, an effort to support the enactment of another bad policy—the job-destroying Dodd-Frank Act—and then to keep it fully in force. The Big Short is entertainment, not the truth.

Conclusion

I’m not going to appraise whose argument is more true than the other. It’s even possible that all arguments by the showcased authors are correct. Yes, it’s possible that unethical Wall Street behavior AND government incompetence led to a self-inflicted financial meltdown.

Anyway, the fact of the matter is that the debate over the cause of the financial crisis is still hotly contested among pundits.

If you’re interested in reading more about this debate, you should check out Josh Rosner and Barry Ritholtz‘s criticisms of Wallison’s position. Not one to go without the last word, Wallison responds to both criticisms here and even released a short, counter-video outlining his argument:

[Wallison bringing out the big guns]

Hopefully, if there’s anything you’ve learned from this post, it’s that Peter J. Wallison doesn’t like losing an argument.

On a more serious note, stick around for the post where I’ll examine another set of conflicting Big Short narratives. Until next time.

 

Thanks for Reading.