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January 13, 2016

HOTONTHEBLOG

Featuringfreshtakesandrealtimeanalysisfrom
HuffPost'ssignaturelineupofcontributors

DeanBaker

DavidStockman

PeterSalovey

RobertReich

ShannonWatts

Becomeafan

Codirector,CEPRauthor,'TheEndofLoserLiberalism:
MakingMarketsProgressive'

'TheBigShort':ATaleofStupidity,Greed,and
Corruption
Posted:01/13/20161:03pmEST

Updated:5hoursago

I saw the movie last night. It's a great flick. If anyone doubted that it was possible to make a humorous entertaining film about credit default
swaps and collaterized debt obligations, TheBigShortis the definitive answer to the question. But now let's get to the substance.
Not surprisingly, the movie is prompting another round of revisionist accounts of the housing bubble. If you had not already guessed, the
movie's account is one in which the Wall Street boys ran wild and ended up drowning the country and themselves in their own greed.
Fortunately for the bankers, they could turn to the government for help. The rest of the country wasn't quite as lucky.
Before going into detail, let me briefly give the account of my own relationship with the housing bubble. (Regular BTP readers can skip the
next few paragraphs, you've heard it before.) I first began writing about the housing bubble in the summer of 2002. I had noted that house
prices had been substantially outpacing the rate of inflation. This concerned me since housing also seemed to be driving the economy.
Residential construction was at unusually high levels and the increase in housing equity seemed to be driving consumption, as saving rates
were falling to ever lower levels.
What ultimately convinced me there was a bubble was testimony from Alan Greenspan in which he explained why there was not a bubble.
None of what he said made any sense. Therefore I became convinced there was in fact a bubble since the Chair of the Fed could find no
remotely plausible explanation in the fundamentals to justify the run-up in house prices.
I should point out that I was looking for bubbles since we were still recovering from the impact of the stock market crash at that point. I had
warned of the stock bubble for several years before it collapsed.
At that time, I was not especially looking for bubbles but concluded the market was in a bubble when I was trying to reconcile predictions of
forever high returns in the stock market with the slow economic and profit growth projected by the Social Security trustees. (It wasn't
possible.)
The fact that so many economists, across the political spectrum, were prepared to accept an impossibility in prescribing policy for the
country's most important social program taught me a great deal about economists. Most do not actively think for themselves even on very
important issues; instead they defer to other economists who they think have more standing. This recognition made me more comfortable in
arguing against the rest of my profession about a housing bubble.
Anyhow, when I began warning of the bubble I was openly critical of Fannie Mae and Freddie Mac. On several occasions, I was on panels
with the chief economists of both companies. I managed to get them and many employees of Fannie and Freddie quite upset by arguing both
that the housing market could collapse and that it may take down one or both of the GSE's as a consequence.
I am pointing this out in the context of TheBigShort because I have no interest in defending the behavior of the GSEs. They were big actors
in the run-up of house prices. If they had been more responsible in assessing the market they could likely have reversed the course of the
bubble.
I was also very critical of the efforts of many housing groups to push low and moderate income families into homeownership. Even in
normal times buying a home will not be a good idea for a person who does not have a stable employment and family situation. In a bubble,
encouraging low and moderate income families to buy a house is encouraging them to throw their life's savings into the toilet.
Anyhow, this matters for the story in TheBigShort, because the revisionist account insists that it was not profit-driven Wall Street banks
and mortgage brokers who propelled the bubble, but rather a misguided government policy to promote homeownership among low- and
moderate-income families. The leading promulgator of this view is Peter Wallison, a fellow at the American Enterprise Institute who was
White House Counsel during the Reagan administration.

Wallison was on the Financial Crisis Inquiry Commission that Congress created in 2010. In that role he made a lone dissent, departing even
from the other Republican appointees, in arguing that the blame all lay with the government's policy rather than Wall Street run wild. He
restated this case in a comment on TheBigShort:
The Department of Housing and Urban Development was given authority to raise the goals--and it did, aggressively. Between 1993 and
2000, HUD raised the 30 percent goals to 50 percent, and between 2001 and 2008 it raised the goals to 56 percent. Thus, by 2008, 56
percent of all mortgages the GSEs acquired had to be made to borrowers below median income. Notably, HUD's relentlessly rising
quotas occurred in both Democratic and Republican administrations.
Understandably, it was difficult for the GSEs to meet these quotas and still acquire only prime loans. Accordingly, between 1993 and
2008, they began to accept increasing numbers of subprime and other risky mortgages. These caused their insolvency in 2008 and their
takeover by the government that year. Fannie later reported that in 2008 it was exposed to $878 billion in these deficient mortgages,
which caused 81 percent of its losses that year. Freddie's percentage exposures and losses were proportionately the same.
"The connection between these numbers and the financial crisis is unavoidable. Because the GSEs dominated the mortgage market,
when they reduced their underwriting standards to meet the affordable housing quotas the rest of the market followed. Soon, borrowers
who could have afforded prime mortgages were getting loans with zero down payments. The result was an enormous housing price
bubble, the largest in U.S. history, and when the bubble began to deflate, borrowers who could not meet their mortgage obligations
were unable to refinance their loans. The number of defaults was unprecedented. This was the mortgage meltdown.
This argument fails on the evidence, as I will show in a moment, but even more basically it fails on logical grounds. Wallison tells us:
"Because the GSEs dominated the mortgage market, when they reduced their underwriting standards to meet the affordable housing quotas
the rest of the market followed."
Think about this for a moment. Wallison tells us that the Fannie and Freddie starting making high-risk loans without adequate collateral in
order to increase homeownership. In other words, these are loans where it was reasonable to expect they would lose money.
And how do the private banks who issue mortgage back securities (MBS) respond? They lower their standards too.
This response doesn't correspond to the economics I learned. If your competitors undercut you so that you can no longer make a profit, then
you leave the market. You don't lower price and expand your business to lose money. In other words, Wallison's story makes zero sense even
on its face.
It also contradicts all the data. The worst loans were securitized by the private investment banks. This was widely reported at the time as the
investment banks were winning away market share from Fannie and Freddie. For example, this USA Today piece touted the explosion in
subprime lending in the bubble years. It also included a list giving the players and their market shares. Fannie Mae was a small actor in
issuance and Freddie Mac was nowhere to be found. Fannie and Freddie were losing market share rapidly in the bubble years, precisely
because they were not securitizing the worst loans.
In fact, the loss of market share was a topic for concern among investors. A 2006 Moody's report on Freddie Mac's economic prospects gives
the basic story from the standpoint of investors:
Freddie Mac has long played a central role (shared with Fannie Mae) in the secondary mortgage finance market. In recent years, both
housing GSEs have been losing share with in the overall market due to the shifting nature of consumer preferences towards adjustablerate loans and other hybrid products. For the first half of 2006, Fannie Mae and Freddie Mac captured about 44% of total origination
volume - up from a 41% share in 2005, but down from 59% in 2003. Moody's would be concerned if Freddie Mac's market share (i.e.,
mortgage portfolio plus securities as a percentage of conforming and non-conforming origination), which ranged between 18% and 23%
from 1999 through the first half of 2006, declined below 15%. To buttress its market share, Freddie Mac has increased its purchases of
private-label securities. Moody's notes that these purchases contribute to profitability, affordable housing goals and market share in the
near term, but offer minimal benefit from a franchise-building perspective.
As Moody's analysis makes clear, Freddie and Fannie were rapidly losing market share precisely because they were not involved in the
subprime and exotic mortgages being securitized by the private issuers. As the analysis notes, Freddie bought stakes in private-label MBS at
the end of 2006 to gain back market share. This ended up being an incredibly foolish business decision, but it is clear that it was done to
keep up with private issuers. Freddie Mac was not driving this market, it was following it.
The better quality of Fannie and Freddie loans showed up clearly in the delinquency data. Even at the worst points in the crisis, over 90
percent of Fannie and Freddie's mortgages were current and fully performing. By contrast, less than 70 percent of option-ARMs were fully
performing.
There are many areas of controversy about the housing market, but the source of subprime mortgages in the crisis is not one of them. Fannie
and Freddie could have been more responsible in recognizing the bubble and trying to rein it in, as I argued at the time. But they were not
worst actors. That honor belongs to the private investment banks that were making money hand over fist securitizing garbage, exactly as told
in the Big Short.
This raises another issue that has been debated in discussions, whether the behavior of the bankers was criminal or just stupid. WallStreet
Journal columnist Greg Ip weighs in on the stupid side, telling readers that the bankers themselves were heavily invested in real estate,
therefore they must have believed in the bubble.

This either/or question misunderstands the issue. It is likely that most, if not all, of the bankers issuing and securitizing junk mortgages
believed that house prices would keep rising, and in a rising housing market every mortgage is a good mortgage. But this doesn't mean the
bankers didn't break the law.
There are rules for issuing and securitizing mortgages. These rules were completely ignored in the peak years of the bubble. Mortgages were
routinely issued without proper documentation or on terms that would never pass muster with any serious underwriting process. These were
bundled in securities by investment banks that knew full well they were dealing with crap and then they were blessed by the bond rating
agencies with investment grade ratings. At every step, there were people who knew they were not following the law, but thought it would not
matter.
The law breaking was not following the rules. Surely none of these people anticipated sinking the U.S. and world economies. They just
thought they could ignore the rules to enhance their profits. The best analogy is probably a drunk driver. He never anticipated killing the kid
when he got behind the wheel, but he knew that driving under the influence is against the law.
This is the situation that drove the bubble in its final phases. These guys (almost all of them were men) undoubtedly thought house prices
would keep rising forever, or they possibly didn't care. What they did know is that they were making tons of money by not following the
rules, and TheBigShort captures this aspect perfectly.
FollowDeanBakeronTwitter:www.twitter.com/DeanBaker13
MORE: FinancialCrisisTheBigShortIncomeInequalityGreatRecessionHousingBubbleTheRecessionHousingCrisis

Conversations
10 Comments

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Lion Kennedy Works at Retired

The crooks that ruined thousands and thousands of people repeatedly broke
rule after rule and knew it. They are still living the good life. But if I would steal
something at the local convinience store I might get shot. This is a truely broken
system.
Like Reply

14 5 hrs

David Rigotti
"There are rules for issuing and securitizing mortgages. These rules were
completely ignored in the peak years of the housing bubble. At every step, there
were people who knew they were not following the law, but thought it would not
matter."
That is patently false. If anything, changes made to the Community
Reinvestment Act under President Clinton made it not only legal to provide subprime mortgages to dubious borrowers, IT MADE IT MANDATORY. In an
attempt to ensure minority community access to cheap borrowing, the
government actually made it a legal requirement for banks to service a
certa... See More
Like Reply

3 3 hrs

Gene Weik
First you make sub-prime loans then put them in with some good loans,
then have the rating agencies give them AAA+ rating (knowing they
were not). Sell them to people without telling them there were loans that
had a better chance of default than being paid.
There you go FRAUD.
Like Reply

1 3 hrs

Jake Cormier Woodinville, Washington

No one is saying that making high risk loans was illegal. The illegal part
was when they bundled a bunch if high risk loans together with a
couple good loans and magically transformed the entire set into a AAA+
security. The people that made these bundles, and the people at
Moodys et. al. that blessed them, committed fraud.
Like Reply

1 1 hr

John Strate Works at Wayne State University

The blame game debate goes on. Perhaps the question to ask is whether the
area of a rectangle is due more to its width or to its height. It looks like the
confluence of both disastrous government policies (perhaps put in place
because of rent seeking or lobbying by the financial services and mortgage
industries) and rampant greed and unethical/illegal behavior by private
mortgage bankers/lenders.

mortgage bankers/lenders.
Like Reply

3 2 hrs

David Rigotti
A perfect storm fueled by a seemingly innocuous but ultimately fatal
assumption: that a systematic collapse in housing prices accross the
United States could never happen. We don't throw people in jail for
being wrong, do we?
Like Reply

1 1 hr

Mark Keeler Toronto, Ontario

David Rigotti Except when it becomes apparent that people may have
USED that to their own advantage to defraud investors.
Like Reply 42 mins

Dennis Burgard Jacksonville, North Carolina

Dean, i've been a real estate broker for 20 years. As an owner and manager of
a company, I have a different take on the problem that I've never seen
mentioned....CASH. Investors seek returns, and at the time of the housing
bubble, the stock market had been stagnant for years. What I notices when I
examined our sales, was an injection of cash purchases that had never been
seen before. We started having more cash sales on a monthly basis then we
normally had in a year. There are three reasons this is important. 1. When you
purchase a home with cash, there are no limitations on what you ca... See More
Like Reply

3 1 hr

David Rigotti
Very interesting. I've never heard of this aspect of the housing bust
before... the manipulation of local markets by housing investors. Do you
know of any literature that documents these occurences? I would be
very interested in reading more!
Like Reply

1 1 hr Edited

Bob Fowler Works at Self Employed Entrepreneur

"These were bundled in securities by investment banks that knew full well they
were dealing with crap and then they were blessed by the bond rating agencies
with investment grade ratings."
This is the one thing that truly led to the meltdown. Yes, investment banks were
selling what turned out to be junk but only with the help of firms like Moodys. If
Moodys had done the job they were charged with doing then the investment
banks would not have been able to package and sell these securities like they
did.
Like Reply

2 3 hrs

David Rigotti
Actually, this is a common misconception. The fact that they were
selling them wasn't the problem since the people buying them were
typically doing so with their own "unleveraged" capital. It was the fact
that the bank HELD ONTO a significant portion of these securities that
led to problems. When the market collapsed, the banks could no longer
sell these assets which became "illiquid". Unable to rase the capital
needed to finance their deposits, a run on the investment banks
occured and all hell broke loose as credit markets were frozen. So it's
not the fact that they were selling CDO's that was the problem, it's the
fact that they used too many of these insecure CDO's as financial
backing for their deposit banking business. So the ratings of these
investments doesn't really matter, since the fact that they were being
sold to outside investors is inconsequential.
Like Reply

2 2 hrs

Bobby Hoffman Monmouth College

Right - this is dealt with in the film during the scene where Steve Carrel
goes to meet with an employee at Standard and Poors to shake them
down about what is happening in the market during the run up to the
melt down where the mortgage market is beginning to collapse without
the corresponding securities being downgraded by the rating agencies.
And the woman at S&P basically says that if they don't give the banks
the ratings they need, the banks will go down the street to Moody's.
That was one of the points in the movie that I was completely disgusted
by- it was like comically banal..
Like Reply

2 2 hrs

Glenn Klotz University of California, Santa Barbara

"What they did know is that they were making tons of money by not following the

"What they did know is that they were making tons of money by not following the
rules, and The Big Short captures this aspect perfectly." Of course they broke
the law and they did it with absolute impunity. So what did the rest of us learn in
this fiasco? That it's ok to break the rules if the rules only matter for everyone
else. That making investments in corrupt politicans is the smart move if you
intend to ignore the rules. On to the next "bubble" or as they call it the next
sucker game and BIG profits.
Like Reply 3 hrs

Lydia Filz
Of couurse they knew the housing market would crash. That's why they were in
such a hurry to give out mortgages. Mortgages without any proof of income.
Mortgages where they actually told the people to lie about their income.
Mortgages that would increase with adjustable rates. Soak everybody for as
much as they could before the whole thing fell down. I knew someone that was
counting on getting a 25 cent raise to be able to pay her mortgage and that was
before her adjustable rate was due to go up.
Like Reply 1 hr

Richard Thomas Clinton High

And even worse... if a Wall St. banker was driving drunk and really killed a kid
he wouldn't be held accountable either because of affluenza!
Like Reply 2 hrs

Tough Patrick
Brace yourself for 2017 crash: Look at the recent markets, They are dying and
people are pulling out their capital. China investors? Not any more, these
"institutional investors" are also loosing their capital. Millennials?, they are a
paycheck away from broke and buried with student debt. Low rates? Now that
we are at the peak of housing, where do rates go from here, FREE? Oh wait
that is known as a Sub Prime Rate! Which busted the market. HELOC? did you
realize that they are all now resetting, which means people are pulling out of
their 401K's to pay the balloon pmt. Housing Starts... See More
Like Reply 2 hrs

Mark Keeler Toronto, Ontario

Between China, crashing oil, and a really fragile consumer market, I'd
be very cautious at this point.
Like Reply 40 mins

Katrina Cox Rucker Murfreesboro, Tennessee

test
Like Reply 4 hrs
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