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What 'The Big Short' Got Wrong

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Last year’s movie “The Big Short,” starring Christian Bale, Brad Pitt, Ryan Gosling and Steve Carell, has renewed interest in the history (and myth) of the 2008 mortgage meltdown. In typical Hollywood fashion, the movie lays the blame for that global stock market and banking collapse on the “greed and stupidity” of virtually everyone on Wall Street: brokers, investment bankers, mortgage bankers, mortgage brokers and securities rating agencies. While there’s certainly plenty of blame to go around in any market, the sheer magnitude of the mortgage meltdown — during which U.S. retail investors lost some $15 trillion — and its ultimate restructuring of the U.S. brokerage industry suggests to me that perhaps there were also some less common factors at work.

In her 2016 book “Lehman Brothers: A Crisis of Value,” former British politician and securities regulator Oonagh McDonald provides a more comprehensive explanation of the 2008 market crisis. She offers perspectives of the market crisis from both sides of the Atlantic, concluding that the crisis was ultimately caused by the U.S. Federal Reserve’s failure to understand the complexity of the interconnected mortgage-backed securities markets when it decided not to bail out Lehman Brothers.

While both explanations have some merit, as a writer, I find them unsatisfying, particularly when viewed from the hindsight perspective of the eventual outcome. Once the smoke from the mortgage meltdown cleared, all but two of the largest — once extremely lucrative — Wall Street investment banks had been acquired by commercial banks, and the Glass-Steagall Act of 1933′s 65-year prohibition against lending banks engaging in investment banking had completely evaporated.

In her very comprehensive review of competing theories about the causes of the mortgage meltdown (including ineffective regulation, the difficulty of measuring and monitoring the value of complex “synthetic” investment vehicles, the sensitivity of markets to “trust,” and the failure of the Efficient Market Hypothesis), McDonald ultimately concludes that had the Federal Reserve better understood the nature of the mortgage-backed securities that made up the bulk of Lehman Brothers’ investment portfolio, it would have acted to prevent its collapse, which then caused the long, costly line of Wall Street dominos to topple.

She cites a “study carried out by advisory firm Alvarez & Marshall, [which] argued that an orderly [SEC] filing would have enabled Lehman to sell some of its assets outside of the federal court bankruptcy protections and would have given it time to unwind its derivatives portfolio that might have preserved value.” Noting that Lehman had 1.2 million [real estate] derivative contracts with “notional” value of $39 trillion, she quotes A&M CEO Bryan Marshall: “That is what the Fed and Treasury didn’t understand — the worldwide implications of the [Lehman] derivative book. […] The Lehman creditors lost $150 billion. That’s $150 billion of value out of pension funds and savings.”

For its part, “The Big Short” cites a shortage of mortgages to roll into lucrative collateralized debt obligations (CDOs) as the driving factor for including increasingly risky sub-prime home mortgages in those structured securities. It essentially accuses the securities rating agencies of being bribed by the investment banks to rate those CDOs highly, despite the inclusion of those sub-prime loans. The argument that the raters may or may not have bought into was that only a small percentage of even the riskiest mortgages ever defaulted, and when bundled together with large numbers of other loans, the risk was further reduced.

As I said, both views do have grounding in reality. Yet both McDonald and Michael Lewis, author of “The Big Short” book, also appear to have ignored two factors that, at least in my view, were major contributors to the mortgage meltdown — and provide some insight into the possible reasons behind it. The first is the gradual erosion of federal lending requirements, which began with the Community Reinvestment Act of 1977 and reached its pinnacle when the “Affordable Housing Mission” was added to the charters of Fannie Mae and Freddie Mac in 1992. As the ability of borrowers to pay back their mortgages became less and less of an acceptable criteria for making (or refusing) loans, overall loan quality declined.

Then there was the raising of interest rates by the Federal Reserve. In October 2000, the Federal Reserve prime interest rate was 6.51%. Then came the dot-com stock market crash of 2001, and by January 2004, the Fed had cut its rate to 1%. These low rates were reflected in residential mortgages rates, as adjustable rates on mortgages fell from 8% in May 2000 to 4% in May 2004, fueling a U.S. housing boom financed by an accompanying mortgage boom. Despite frequent assurances by then-Chairman Ben Bernanke that the Fed wouldn’t raise its rates, by October 2006, the Fed funds rate was up to 5.25%. By May 2007, the one-year ARM rate was 7%.

How does all this affect the mortgage meltdown of 2008? If I were writing this novel, here’s how I’d pull it all together. By 2001, the big U.S. lending banks had a problem. After the dot-com crash and 9/11, the U.S. economy was weak, and thanks to the 20-year erosion of lending standards, they had to make riskier and riskier mortgage loans. What to do?

Suppose a few bankers are sitting around and one of them complains: “It’s not fair that we can only borrow up to five times our assets while investment banks can borrow on their assets up to 30 times. If we could leverage these risky loads that much, we could make a lot more money.”

Another banker chimes in: “Well, there’s your answer; why don’t we just sell these mortgages to the investment banks? They could afford to pay us top dollar and still make a fortune on them.”

“Yeah,” says another, “but how do we get them to buy these high-risk loans we have to make?”

“Well,” the first banker answers, “suppose we convince them that if they packaged all the risky loans together with some less risky loans, the total risk will be lowered. Then they can sell them to investors as low-risk investments at considerable mark-ups. Even better, since we are Federal Reserve banks, we’ll promise them that we won’t raise interest rates so their risk will be even lower.”

You can see where this is going. After some years pass, the same bankers are sitting around congratulating themselves about how successful their CMOs had become. “The brokerage firms are buying our loans so fast,” says one, “that we can’t keep up with the demand. We’ve even dropped our underwriting standards lower and they’re still buying us out.”

“Yes, this is great,” says another banker. “But it’s beginning to bother me that we’re all making good money on these loans, but the brokers are making billions. That damn Glass-Steagall Act is costing us a fortune.”

“Well,” says a third banker, “just maybe our little scheme has provided us a solution for that problem, too. To keep up with the growing demand for CMOs, aren’t most of those BDs holding a lot of mortgages in their inventory? And didn’t they use their 30 times leverage to buy them? What would happen if interest rates went up and the value of all those loans fell? With higher interest rates, the default rates on those ARMs would probably go up, too — driving values down even further. Seems like some of those firms might have quite a problem.”

“You know, I think you might be onto something,” says the first banker. “And, with an election year coming up, I’m thinking the administration in Washington would want to resolve the crisis as quickly as possible. Perhaps we could come to the rescue by buying those struggling firms. You know, for the good of the country, and at considerable discounts. But for us to do that, Treasury would have to waive those pesky Glass-Steagall restrictions.”

A bit far fetched? Maybe. But following the mortgage meltdown, JP Morgan Chase acquired Bear Stearns, Bank of America bought Merrill Lynch, Barclays got Lehman Brothers, Wachovia AG Edwards went to Wells Fargo, and UBS Warburg Dillon Read was acquired by Swiss National Bank. Today, of the great Wall Street investment banks, only Goldman Sachs and Morgan Stanley remain independent.

Besides, do you really think the Federal Reserve banks didn’t understand the complexities of mortgage-backed derivatives? Or that the folks who run the largest banks in the world are stupid? Greedy, maybe, but not stupid. Even if they are, how do you explain the fact that they ended up back in the investment banking business — owning some of the country’s biggest brokerage firms?

— Read “Janet Tavakoli: Sequel to Wall Street Horror Show Is Coming” on ThinkAdvisor.


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