Why the Big Short didn’t work but the next one likely will!

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.


Kevin Villani
La Jolla, Ca 92037

Author of Occupy Pennsylvania Avenue

9 thoughts on “Why the Big Short didn’t work but the next one likely will!”

  1. Interesting post. I ordered the Kindle version.

    Dodd-Frank is the “reform” from hell and will blow up worse than 2008 but Bush and even Margaret Thatcher had the delusion that home ownership would make people middle class rather than the real logical connection between middle class values first, then home ownership.

    The vultures appeared soon after.

    I wonder if the California bubble will go much longer. there are mansions all over that were built on spec for Chinese buyers and which are now vacant.

    The Chinese have always liked the southern California life style. There was a development in China, described by the NY Times a few years ago, and it is even called “Orange County.”

    “I liked it immediately — it is just like a house in California,” exulted Nasha Wei, a former army doctor turned businesswoman, sitting on a white suede banquette in the four-bedroom home in Orange County (China) she moved into this year.

    Bits of American geography are popping up all over Beijing, the latest fashion in real estate marketing and sales. Soho, Central Park, Palm Springs and Manhattan Gardens are among recent developments.

    There are two Sun Cities. American place names have supplanted offerings like Jade Dragon Apartments and East Lake Villa, reflecting Chinese consumers’ increasingly Western aspirations.

    “Especially in Beijing, it’s a kind of fashion — and if you don’t chose a Western concept right now you’re really out of it,” said Victor Yuan, whose Horizon Market Research advises developers on how to set their buildings apart. In surveys, his company found that 70 percent of developers were emphasizing Western style as a marketing tool.

    That was in 2003. Those houses had to build outdoor kitchens because of the smoke from Chinese cooking. The mansions sitting empty in Los Angeles have Chinese style kitchens already built.

  2. I’ve started reading the Kindle version but it does need some editing. Already noted a few typos and incomplete sentences. My own Kindle book also has many and editing them is a task I haven’t attempted yet.

  3. repealing glass steagall was not wise. there should be a difference between those who hold funds in trust and those who are willing to take a flyer for great gain. shift key shorted. isues are not only financial but moral.

  4. A couple of points:

    1. The panic of 2008, was not the first housing finance crisis. There was a bad one in the late 80s and early 90s that was called the savings and loan crisis.

    2. The 30 year fixed rate mortgage contains a number of risks. If interest rates go up, the principal value of the note goes down. And it goes down farther than it would go up if rates came down, because the owner can refinance in that event. The mortgages should have prepayment penalties to reduce this asymmetry, but they are generally prohibited by law. If the value of the property goes down, and the owner skips, the bank is left holding the bag. Traditionally owners had to put up a 20% down payment. That investment gave them ample incentive to stick it out if there was a problem, and provided the lender with some cushion on the value of its collateral. That is not true of 3% down mortgages.

    3. The mortgage derivative instruments were an attempt to reallocate some of these risks. They failed. But, they were not badly intended. The only derivative instrument that failed because of regulatory failure was the the so called credit default swap. It is in fact a credit insurance policy. Which has a long and legal history. But CDSs were not priced or reserved as insurance products, which was a major source of the panic. The regulatory failure was that congress passed some ambiguous legislation in the 1990s that removed swaps from state regulation. Insurance is regulated by the states. The state insurance regulators failed to try to get on top of this issue. The failure of AIG was important and ironic. The irony is that AIG was an insurance conglomerate. It should have known that the product was under priced.

    4. The Fed and the GSEs have worked as hard as they can to re-inflate the housing bubble. They have pumped it farther than they did ten years ago. Go tho this link and look at the charts:

    The Bigger Picture for Median U.S. New Home Sale Prices December 16, 2015

    Be afraid. Be very afraid.

  5. “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 …”: we have neither of these distortions in Britain, but we have a huge housing bubble too. I think (rather than know) that the same could be said about Australia.

  6. The financial meltdown was an amazing example of wholesale and retail corruption starting with the liberal federal government.

    The lax underwriting requirements imposed on financial institutions by the feds (and, it must be said, by community organizers – “you know who” was a foot soldier) resulted in not only loosened loan underwriting but fabricated loan applications on the part of the real estate agents and mortgage providers. The pressure was applied from above and, after all, one was doing a “good thing” in helping the unqualified get a home. A gold rush of sorts in the real estate market.

    The local banks were able to sell these good and bad debts to the big banks who bundled them into “tranches” and were able to get the rating agencies to fabricate a much higher rating for these notes than they deserved. Other large institutions took the ratings at face value and got screwed (to what extent where they ever made whole? I can’t recall).

    The speculator’s (who realized that the above was happening) main problem was to figure out how to profit from it. The answer was the credit default swaps…”you pay me (the speculator who realized the truth) if default occurs, I’ll pay you if it doesn’t”. They deserve credit for popping the bubble sooner rather than later.

  7. Nicole Gelinas points out that a lot of this began when banks and the mortgage giants like Morgan-Stanley became publicly traded companies.

    The investment banks took a major step as they became publicly traded companies. This began with Dean Witter in 1972 and Morgan Stanley took the step in 1986. Now, the traders would be risking someone else’s money and this was a fateful decision. The author points out that Brown Brothers Harriman remained a partnership in which partners risk their own capital and it has not gotten into trouble with the speculation of the 90s and beyond.

    They were leveraged over and over. First by selling their stock, then by the mortgage instruments they were trading.

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