In a series of visual puns, Margot Robbie describes the collapse of the real estate bubble while sipping bubbly in a bubble bath, in this synopsis of The Big Short, nominated by Oscar for best film.
In Part IV of the Dunning-Kruger Effect, we laid the groundwork for understanding its consequences to society as a whole by focusing the Great Recession, as seen through the lens of the film The Big Short. We began an exploration of how the American mortgage bond industry, formerly a pillar of the world economy, degenerated into the greatest financial fraud in history. We continue here with the film’s exposition, examining the role that individual borrowers, mortgage brokers, bond ratings agencies, and bond traders played in the Great Fraud.
The Bubble Builds
Dr. Michael Burry may have been the first person to realize that there was “value” to be had by betting against subprime loans, but others eventually came to the same conclusion. In the year 2000, the total amount of traditional default swaps outstanding was $900 billion. By the end of 2007, derivatives of the type that Burry pioneered equaled $62.2 trillion, roughly five times the entire GDP of the USA; and ten times the amount of total corporate debt.
While Burry took a numerical approach―loan to value ratios, types of adjustable loans, a borrower’s creditworthiness, down-payment percentage, a home’s location, secondary lien, etc., to determine that the subprime industry was ripe for plucking, others took a different approach to suss out the truth.
Steve Carell‘s character (based on FrontPoint Partners’ managing partner Steve Eisman) relied on his evaluation of the people involved. In the film, he interviews a Florida pole dancer who owns five properties with multiple mortgages on each, assured by her mortgage broker that if the market softened, she could always re-finance. He meets with that self-same mortgage broker who brags about being able to close a loan on Friday and sell it to a Wall Street investment bank on Monday, including loans for so-called NINJAs―No Income, No Job Applicants who’d leave critical questions blank that he would helpfully fill in for them. He meets with a senior analyst at Standard and Poor’s who explains why her firm, “a ratings shop,” rubber-stamped as triple-A every “dog shit” bond that the big Wall Street banks plopped on her desk. And he has dinner with a man at the very heart of the subprime fraud.
Ryan Gosling‘s character (based on a subprime loan trader working for Deutsche Bank) invites Carell and his partners to a subprime mortgage conference held at Sheldon Adelson‘s Venetian hotel and casino (irony noted), to surreptitiously meet “the enemy.” That is, the parties that were on the other side of their trades, the people that were betting against them. Carell and company were anxious that these old-time bond traders knew something they didn’t. Gosling assures them that on the contrary, they were, in the immortal words of George Clooney‘s character in the film O Brother Where Art Thou?―dumber than a sack of hammers.
Gosling arranges for Carell to have dinner with a smug, self-assured “CDO manager”―let’s call him “Chow.” Chow runs an investment advisory firm with some $15 billion under management for clients who trust him to analyze various CDO investments. (We’ll get into the nature of “Collateralized Debt Obligations” in a moment.) But instead of exercising what should have been a fiduciary duty to his clients, Chow brags that he was, in effect, a double-agent working for Merrill Lynch, whose reputation as Wall Street’s largest CDO machine didn’t exactly engender the trust of their clients. Merrill packaged the worst of the worst subprime loans into CDO bonds and then had Chow “analyze” them for purchase by his clients. (Not only did ML send Chow CDOs to launder, but suckers clients to buy them as well!) Despite being comprised exclusively of subprime loans, 80% of them were still being rated triple-A, so it wasn’t exactly a hard sell.
In his last year as a portfolio manager for a New York insurance company, Chow had earned $140,000. In his first year as CDO “analyst,” he took home $26 million. Carell knew a psychopath (i.e. a high functioning sociopath) when he saw one; a man whose greed and indifference contributed to the misery of tens of thousands of hapless borrowers, suckered into taking out loans they never had a prayer of paying back. In a superb acting performance, Carell displays a visceral hatred of the man, and after the dinner orders his partners to bet against every CDO this mofo was buying.
In The Big Short, Selena Gomez explains synthetic CDOs
Collateralized Debt Obligations
Collateralized Debt Obligations, or CDOs, made their debut in the Wall Street’s world of “structured finance” in 1987. Originally, they were bonds composed of combinations of corporate loans, bank loans, and emerging market bonds. Later, subprime loans were included. During the height of the mortgage bond mania of 2004-2007, they went from a total of $500 billion in 2006 to $1.4 trillion a year later.
As Wall Street ran out of decent loans to assemble into mortgage securities, they increasingly had to scrape the bottom of the barrel, sometimes creating bonds composed exclusively of subprime loans. These were disingenuously labeled “asset backed securities” and assembled into CDOs. As mentioned, 80% of those were still mysteriously rated triple-A. As the amount of subprime loans was exhausted, only the dregs of the dregs were left. These were packaged together with unregulated swaps into “synthetic CDOs.” Or as Carell’s character so memorably describes them, “dog shit wrapped in cat shit.”
The Ratings Agencies
Perhaps the moat essential players in the financial collapse were the bond rating agencies, primarily Standard and Poor’s and Moody’s. Carell and his partners, in a scene where they interview and executive at Standard and Poor’s, are stunned to learn that, for a flat fee, S&P routinely approved as triple-A almost every bond that Deutsche Bank, JP Morgan Chase, Goldman Sachs, and other Wall Street banksters brought to them. As Upton Sinclair once observed:
“It is difficult to get a man to understand something when his salary depends on his not understanding it.”
Moody’s Investors Service could earn five times rating a mortgage pool ($250,000) versus what it could earn rating a municipal bond of comparable size. In 2006, it was one of the most profitable companies in the world. Between its initial IPO in 2000 and the subsequent spin-off of Moody’s Analytics in 2007, its stock rose 340%. According to a report entitled “Did going public impair Moody’s credit ratings?”, its authors concluded:
Consistent with Congressional allegations, we find that Moody’s credit ratings for new and outstanding corporate bonds are significantly more favorable to issuers relative to S&P’s after Moody’s initial public offering (IPO) in 2000. The higher ratings assigned by Moody’s after its IPO are more pronounced for clients that are large issuers of structured finance products and operate in the financial industry, consistent with testimonies that easier rating standards originated in the structured finance products group of Moody’s. Moody’s ratings are also more favorable for clients where Moody’s is likely to face larger conflicts of interest: (i) large issuers; (ii) firms that are more likely to benefit from higher ratings, on the margin; and (iii) in industries with greater competition from Fitch. Moody’s higher ratings, post IPO, are also less informative when accuracy is measured as expected default frequencies (EDFs) or as the likelihood of bond defaults. Our findings have implications for incentives created by a public offering for capital market gatekeepers and professional firms.
After the collapse, S&P was sued in at least 41 different actions. Instead of being driven out of business and their principals sent to jail, courts ruled that they were innocent. They were simply offering their opinion as to the value of the bonds, and thus covered by the First Amendment’s right to free speech. In the end, a small measure of justice and accounting was achieved when the Department of Justice sued S&P in 2013. Two years later, S&P, without admitting guilt, paid a record $1.5 billion in fines (more than a year’s profit). Bloomberg Business reported it as follows (emphasis mine)
The company’s leadership ignored senior analysts who warned that the company had given top ratings to financial products that were failing to perform as advertised,” said Attorney General Eric Holder in prepared remarks. “While this strategy may have helped S&P avoid disappointing its clients, it did major harm to the larger economy, contributing to the worst financial crisis since the Great Depression.
S&P admitted in the statement that its ratings decisions were affected by business concerns, a fact it disputed two years ago when the lawsuit was filed. To win business, S&P awarded top grades on bonds built out of risky subprime mortgages that investors thought were as safe as debt from the U.S. government. When housing prices fell, the bonds defaulted, helping freeze credit markets and trigger the worse recession since the 1930s.
In the film’s epilogue, we learn that with the exception of a single European trader, nobody directly involved in the most massive criminal financial fraud in history went to jail. Last year, JP Morgan Chase and four other banks were found guilty of rigging foreign currency rates. Given the sheer scale of this criminal enterprise, knowledge of its operation must have been known at the very top, and was not simply the work of an obscure trader toiling behind the fortified walls of his cubicle (the usual patsy in these kinds of cases). As the saying goes, a fish rots from the head down. In the case of JP Morgan Chase’s CEO Jamie Dimon, he was sentenced to no jail time and given a 35% raise (presumably for negotiating a pittance in fines compared to the damage done). And just this month, Goldman Sachs was fined a paltry $5 billion for their role in the great mortgage bond fraud.
The Great Vampire Squid embracing the world’s financial system
Coming up: In Part VI, we examine more closely the psychological and cognitive dimensions of the Dunning-Kruger effect by placing it in the context of the larger fields of Behavioral Economics and Behavioral Finance. And we show how the birth of the Tea Party was the direct result of the implosion of the mortgage bond industry.