Just finished watching the Big Short. Fantastic movie, well acted, digestible, and surprisingly balanced. But some aspects are really nagging at me. While there is no obligation for the writers to dig deep, I feel it’s important. The prevailing narrative - which the Big Short no doubt feeds in many ways - is that capitalist greed and the externalities of collusion have pulled the wool over our eyes once again. Here’s a different perspective.
Collateralized debt obligations are an overly convoluted theme in the movie yet actually pretty easy to grasp. A quick recap: the bank calculates an interest rate on a home based on the expected value and likelihood of repayment, creates a mortgage out of it, and lends it to a new homeowner. The bank then sells many of these mortgages to investment firms, who bundle them up for resale in a similar vein as index funds - diversified sets of loans apportioned by risk profile (called tranches). The instruments are collateralized because homeowners repay investors via monthly mortgage payments.
In the Big Short, we’re told greedy banks and firms begin to stack pisspoor or subprime mortgages (those with ratings like B and BB) with excellent ratings (AA and AAA), which is no bueno and let’s call it a day. But this by itself isn’t exactly incriminating. It’s how insurance companies diversify their own risks, and it makes rational economic sense: spread the exposure - probability of default - by combining high risk assets with low risk assets, and depending on how the instrument is structured, the average net return is hopefully positive. Profit!
Where all this turns belly up is when subprime homeowners with adjustable-rate mortgages can no longer afford their monthly payments. Adjustable-rate mortgages (ARM) are those with interest rates that vary over the life of the loan, almost always in conjunction with current market lending rates. Typically ARMs are front-loaded at a discount price; the initial interest rates are intentionally cast low to give consumers cheap monthly payments in the early years (adjustment period) of the loan lifecycle. When a mortgage hits the end of the adjustment period, the prevailing rate can significantly increase the monthly payment amount and overwhelm unprepared or low-wage homeowners.
When a peak number of subprime mortgages go into default, the principal loss can quickly blow out investor returns, and the CDO as an interest-bearing instrument becomes worthless. Not a good situation for anybody, especially when investors buy into Fed Chairman Alan Greenspan’s optimistic praise in 2005 and recklessly throw in more dough1:
Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country … With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. … Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.
While the widespread exposure inherent to rapidly defaulting ARM-based CDOs was a catalyst, it is not alone sufficient to explain the housing collapse. Even the worthwhile scrutiny given to synthetic CDOs, in which the real CDO market is bet for or against, is yet another proximate cause of the crisis, not the ultimate.
Now, how the bank underwrites a particular mortgage’s rate is relevant. It’s a complex task, rooted in actuarial science, and banks specialize in other domains, so naturally they outsource the process to rating agencies. Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in insurance, finance and other industries and professions2. The movie gets a little closer to an answer in the scene at Standard & Poor’s, wherein Baum asks the auditor if S&P has ever not given the banks the rating they’ve requested when grading a prospective instrument. She reluctantly admits they haven’t and blames it on the market - “If we don’t give them the rating they want, our competitors will.” A true statement, but a skeptical audience wonders why the market has failed us here. That’s just what unfettered capitalism inevitably does:, says the Keynesian, but maybe we can do better. The defining worth of a rating agency to its customers is expertise in actuarial modeling and the rigorous assessment of potential contracts. If a rating is bad - too high or too low - the banks eventually lose money, and lots of it. An accurate rating is therefore crucial to any agency that wants to keep its doors open.
A better question might be, what could cause such a tremendous breakdown of critical institutions in a vigorously competitive market? My guess is something big, something contrived, and likely something ideological. Now we’re definitely getting closer to an answer.
In the wake of the Great Depression, FDR’s New Deal established the government-sponsored enterprise (GSE) Fannie Mae in 1938 to combat the abysmal state of the housing market. Later, in 1970, the executive branch established Freddie Mac in order to compete with Fannie Mae and thus “facilitate a more robust and efficient secondary mortgage market.” I’ll quote some key passages from Wikipedia to tell their story3:
Fannie Mae created a liquid secondary mortgage market and thereby made it possible for banks and other loan originators to issue more housing loans, primarily by buying Federal Housing Administration (FHA) insured mortgages. For the first thirty years following its inception, Fannie Mae held a monopoly over the secondary mortgage market.
In 1992, President George H.W. Bush signed the Housing and Community Development Act of 1992. The Act amended the charter of Fannie Mae and Freddie Mac to reflect the Democratic Congress’ view that the GSEs “have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return;” For the first time, the GSEs were required to meet “affordable housing goals” set annually by the Department of Housing and Urban Development (HUD) and approved by Congress. The initial annual goal for low-income and moderate-income mortgage purchases for each GSE was 30% of the total number of dwelling units financed by mortgage purchases and increased to 55% by 2007.
In 1999, Fannie Mae came under pressure from the Clinton administration to expand mortgage loans to low and moderate income borrowers by increasing the ratios of their loan portfolios in distressed inner city areas designated in the Community Reinvestment Act (CRA) of 1977. Additionally, institutions in the primary mortgage market pressed Fannie Mae to ease credit requirements on the mortgages it was willing to purchase, enabling them to make loans to subprime borrowers at interest rates higher than conventional loans.
The federal government effectively created a mortgage whale intent on incentivizing lending to financially unsound homeowners, dramatically distorting the greater market as only a fiscally inexhaustible monopoly can. As Nassim Taleb notes in Black Swan, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events ‘unlikely’.”4
1 : Remarks by Chairman Alan Greenspan - FederalReserve.gov 2 : Actuarial science - Wikipedia 3 : History of Fannie Mae - Wikipedia 4 : Nassim Taleb: Black Swan