In promoting the Hollywood version of The Big Short by Michael Lewis, Paul Krugman (NYT, December 18) misrepresents the central point of this excellent book, previously made by Peter Wallison, who Krugman attacks for his Republican dissent to the 2010 Financial Crisis Inquiry Commission (FCIC) majority Report.
The Hollywood version reflects the Report’s fundamental conclusion that the root cause of the financial crisis was Wall Street greed: hardly newsworthy, disputable or dispositive. The Big Short is about the equally greedy speculators who were shorting the housing market: had they succeeded early on – as they do in less distorted markets – they would have prevented the bubble from inflating to systemic proportions.
Contrary to the “indifference” theorem (i.e., between debt and equity finance) of Nobel Laureates Franco Modigliani and Merton Miller, both household borrowers and mortgage lenders chose to finance almost entirely with debt, a strategy best described as “going for broke.” The first distortion – tax deductibility of debt – makes leverage desirable until discouraged by rising debt costs. The second distortion – federally backed mortgage funding as Depression era deposit insurance became virtually universal and the Fannie Mae “secondary market” facility morphed into a national housing bank – prevented these costs from rising. This highly leveraged strategy was guaranteed to fail systemically if bad loans entered the system.
When House Speaker Nancy Pelosi announced the FCIC in 2009 as a successor to the politically appointed Depression era Pecora Commission, she was probably unaware that a soon to be published book by Michael Perino, THE HELLHOUND OF WALL STREET would once again expose the fraudulent intent of its predecessor. That report counter-factually blamed the strong universal banks for the failure of the small less diversified banks to pave the way for the Glass Steagall Act, which not only divested banks of their risk diversifying sales and trading activities but also provided limited federal deposit insurance to avoid runs on the smaller weaker banks.
President Clinton wisely deregulated the banking industry with the repeal of Glass Steagall restrictions allowing banks to have investment banking affiliates, but left now virtually universal deposit insurance in place. He then quite unwisely subjected discretionary permission to branch and merge to the extortion of community action groups such as ACORN, resulting in $4 trillion in mortgage commitments under the Community Reinvestment Act, and then compounded the problem by simultaneously ratcheting up the risky lending mandates of the government backed enterprises Fannie Mae and Freddie Mac.
For the “big short” to succeed, speculators needed to convince creditors of lender and borrower insolvency once the house price bubble inevitably burst. This reckoning was long delayed as cheap Federal Reserve credit continued to be channeled to the housing bubble by Fannie and Freddie well beyond the point of their insolvency because their HUD Mission Regulator – in addition to further ratcheting up their affordable housing mandates – required them to maintain a 50% share of a market now virtually devoid of qualified borrowers. Their shareholders would have balked, bursting the bubble, so politicians – led by Congressman Barney Frank and Senator Chris Dodd – refused to require higher capital requirements. All mortgage lenders would now “go broke” making loans almost sure to default in pursuit of market share.
The housing bubble inflated to unprecedented proportions as politicians cheered and prudential regulators provided assurances. The nominally private but publicly insured banks and Fannie and Freddie all went well beyond broke together.
The massive mostly opaque and hence market-distorting taxpayer bailout continues, the Dodd-Frank “reform” legislation may prove more problematic than its predecessor Glass-Steagall, and housing finance is moving towards a consolidated government–sponsored “single lender” with a “duty to serve.”
Experiencing the fog of war in Wall Street derivatives trading rooms is entertaining, but the true story of why the Big Short failed due to massive political malfeasance and why the bubble has once again been inflated and will cause another crash when it bursts due to the subsequent political cover-up is a more compelling tale.
La Jolla, Ca 92037
Author of Occupy Pennsylvania Avenue