When I first sat down at the theater to watch The Big Short, I fully expected to be inundated with the establishment version of what caused the the 2007-08 credit crisis and housing market meltdown. I was not disappointed. This isn’t to say I didn’t enjoy the film. I did. It is well written, well acted, and thoroughly entertaining. But from an economics stand point, the film and story has some glaring problems. I should point out that because of this, my wife had to tell me to “shut up” more than once. Let’s start with the aspects of the film I enjoyed.
The Film Making
Adam McKay and Charles Randolph wrote a crisp, well-paced script that kept the story going while explaining some of the more “complicated” points of finance, specifically the securities involved with real estate market. I am not usually of fan of breaking the fourth wall, but McKay employed it perfectly here. Some might think it’s a bit hokey, or even condescending, to use celebrities to explain sub-prime loans, CDOs, and synthetic CDOs, it was a good bit to use to educate people about the nature of these financial instruments. I had some quibbles with the explanations of these instruments, but we’ll get into that later.
When you put together a cast of heavyweights such as this, you know the acting is going to be superb. Ryan Gosling pulls off the smarmy, douchebag Wall Street investor Jared Vennett with ease. John Magaro and Finn Wittrock are superb as the naive hedge fund managers Charlie and Jamie. Christian Bale is his always superb self as doctor turned investor Michael Burry. My favorite is Steve Carrell as the self-righteous asshole hedge fund manager Mark Baum. He excels at portraying a man who hates the industry in which he works and thinks he’s smarter and more moral than the rest of the investors. The only person who I thought was forgettable was Brad Pitt, but that was more to do with his character than anything.
All that being said, The Big Short has some serious holes, specifically when it comes to the history and causes of the 2008 financial crisis.The entire premise of the film hinges on four groups of outsiders seeing a problem within the US housing market, and then these groups shorting it. The problem here is only one of these outsiders (Michael Burry) actually noticed that mortgages were worse than there ratings suggested. The others just took the information and ran with it. And even though Burry caught the inconsistencies within the MBS/CDO markets, the film never once mentions any underlying cause for the banks to become stupidly greedy and start handing out loans they knew were going to fail.
Now it must be conceded that fraud was happening on Wall Street (looking at you, rating agencies), but this was really only an effect of the root cause of the problems. In my estimation, the three main causes of the crises were the Federal Reserve’s policy on interest rates, the shift in policy from the Department of Housing and Urban Development (HUD) regarding the Community Reinvestment Act (CRA), and the shift in underwriting policy from the two largest government-sponsored entities (GSE) involved in housing, Fannie Mae and Freddie Mac.
The CRA and Fannie & Freddie
I want to start with the latter two market interventions since they go hand in hand. The CRA was introduced in 1977, and for the first 15 years was seldomly reinforced. But under the Clinton administration in 1993, HUD made a policy change to enforce the law more vigorously. This policy change, outlined in this white paper from 1995, was greatly influenced by a 1992 study from the Boston Federal Reserve Bank on mortgage lending practices in the city of Boston. The paper asserted that mortgage lending practices were institutionally discriminatory due to the fact that Black and Hispanic borrowers from Boston were two to three times more likely to be rejected for a mortgage than there white counterparts. Because of this, HUD decided to expand their requirements for banks to hold a certain amount of CRA eligible loans, known as sub-prime and Alt-A loans, particularly targeted toward low to middle income (LMI) households.
At the same time all of this was happening, Fannie and Freddie were shifting their loan underwriting standards to allow for more LMI loans to be originated. Now it is a common misconception that Fannie and Freddie can originate loans. This is incorrect, as only private institutions can originate loans. Many on the left have used this fact as a way to exonerate Fannie and Freddie and place all blame on the banks. But one thing Fannie and Freddie can do that greatly skewed the housing market is buy loans. By being a major purchaser of loans, they can directly affect the underwriting policies banks use for loans. So when Fannie and Freddie started offering to buy up 3% down loans, and eventually 0% down loans, that were targeted to LMI households, banks started create many of these loans. In fact from 2001 to 2006, sub-prime loans went from 7.2% of the market to 18.8%, and Alt-A loans shot from 2.5% to 13.9%. In that same time period, the prototypical 30-year fixed mortgage went from 57.1% to 33.1%. And all of this is in no small part because Fannie and Freddie were buying up an enormous amount of these loans. From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion worth of sub-prime and Alt-A loans, which consisted of 40% of the loan purchases of that time.
And the real kicker to all of this is that the loans were backed by the federal government. This gave the banks originating the loans the incentive to ignore sound underwriting principals because they knew that loans were most likely going to be purchased by Fannie and Freddie or these loans were going to be basically insured. This allowed for a massive misallocation of capital within the finance sector.
The Federal Reserve
The Alan Greenspan-led Federal Reserve played a key role in the creation of the housing bubble of 2002-2007. The Federal Reserve can’t control the interest rates on mortgages, but what they can control is the Fed Funds rate, which is the rate banks use when loaning money to each other or borrowing from the Federal Reserve itself. This is important because interest rates are the price for money. When one wants to borrow money, the cost of doing so is the borrowed of plus the interest. Like all prices, interest rates are best set by the market through the discovery process, but that doesn’t exist thanks to the Federal Reserves monopoly on interest rates. This monopoly on interest rates is why the Federal Reserve played such a crucial role in creating the housing bubble.
In 2001, the economy was suffering from the crash of the Nasdaq/Dotcom bubble (also created by the Alan Greespan Fed). As a way to jump start the economy, the Federal Reserve started cutting the Fed Funds rate to spur an increase in housing. In fact, this is exactly what mainstream economist du jour and destroyer of nations Paul Krugman said in late 2002 that the Federal Reserve needed to do to get out of the recession of 2001. As the following graph shows, Alan Greenspan did just that.
As you can see, the Federal Reserve started to slash rates in what was already a growing housing market. They took these rates to historic lows in 2002 and held them there through late 2004. It wasn’t until the Federal Reserve believed the economy was healthy that rates began to rise. But what they thought was health was really a bubble created by their loose monetary policy.
So as you can see, while The Big Short is an entertaining film that does touch on aspects of the financial crisis, it leaves much to be desired on the economics front. It fails to highlight how banks were able to borrow money at such a cheap price that they didn’t care how leveraged they were. Couple that with the policies of the CRA and Fannie & Freddie, and you had a recipe for disaster served up by the Federal government.
You can follow Jake on Twitter at @RantinArkansan.