The Big Short, Partial Truths, and Market Bubbles

Bad Bonds

(Spoiler warning.)

The film "The Big Short" is correct as far as it goes.

To be sure, several scenes ring false. When meeting with an unimportant and rude visitor, a Standard & Poor's bond analyst is unlikely to confess that she rates bonds according to the issuers' wishes, because otherwise they'll take their business "down to street to Moody's." Nor, I suspect, did mortgage-securities salesmen attending a Las Vegas convention fire Uzis at targets that wore Arab headdresses. (Also, Bill Bernstein informs me that Christian Bale's portrayal of hedge fund manager Michael Burry's Asperger syndrome was far "over the top.")

(To its credit, the film is more honest than its predecessor "Moneyball"--also adapted from a Michael Lewis book--which played its fabrications straight, such as the implication that Billy Beane's recently acquired players were the ones who sparked his team's 20-game winning streak rather than the excellent pitchers already on the roster. In contrast, "The Big Short" implicitly confesses its sins by periodically informing viewers that an incident "really happened." We are left to wonder, probably correctly, about the veracity of the incidents that are unaccompanied by that promise.)

Well, that's entertainment. "The Big Short" accurately relates the basic story: Housing prices had soared and mortgage-lending standards had plunged, leading to the creation of millions of dubious mortgages (mostly with adjustable-rate features that would boost required payments when short-term interest rates increased). Those loans were packaged into complex securities that received higher credit ratings than their underlying collateral would have. As 2007 began, few understood how large that time bomb was and how easily it would be triggered by rising short-term rates.

"The Big Short" amusingly captures the collective naivete. The Florida-bartender-turned-mortgage-broker who parlays his brokering wealth into hobnobbing with strippers realizes that his NINJA (no income, no job) clients should not be receiving loans, but he can't think through the implications. If he is surrounded by a party, he cannot perceive how that party might end. Neither can the snickerers at Goldman Sachs, who can't believe that somebody would be foolish enough to bet against housing. Unlike the former bartender, they have the processing power to foresee change, but they lack the emotional strength. They are swept up in the excitement and have placed their brains on hold.

The film describes investments in substantial detail. It tells how collateralized debt obligations consisted of a collection of mortgages sliced into different offerings that varied in quality, depending upon their priority in receiving cash flows. Those who wished to short CDOs could not do so through the retail marketplace but could buy credit default swaps from institutions. The swaps had a negative carry, requiring them to make monthly payments that put their funds into the red, as long as the mortgage market remained in reasonable health.

There was a whole lot of leverage. In a cameo, the improbable duo of Selena Gomez and economist Richard Thaler compare derivatives on mortgage bonds to side bets in a casino. The size of the position can swell to many times its starting point. The hedge funds that shorted the mortgage bonds, the chief subjects of the film, borrowed to make their investments. Debt laden upon debt. According to "The Big Short," some segments of the mortgage-bond market had effective leverage ratios of 20:1.

Mirror, Mirror Ultimately, the film deconstructs itself. "The Big Short" wishes to have it both ways, deriving comic effect from the mass cluelessness while casting Wall Street banks as Ernst Blofeld. But that circle cannot be squared. Either those Wall Street workers were caught up in the moment along with everybody else or they were not. And the film shows that they were not. Greedy? Sure. Unlikeable? Check. But criminally knowing? Not many. As with most giant financial flops, the mortgage-bond con was largely unintentional, with those who received, wrote, securitized, and bought mortgages all happily believing in the housing fairy.

So, too, did those who wrote government policies that supported home ownership, and those who worked in agencies that furthered that aim. The villains of the business press' version of this morality play (and make no mistake, "The Big Short" is very much a morality play), Fannie Mae and Freddie Mac, receive nary a mention. As the business press has (mostly) told the story, government drove private enterprise into this disaster. "The Big Short" portrays just the opposite, with government's only fault being that it policed the baddies too loosely.

Those are two sides of the same elephant. "The Big Short" is correct that the usual human failings of greed and arrogance drove Wall Street to make and distribute bad products, products that eventually would not only impoverish many retail investors, but also sink several Wall Street banks themselves. And the business press is correct that government policies, also created by flawed humans, offered support and encouragement for these mistakes. They are both right--and they are both wrong.

To which I would add the failings of Main Street. Homeowners have delighted in feeling aggrieved, sometimes at "The Big Short's" demon of the big banks and sometimes at business press' demon of government. In blaming others, Main Street has been outstanding. In accepting responsibility, not so much. The greed inspired by the house-flipping TV shows and the arrogance of coworkers who turned real estate profits was no different than the greed and arrogance found at Wall Street banks, aside from scale. Nobody was forced to buy a house. Nobody was forced to overstretch for a mortgage. Just as nobody was forced to write a mortgage or package them into bonds. People did all those things because they believed it would be to their benefit.

If we look into a mirror, we will see who caused the mortgage-bond bubble. I certainly did my part, upgrading to a pricier house in early 2006. Fortunately for those who purchased my mortgage--the bank sold it almost immediately--I have obediently made my monthly payments.

The Fault in Our Stars My point? "The Big Short" implies that if government clamps down hard enough on Wall Street, market bubbles, and therefore market crashes, may be averted. The business press suggests a similar result--if government is kept at arm's length. Each has a point, but each is deeply flawed in believing that bubbles come from a single, evil source. Bubbles, at least of the very large variety, come from throughout society, and from people behaving … just like people. That is how they become so thoroughly encompassing, so difficult to identify, and so challenging for investors. Bubbles are us.

"The Big Short" was well-made, deservingly packing my local theater, but its main theme is a side track for investors. That Wall Street is packed with sharks is the secondary concern. Sharks are to be found in every occupation, and most Wall Street offerings are far safer and better than 2006-vintage CDOs. The real danger lies not in somebody selling us a bubble that they have created but in selling us a piece of our own bubble.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.