What 'The Big Short' Got Wrong

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.”