Thursday, February 23, 2017

The Big Short: A Great Movie, Not A Policy Prescription

Norbert J. Michel, Ph.D.

Research Fellow in Financial Regulations
Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
For the last year or so, countless people have asked me what I thought of the movie “The Big Short.” Thanks to Netflix, I’ve finally seen it. I was impressed. It was pretty entertaining and did a great job explaining some complex financial topics. If I were still teaching, I’d probably use clips from it to liven up lectures on mortgage-backed securities (MBS) and credit default swaps (CDS). (Not that those lectures would need livening up.) But as a descriptive analysis of what caused the 2008 meltdown, the movie came up, well, short — mostly because of what it left out. One exception was the gratuitous shot at Alan Greenspan for basically being the architect of the 2008 financial crisis. Greenspan was an unelected bureaucrat who did what elected officials want all Fed chairmen to do:
keep the credit flowing. Besides, there’s a really long list of elected officials, from both political parties, directly responsible for terrible policies that contributed to the crisis. Why not, for example, pick on Bill Clinton? Not only did he reappoint Greenspan, but Clinton’s National Partners in Homeownership program set an explicit goal of raising the U.S. homeownership rate from 64 percent to 70 percent by 2000. It was specifically designed to work with Fannie Mae’s Trillion Dollar Commitment, a program that earmarked $1 trillion for affordable housing between 1994 and 2000.

 Clinton openly relied more heavily on the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to securitize more home mortgages. In other words, he pushed more people into debt. Aside from the details, a big problem was that the U.S. homeownership rate had been stable at about 64 percent from 1968 (the year Fannie completed its transformation to a GSE) all the way till 1994. You don’t need a Ph.D. in economics to guess – correctly – that something was bound to go wrong: the government tried to boost the rate to some arbitrarily high number above where the market had stabilized by inducing more people to take out mortgages. It would have been nice if the movie had provided more of this context, especially given how colorfully it described the flood of low-quality mortgages. In one of my favorite scenes, actress Margot Robbie, in a bubble bath, explained MBS, short selling, and subprime loans. And she did it all in just a couple of minutes. The script gets right to the cusp of the problem: there are only so many homes and people with good enough jobs to buy them. And that’s why it was a terrible idea to force that stable rate up in the first place. But according to Robbie, the banks simply started filling the MBS with riskier and riskier mortgages to keep their profit machine churning. They just got greedy and lied about the quality of the mortgages they were selling. I’m sure they did want to keep making money, but we can’t let government policies off the hook here. Those policies had every bit as much to do with creating the excessive credit that inflated home prices. And it goes well beyond Clinton and Fannie Mae. If I were writing a book, I could go all the way back to before the Great Depression to start talking about terrible federal policies. But I’m not writing a book, so I’ll fast forward to the 1980s and give a tiny list of policies that increased risk taking in financial markets.
  • In 1988, banking regulators imposed the Basel capital requirements on all banks. These rules gave banks an incentive (via a preferential capital charge) to hold GSE-issued MBS instead of actual mortgages.
  • In 1991, the Federal Deposit Insurance Corporation Improvement Act allowed the Federal Reserve to make emergency loans to investment banks. (Previously, these loans were only available to commercial banks.)
To hammer the theme that private greed caused the crisis is one thing. But to simultaneously minimize the fact that government officials were, at the very least, complicit in everything that contributed to it is more than a minor slip. The film leaves the impression that financial markets were out of control and divorced from government policies, and that’s completely wrong. But it was still a good movie. I especially liked Batman’s portrayal of Michael Burry, the socially awkward finance freak that figured out a unique-ish way to make his clients rich, all while taking the edge off his nerves with heavy metal. Here’s an interesting thought experiment, though. What if things hadn’t worked out quite as they did? Would Burry have been equated with, say, the likes of Angelo Mozilo or Bernie Madoff? Burry saw – as did many people – a brewing disaster in the housing market. But unlike most people, Burry was also in a position to either make, or lose, his clients a ton of money based on what he thought. To succeed, Burry couldn’t simply place a bet with an investment bank that would give him billions if the housing market eventually crashed, sometime in the 21st century. And he couldn’t just do it on a handshake. Instead, he had to bet against the market for a specific time, put up collateral as security, and make regular payments. And he needed his clients’ money to do this. If too many of Burry’s clients pulled their money out his fund, the investment banks would keep the collateral and cancel the contracts. Burry had some room for error, but he was betting the market would collapse in the first quarter of 2007. And he was wrong. Not by much, but he was wrong. (The national housing price index didn’t really start falling till the end of 2007; in states such as Nevada and Florida, prices started dropping in 2006.) All that time between when he made the bet and when the collapse finally hit, his investors became incredibly anxious because they were losing money. Burry had basically put all of their eggs in one obscure basket, and it didn’t look like it was working. So many of them pulled their funds that he eventually had to freeze the funds he had left, and his clients sued him. Soon after, he earned them a return of 489 percent, so it worked out. But prior to that, he was losing big. In the movie he kept marking his investors’ rate of return on a white board. Near the end of the movie there were three consecutive large drops: returns of negative 8.9 percent, negative 11.3, and negative 19.7 percent. He was really leaning on Metallica for a while there. It’s easy for everyone to look at what happened in hindsight, but it’s entirely different to take a financial stake like Burry did in what one thinks will happen. That’s why it’s so important for government officials to resist crafting special rules that lower financial firms’ risk.

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