By James H. Nolt
I saw the new movie “The Big Short” with my son Christmas Eve. Both of us were so impressed that we hastened to recommend it to all of our friends and relatives. The movie is a docudrama about a small number of investor misfits who bucked the conventional wisdom during 2005-2008 to bet on the catastrophic fall of mortgage-backed securities (MBS) using Credit Default Swaps (CDS) and other short instruments.
The movie may seem an unlikely hit given the complexity of the topic, but one reason we admired it is that it did a pretty good job of making a complex topic comprehensible to a reasonably well-educated and attentive audience. It is so cheeky and “in-your face” iconoclastic that even those who do not understand every nuance of the film may come away with a desire to learn more.
The film is not only educational, but it is also remarkably funny in parts, although your laughter might be tempered with head-shaking disgust at the scale and audacity of the fraud that stoked the housing bubble and then collapsed it for profit. However, as regular readers of this blog will know, 2008 was not an extraordinary aberration of greed run wild, but a rather typical instance of the business cycle that has numerous historical precedents.
I heard patrons leaving the theater in Ohio where I saw the movie commenting that it was a mistake to end the Glass-Steagall Act’s firewall between deposit and investment banking. Other theatergoers were heard to comment favorably about Bernie Sanders’ campaign for president as they emerged from seeing this highly effective yet still entertaining agitprop.
There have been a number of documentary and fact-based fiction films made about the 2008 global financial crisis. This is my favorite so far. What makes it appealing is that it does not concede the popular media’s constant refrain that the financial products underlying the crisis are too complex for ordinary people to understand. That dodge patronizes the audience. This film explains even difficult concepts like structured finance (using tranches) and collateralized debt obligations (CDO) using simple analogies that explain how these techniques make money and why regulators failed to restrain the excesses. This is similar to how I teach these topics to university students.
Critics will point out the film takes dramatic license with certain incidents and dialogue, but unlike many other fictionalized treatments of the crisis, this one uses the real names of key participants and banks. It builds the narrative upon real events documented by multiple sources.
Perhaps the film’s most telling point is at the very end when it notes that the cycle may again repeat because very little has been done since 2008 to regulate or restrain the excesses that led to the crisis then. Just before the closing credits, the film mentions that a seemingly new financial product with the exotic name “bespoke tranche opportunity” is simply old wine in new bottles. These are just a revival of the CDOs that played a central part in inflating and then bursting the 2008 housing bubble.
As complex as financial products get, at the heart of all complex, high-yield securities is leverage. Many articles in this blog series have emphasized the key importance of leverage in boosting bullish yields. As long as the yield (capital appreciation plus income) of any asset is higher than the cost of borrowing, investors can earn higher returns by increasing debt leverage. Extraordinary leverage is often hidden in complex products such as the Frankenstein monster called synthetic CDOs. However, the basic rule of thumb for any savvy investor is that if yield seems high on any asset, look for the leverage that boosts it.
As I have often said in previous blogs, the danger of leverage is that either the cost of debt will rise, the yield on the underlying assets will fall, or both. Once the cost of debt (the interest rate) is higher than the yield of the assets, the position is “underwater” and its losses will be magnified the same way its gains were during the boom.
When lots of leveraged positions go underwater at the same time, a general financial crisis occurs. Investors who are underwater have two options: (1) unwind the position by selling the underlying assets, thus cutting their losses, or (2) default, which may involve bankruptcy. In either case, there will be many sellers of the underlying asset (e.g., housing in 2008) simultaneously trying to unload, resulting in the collapse of prices and thus causing more leveraged positions in the asset to go underwater—a snowball effect.
As the film, “The Big Short,” illustrates, powerful financial institutions have a third option, which they exercised during 2008. When they notice, before most of the public, that numerous leveraged positions are inevitably headed over a cliff, they may have pricing and credit power sufficient to delay the collapse just long enough for them and their favored clients to exercise option one and unwind their own vulnerable positions before the hoard of suckers gets swamped. Simultaneously, the insiders erect their own short positions in those doomed assets to profit when they fall, thus hopefully covering their losses from unwinding their bullish positions.
The movie shows that this was done during 2008 when many of the big banks who were pricing their own exotic CDOs pushed the prices up even as the default rate on the underlying assets—in that case, subprime mortgages—was soaring. The logic of free markets says that if the underlying asset becomes riskier, the risk of any asset based on it must rise and thus its price must fall. This did not happen at first precisely because the market for these exotic financial instruments was not a free market, but a rigged market strongly infused by the power of the big banks. This is an excellent illustration of the main points I have been making throughout this series.
Several of the big banks, seeing what was happening before most outsiders (except for the “shorts” who are the heroes of the movie), artificially held up the prices of the doomed assets long enough to save themselves (if not their stockholders) and favored clients. They did this in two ways. They continued to unload the “dog shit” assets on unsuspecting clients, so demand remained strong for a few months past when it should have collapsed had the public been more wary. The other way was by maintaining bullish, loose credit. That is, stoking lending to maintain bullish asset demand to keep the whole fiasco hidden just long enough to save their own skins and rake in large profits in the process.
As much as possible, the big banks unloaded these recklessly bullish last-minute loans onto outsiders, still clueless bulls who did not yet grasp the secret that the game was up. By holding up doomed asset prices a few months longer, the banks also squeezed the bears who were betting against them, the shorts of the movie title. They thus forced many of the shorts to sell their own short positions to the banks (at a sweet profit for those shorts, but less than they might have earned if they had held on) so that the banks themselves would reap the biggest gain from them, rather than the shorts who had the wisdom to bet against the banks’ rigged game in the first place. This film is a potent illustration of private strategic power in action.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of woodleywonderworks]