The Big Short and Dunning-Kruger Effect Concluded

 Little Shop of Horros

In Wall Street’s Little Shop of Horrors, the banksters demanded: Feed me subprime loans, Seymour, feed me all night long


In this seventh and final chapter, we conclude our analysis of the Dunning-Kruger effect; and of the Oscar Award winning movie The Big Short, interpreting one in the light of the other. Additionally, we attempt to answer the question: Are we wiser now? Or are the cognitive blinders that produced the 2008 crash still in place, leaving us vulnerable to the next economic catastrophe?

Mortgage Bonds

In the beginning of the film, The Big Short introduces us to Lewie Ranieri, the godfather of mortgage-backed securities (circa 1977). Before the packaging of individual mortgages into bonds, the economic impact of a single loan transaction was limited. One borrower’s liability was another lender’s asset. A zero sum game. However, combine that one loan with thousands of others into a single financial instrument (aka securitization, a word that Ranieri is said to have coined) and thousands of other investors can enter the fray.

Owning a bond, or more likely, a tranche of a bond (a stratified layer that carries its own credit rating) greatly diminishes one’s risk. No worries that an individual  borrower pays a loan back early, depriving you of expected interest payments. No worries about individual loan defaults, since they would only be a miniscule percentage of the whole bond. Set against a background of long term real estate appreciation (Moody’s rating model assumed a steady 4% rise, no matter what the actual facts on the ground were), the geographical dispersion of homes mitigates regional economic downturns. They make mortgage lending more efficient, lowering interest rates to borrowers, and provides a greater level of transparency for the entire market.

Perhaps most importantly, these bonds enabled a highly liquid secondary market to thrive. Initially, they were exclusively insured by government and quasi-government agencies: Ginnnie Mae, wholly owned by American taxpayers/citizen (and post-crash lender of the last resort); and the two main quasi-government agencies (aka government sponsored entities, or GSEs), Fannie Mae and Freddie Mac

Credit Default Swaps and CDOs

For some three decades the mortgage bond industry rolled merrily along, the law of large numbers its steady ally. It wasn’t until 1994 that private insurance in the form of credit default swaps (CDS) entered the picture, privatizing what was once an exclusively government function. Problem was these derivatives lacked transparency, with no regulatory oversight or even a registry of how many there were in existence. This proved to be especially catastrophic when private investment banks became larger, publicly traded entities that then became subject to tens of trillions of dollars of bets against their very existence.

Furthermore, bonds that had been traditionally assembled by government and quasi-government agencies were now being put together by private investment banks like Goldman Sachs. Packaging and selling their own mortgage bonds generated billions in profits, but there was a only finite number of mortgages to securitize, so the Great Vampire Squid invented the collateralized debt obligation (CDO).

The CDO was a highly complex and opaque financial instrument that took the lowest tranches of subprime loans from various existing bonds and combined them into new bonds― dog shit wrapped in cat shit, as Steve Carrell‘s character so colorfully observed. Despite being comprised of the riskiest loans, Goldman got 80% of them rated triple-A from the always compliant Moody‘s and S&P ratings agencies. Where before the mortgage bond industry was characterized by a high level of transparency, CDOs were designed to do the exact opposite, even going by the alternate moniker of “asset backed securities” to produce the illusion of security.

In the end, the independence, lack of transparency, and poor regulatory oversight of CDS and CDOs proved catastrophic to the health of the mortgage bond industry and real estate industry in particular, and to the economy of the USA, and the world as a whole.


In our first six chapters, we detailed some of the factors that precipitated the financial collapse. But an absolutely critical factor was the role that financial leverage played in the collapse of venerable Wall Street investment banks like Lehman Brothers, founded in 1850. Leverage is just another word for borrowed money. By 2007, Lehman was leveraged 37:1, meaning for every 37 million dollars they invested in various real estate instruments, only one million was their own. The rest was borrowed. In the world of large numbers, that meant that a mere 3–4% decline in the value of those instruments would bankrupt the company, notwithstanding that Lehman had assets of $639 billion at the time. (To better understand how that could happen, see what Albert Einstein called “the Eighth Wonder of the World”― compound interest.) On September 15, 2008, Lehman filed for


When the smoke cleared and the rubble stopped bouncing, Congress ordered an investigation and the Financial Crisis Inquiry Commission was born. In January 2011, its 10-member committee issued its findings in their 663 page report titled CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION, summarized (and truncated) as follows:

This financial crisis was avoidable; widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets; dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis; a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis; a systemic breakdown in accountability and ethics; collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis; over-the-counter derivatives contributed significantly to this crisis; [and] the failures of credit rating agencies were essential cogs in the wheel of financial destruction.

In a dissenting opinion, one of the members, Peter J. Wallison of the American Enterprise Institute, wrote [emphasis mine]:

“[I]t was the U.S. government’s housing policies — and nothing else — that were responsible for the 2008 financial crisis…  If the U.S. government had not chosen this policy path — fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high-risk residential mortgages — the great financial crisis of 2008 would never have occurred.”

Naturally, this blame-the-government rationale became the rallying cry of the anti-government, anti-everything-regulatory crowd. Ignoring the role that greed, fraud, deregulation, and corruption played in the collapse, Wallison holds the US government’s housing policies exclusively responsible.

He seizes upon provisions in the Community Reinvestment Act (CRA), originally created in 1977 to prohibit (zip code) red-lining of certain neighborhoods, to substantiate his thesis. But the Commission rejected his argument.

The Commission concludes the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law to increase home ownership by reducing mortgage-underwriting standards. [xxvii]

(Government policy  developed over three decades by both Democratic and Republican administrations, reached its breaking point under George W. Bush. In 1992, the government required that 30% of Fannie and Freddie’s loan portfolio consist of mortgages made to borrowers who were at or below the median income in the places where they lived. That percentage was raised to 42 percent in 1995; to 50% by 2000 and finally to 55% by 2007.)

In addition to Lehman Brothers, investment banks Bear Stearns and Merrill Lynch were utterly destroyed.  Many more would have gone bankrupt save for the ginormous taxpayer bailout that kept the world from plunging into another Great Depression. Similarly, Wall Street’s biggest insurance company, American International Group (AIG), the largest underwriter of credit default swaps,  survived only by virtue of $180 billion bailout by the American taxpayer. Much the same can be said for the Great Vampire Squid,  Goldman Sachs, who along with Lehman, Bear Sterns, and Morgan Stanley, comprised the four largest US investment banks at the time.

In order to survive, Goldman and Morgan Stanley had to give up their private banking status, making them eligible for taxpayer bailout money through the Federal Reserve’s discount window.  If ever there was an example of the fallacy that we live in a free market capitalist economy, this was it, proving once again that in the age of corporate greed and dominance:  Gains are privatized while losses are socialized.

Privatize gains socialize losses

When Goldman realized that Burry had been right all along, and that they owed him a lot of money, they delayed revaluing his positions and manipulated the market until they could take positions of their own, offsetting some of their losses. Post-bailout, Goldman proudly maintained that it had never received any taxpayer money. A lie, of course, since they received a back door transfer of $14 billion from AIG to cover money owed to their own clients that they had knowingly left twisting slowly, slowly in the wind. In the process, they managed to skim $2.9 billion of that amount to cover losses in its private trading account, thanks to the Herculean efforts of its former Goldman CEO,  Henry Paulson, who in his revolving door role as the US Treasury Secretary, was in charge of distributing government bailout funds in the great trillion dollar taxpayer giveaway.

Fool Me Once…and other Moral Hazzards

While there have been some efforts to prevent another financial collapse, primary among them the Dodd-Frank Act, they are meager at best. Even those fledgling attempts are under relentless assault by K-Street lobbyists to weaken or remove them altogether. Wall Street Banks that were deemed too big to fail before the ’08 crash are now bigger than ever. Prior to the Crash, the four largest banks controlled $8 trillion in assets. After the bailout: $10 trillion.  The wealth gap that existed before the crash has only gotten bigger―the rich have gotten even richer and the poor even poorer. (See the Bernie Sanders presidential campaign for details.)

The criminals who made the Great Fraud possible are still in place, many of them rewarded with promotions and bonuses. (“Hey, those bureaucrat wimps at the SEC could have socked it to us for Z, but I bargained them down to G, so show me the friggin money!”) Despite having paid billions in fines and criminal penalties (Bank of America $16 billion, JP Morgan Chase $13 billion, Goldman Sachs $5 billion), not one of the principal Wall Street actors has been convicted, let alone gone to jail.  (Two hedge fund managers for Bear Stearns were prosecuted for fraud when their subprime loan backed hedge funds failed a year before the crash, but were found not guilty.) All this stands in stark contrast to the failure of many savings and loan institutions in the late 1980s. In the wake of that debacle, special government task forces referred 1,100 cases to prosecutors, resulting in more than 800 bank officials going to jail. Europeans don’t hesitate to put their corrupt bankers in jail. China likely shoots theirs…

The epilogue of The Big Short does mention that one individual, an obscure in-house European bank trader was imprisoned for a short term, but that’s about itYou can thank Congress and its loophole writing K-Street donors for that. (Google “revolving door” for more.). Whether their collusion was entirely responsible for the failure of the Obama Justice Department to bring the banksters to justice, Obama has done nothing to dissuade the public’s perception that we live in a two-tiered justice system that has poor black and Latino youth imprisoned for 25 years for selling an ounce of marijuana, while white collar criminals who screwed granny out of her retirement go scott free, often with bonus money stuffed into their pockets. It also states that 8 million jobs were lost, while 6 million homeowners had their homes foreclosed. Uncounted numbers of regular folks lost huge amounts of their investment and retirement portfolios. Total estimated cost

Ramifications for the 2016 Presidential Election

The wide-spread frustration of the American people directed at the political establishment driving this year’s presidential race can be attributed in large amount to the Troubled Asset Relief Program (TARP); i.e. the taxpayer funded bailout. Hard-working citizens have been forced to dip into their wallets to rescue the very people that destroyed so much of their personal economic futures. The downwardly mobile American electorate has, by and large, an intuitive understanding that they have been, and continue to be, royally screwed by The Powers That Be, even if they if they aren’t familiar with the particulars.

John Kasich, currently rising in the polls and who may be the GOP establishment’s chose alternative to Donald Drumpf, worked for Lehman Brothers as a managing director, so that will likely spawn more than a few negative commercials. Bernie Sanders voted against TARP, while Hillary Clinton voted for it. (What do you want to bet that a key reason Hillary refuses to release the transcripts of her three speeches to Goldman, for which she received $675,000, aren’t laced with reminders about how she helped save their ass?)

Clinton’s disingenuous attempt to discredit Sanders with Michigan auto workers for voting against TARP because it contained money to preserve the auto industry backfired when it was pointed out that Sanders had voted for its rescue in an earlier, stand-alone bill. But in the scotch-drenched backrooms of D.C. deal making, Congress and its K-Street allies made the auto rescue conditional, rolling it into a large omnibus TARP bill that overwhelming benefited Wall Street at the expense of Main Street. Bernie couldn’t swallow that huge piece of rotten meat, so he voted against it.

Donald Drumpf supported TARP, while his opponent, Lyin’ Ted Cruz, elected after the legislation was passed, says he would have voted against it.  This despite the fact his wife, Heidi, has worked for Goldman Sachs as an investment banker since 2005. Heidi was instrumental in procuring a loan from The Squid for as much as a half million dollars to launch Teddy’s Senate career.  Apparently, this was such a piddling sum that he didn’t bother disclosing it to the Federal Elections Commission, as required.  Besides, it would have contradicted his heroic narrative about having sold all their assets so he could self-finance his campaign.



Where the world’s central bankers meet to keep hope alive

Pushing on a String

In light of the total failure of Congress to produce fiscal policies that would actually grow the economy— tax reform, infrastructure spending, student loan reform and forgiveness, etc.— it’s been left to the monetary policies of the world’s central bankers to prevent an even worse financial collapse. These include: quantitative easing (printing money so that banks can lend it out cheap to insiders); zero interest rates;  negative interest rates; debt monetization, reverse repo’s; and coming soon  to a country near you, bail-ins the process whereby a regulatory authority can take money directly out of your account to rescue your bank from insolvency. (For more info, see the European Union’s Bank Recovery and Resolution Directive (BRRD.)

Despite filling the monetary punch bowl with every intoxicant imaginable to encourage spending, both consumers and corporations aren’t buying it. Consumers would rather pay down their debts than spend it on more imported Chinese junk. And corporations, facing reductions in organic growth and profit margins, have chosen to shun reinvestment in basic research and development for acquisitions, mergers, and stock buy-backs to boost their stock prices. Look no further than Japan and its thirty years of economic stagnation for a model of what the failure of integrating fiscal and monetary policies can produce.

Anyone doubting the extent of the Fed’s influence on the stock market should take heed of the fact that since the 2008 crash, over 93% of the stock market growth is attributable to its interventions:

As the financial crisis reached a fevered pitch in 2008, the Federal Reserve took to flooding the financial market with dollars by buying up bonds. Simultaneously, interest rates fell dramatically, as bond yields move in the opposite direction of bond prices. Barnier sees the Fed as responsible for over 93% of the market from the start of QE until today. During the first half of 2013, the Fed caused the entire market’s growth, he said.

All these extraordinary efforts have amounted to little more than pushing on a string. Except, of course, for Wall Street and the top 1%, who have become wealthier thanks to their access to the Fed’s free money punch bowl. While the post-crash bailout has benefited them enormously, little, if any, of the Fed’s efforts have directly benefited Main Street and the struggling middle class.

Pee Wee Herman vs. Superman

Individuals trading for their own account have to compete not only against highly leveraged hedge funds, but computer algorithms, which account for some 70% of all trades; dark money pools; high frequency traders, front-running; spoofing; and other tricks of the trade designed to separate retail investors and traders from their money. In The Big Short, the near impossibility of playing on anything resembling a level playing field is underscored by the efforts of a Boulder, Colorado based “small garage band hedge fund” (advised by the character played by Brad Pitt) to obtain an ISDA license— essential for the leveraged purchase of long-term options and credit default swaps— which would enable them compete with the big boys. Though they had deftly parlayed a $110,000 of their own startup capital into $30 million in four years, they were still a li’l bit short of the entry fee a cool $2 billion.

300 oracle

Consulting the oracle in the movie 300

Days of Future Past

What’s past is prologue.” —William Shakespeare, The Tempest

Predicting the future has been the profession of shamans, soothsayers, prophets, and prognosticators since the beginnings of human history. Prior to the real estate crash of 2007 and the broader financial  meltdown of 2008, predicting future market developments was the province of Wall Street professionals: investment banks, hedge funds, pension funds, private equity groups, financial advisers—money managers of all stripes. Coming from establishment business schools, they all pretty much share the same basic set of economic assumptions.

They were, and are, the embodiment of groupthink, which explains how they were so thoroughly blindsided by the events leading up to the Great Recession. Sprinkle in copious amounts of mania, i.e. greed, captured in The Big Short scene with the pole dancer with six properties and a dozen plus mortgages;  and denial, embodied by the real estate agent explaining that the market was just in a temporary gully while driving around once thriving neighborhoods gone to seed in a forest of For Sale signs and alligator infested swimming pools, and you’re left with the same delusional attitudes that makes the next crash well-nigh inevitable.

And yet, who does the mainstream media turn to for advice and direction in these uncertain times, for some insight into the future?  The same pathetic “experts” who got us in this predicament in the first place. It’d be like asking the neocons who got us into Iraq for their advice on what to do now about the rest of the Middle East.  Oh, wait…

Having spent thousands of hours studying the market over the last twenty years, and thousands of dollars on courses about how to trade stocks and options, with a trusty Bloomberg terminal at my side, I managed at best to break even. Along the way I’ve learned that the financial market is a highly rigged casino whose complexity continues to bring even the most experienced traders to their knees. For example, the hedge fund industry managed to under-perform the S&P last year by over a 100 basis points. Meaning that if you’d purchased an ETF index fund on your own, you’d have made more money than the pros and saved yourself all the money you paid them in management fees and commissions for the privilege of making you poorer.

So poor was their performance in 2015 that the total of hedge funds liquidated the first nine months of the 2015 was 674, up from 661 during the same period in 2014.  And according to one analysis: “Hedge fund inflows declined by roughly 40% in 2015 compared to the previous year, as the under-fire sector continued to post poor performance.” One of the largest hedge funds is Pershing Square Capital Management, run by Bill Ackman with some $11 billion in assets. It’s publicly traded vehicle, Pershing Square Holdings, is down 36% year-to-date (3-17-16).

But don’t take our word for it.  CNN reports on a study just concluded by Citi Bank.

Financial markets are trapped in a “death spiral,” according to analysts at Citigroup.  The bank’s research team described a “negative feedback loop” in the global economy and across financial markets. It is fueled by strong dollar, lower commodity prices, weak trade and declining growth in emerging markets.

The four forces are interconnected and present central banks with the difficult task of fighting deflation and staving off another global downturn, the bank said in a report, released Friday. If the loop continues, Citi warns, the world could slip into “significant and synchronized” global recession. The bank even invented a new term for its doomsday scenario: “oilmageddon.”

Enthusiasm is on the wane.  Wondering what to do with your money?  Given that the Federal Reserve’s balance sheet is leveraged 77:1;  and the European banks are running on empty, you might want to buy a bigger mattress.


The final words from The Big Short come in the Epilogue, which mentions that Goldman Sachs and other banks have created an exciting new investment vehicle: the “bespoke tranche opportunity.” Bloomberg Financial explains:

The 2008 financial crisis gave a few credit products a bad reputation.

Like collateralized debt obligations, known as CDOs. Or credit-default swaps.  But now, a marriage of the two terms (using leverage, of course) is making a comeback — it’s just being called something else.

Goldman Sachs Group Inc. is joining other banks in peddling something they’re referring to as a “bespoke tranche opportunity.”  That’s essentially a CDO backed by single-name credit-default swaps, customized based on investors’ wishes. The pools of derivatives are cut into varying slices of risk that are sold to investors such as hedge funds.

The derivatives are similar to a product that became popular during the last credit boom and exacerbated losses when markets seized up. Demand for this sort of exotica is returning now and there’s no real surprise why. Everyone is searching for yield after more than six years of near-zero interest rates from the Federal Reserve, not to mention stimulus efforts by central banks in Japan and Europe.

The transactions offer the potential for higher returns than buying a typical corporate bond, especially if an investor focuses on first-loss slices or uses borrowed money, or both. Obviously, the downside may be much greater, too.

So, its back to the future. Japan has been mired in recession for decades. China is so far failing in its attempts to turn itself from an economy primarily dependent of cheap manufactured goods into one that resembles the West, with a strong national consumer component. Meanwhile, very few economists give credibility to the economic and banking numbers the communist Chinese government presents for international consumption. And keep a wary eye on its currency.

Emerging markets around the world have ground to a halt, thanks largely to a world-wide collapse in commodity prices. Oil dependent countries like Saudi Arabia, Russia, and Norway are being forced to liquidate stocks and bonds from their sovereign wealth funds, driving markets lower. Funds holding high-yield corporate “junk bonds,” comprised largely of speculative oil drilling and fracking firms, find themselves mired in an illiquid market (a euphemism for “no buyers”), and have resorted to shorting the stock indexes in an effort to preserve their balance sheets. Yields on junk bonds have doubled and even quadrupled in the last 18 months, from 5% to 20%.

Looming beneath the debt waters are billions in equity lines of credit obligations, which don’t show up on the books until the money is actually transferred. And what is generally perceived as a red hot auto sales market in the US, considered a reliable indicator of consumer confidence and overall economic health, is dominated by discounts (squeezing corporate profit margins);  and loan financing, a third of which is comprised of subprime borrowers, many of whom are 30-60 days late on their payments. Auto loans are securitized into bonds the same way home loans are. But as someone once observed: “Subprime borrowers tend to be one broken refrigerator away from default.” What’s good for the goose is good for the gander.

Meanwhile, the Federal Reserve, which took hundreds of billions of dollars of subprime loans off the balance sheets of the largest banks and transferred them to its own, is so far weathering this “toxic debt hangover,” helping to swell its own balance sheet to $4 trillion. But as a result it is now leveraged 77 to 1! That’s over twice the ratio of the most unstable banks that failed during the crash.  How long they can keep that up is anybody’s guess.

In sum, many of the factors that contributed to the 2008 economic crash remain in place, especially the psychological and cognitive factors, namely: denial, greed, mania, selection bias, hubris, and narcissism. (All of which define most of the current crop of presidential candidates, but that’s another story.) The Dunning-Kruger effect describes the problems associated with both the overestimation of one’s own abilities; and the underestimation of others. The Urantia Book tells us how to strike a balance between the two; that is: How do we make a wise estimate.

The true perspective of any reality problem — human or divine, terrestrial or cosmic — can be had only by the full and unprejudiced study and correlation of three phases of universe reality: origin, history, and destiny. The proper understanding of these three experiential realities affords the basis for a wise estimate of the current status.

So, what is the “current status” of the markets and the world’s economic situation?  Not so good, but let us end on a positive note. In a recent interview with New York Magazine, Dr. Michael Burry was asked: “What, if anything, makes you hopeful about the future?”  He replied:

Innovation, especially in America, is continuing at a breakneck pace, even in areas facing substantial political or regulatory headwinds.  The advances in health care in particular are breathtaking — so many selfless souls are working to advance science, and this is heartening.  Long-term, this is good for humans in general.  Americans have so much natural entrepreneurial drive.  The caveat is that it is technology that should be a tool making lives better in the real world, and in line with the American spirit of getting better and better at something, whether it’s curing cancer or creating a better taxi service.  I am less impressed with the market values assigned to technology that enhances distraction.  We don’t want Orwell’s world, but we don’t want Huxley’s world either.

In contrast to Orwell and Huxley’s dystopian visions, I’ll settle for The Urantia Book‘s “evolutionary utopia,” which it outlines in its description of  the “Ages of Light and Life.”

“The era of light and life.  This is the flowering of the successive ages of physical security, intellectual expansion, social culture, and spiritual achievement.  These human accomplishments are now blended, associated, and coordinated in cosmic unity and unselfish service.  Within the limitations of finite nature and material endowments there are no bounds set upon the possibilities of evolutionary attainment by the advancing generations who successively live upon these supernal and settled worlds of time and space.”

Prove you're human: leave a comment.