Michael Lewis’s retelling of the history of the subprime residential mortgage bubble and bust of 2008 was a good read. It has now been made into a multiple Academy Award nominee movie.
But as a helpful guide to understanding the powerful forces that fueled the animal spirits of all those realtors, mortgage lenders, investment bankers and bond traders “The Big Short” comes up very short, indeed.
Viewers can enjoy the story of a small group of trash-talking, odd-ball mortgage bond traders who decided the bubble was going to burst and battled their way to success and riches. The screenwriters even managed to make “credit default swaps” comprehensible for the attentive viewer.
Perspective, please. However, the explanation in both book and movie for why the bubble grew to such gargantuan proportions is essentially superficial and sophomoric: it was all greedy bankers, traders, realtors and credit rating agencies. There are no references to the recurring historical pattern of manias, panics and crashes so well described by Charles Kindleberger in his book with that title, nor to the insights that Hyman Minsky developed regarding the all-too-human behavior that creates financial instability and crises.
In his book, Lewis goes so far as to write that, “The problem was the system of incentives that channeled greed.” But nowhere does he discuss incentives except with respect to “outrageous bonuses” for traders and the transformation of the investment banks from partnerships to public (shareholder) firms, which vastly increased their appetite for risky trading.
Perverse incentives. There is not a word in the movie or book about pressure from “affordable housing” advocates and the obedient politicians of both parties in Washington who continuously pressured lending institutions and government agencies to create and buy subprime mortgages. The chief instruments were the federal government’s Community Reinvestment Act (CRA), which coerced lending institutions into making subprime loans, and the lowering of standards by the two government-sponsored mortgage companies, Fanny Mae and Freddie Mac, as well as the Federal Housing Agency.
The chief front man for affordable housing promoters was Congressman Barney Frank, Chairman of the House Financial Services Committee. In neither the book nor the movie does Barney Frank exist. But he played a leading role in pressuring the government housing agencies to lower their lending standards and bad-mouthing those who warned of possibly dire consequences, as Gretchen Morgenson and Josuha Rosner detail in their book, “Reckless Endangerment.”
It is notable that Frank has confessed to being a part of the problem. In an interview in 2010, he stated “it was a great mistake to push lower-income people into housing they couldn't afford and couldn't really handle once they had it."
Of course, there were lots of other players, mentioned above, who threw wood on the fire once it was lit, and who helped to make this particular boom/bust cycle an unusually severe one. Perhaps the best study of the forces which lead to all major financial crises, especially "subprime 2008," can be found in “Fragile By Design” by Charles Caloramis and Stephen Haber.
I have summarized their findings in an earlier blog, “Why Banks Go Bust”. The bottom line is that “banking systems and financial crises . . . are produced by political bargains that shape the institutional structure, incentives and regulatory framework within which banks operate.”
The big deal. As Caloramis and Haber show, the bargain which played the leading role in the great bust of 2008 was straightforward: banks that wished to take advantage of the 1994 law allowing interstate banking needed to buy off affordable housing advocates who could block the banks’ expansion plans by charging them with failure to comply with the de facto lending quotas that grew out of the 1977 Community Reinvestment Act.
Trashing bonus-driven bankers, bond traders, credit rating agency managers and realtors for responding to the incentives put in place by politicians and regulators may earn “The Big Short” more than one Academy Award. But as a thoughtful story of why the subprime bubble blossomed and burst, this movie deserves a D minus.