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, The Big Short is 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 The Big Short 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 The Big Short, 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 The Big Short:
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 adjustable-rate 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. Wall Street 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 The Big Short captures this aspect perfectly.