For most people, the events of 2008 and 2009 are shrouded in mystery. Millions lost their homes and jobs, banks went out of business or were absorbed by other financial institutions, and there was constant political tension about what the proper response by the government should be. The Big Short is the film adaption of Michael Lewis’ book by the same name and it sought to give both an explanation of the crisis and also to cover the stories of several investors who anticipated the financial collapse and invested accordingly, aiming to earn a large profit.
The story surrounds and largely focuses on the phenomenon of Mortgage Backed Securities (MBSs), Collateralized Debt Obligations (CDOs), and other “complicated” investment securities that became heavily invested in during the 2003-2007 financial boom. Essentially, these bonds were stuffed full of all kinds of bad mortgage loans; loans which were extended to people with no income, low FICO scores, and other various risky situations. In the context of the storyline, it was fund manager Michael Burry who first caught on to the underlying risk in these securities and, while the entire nation was drunk on the false prosperity of the boom phase of the business cycle, decided to bet big against the entire financial system. In financial industry jargon, Burry “shorted” (basically, betting against) the housing market. And a Big Short it was: to the tune of $1.3 billion in credit default swaps. As the story portrays, the banks snickered and grinned as they happily took Burry’s $70 million premium payments, under the assumption that it was a risk free bet; after all, Alan Greenspan stated multiple times that the profitable housing sector was here to stay.
Moreover, as the storyline goes, there were several others who had picked up on Burry’s big bet. An independent hedge fund manager who had set up shop under the Morgan Stanley umbrella, Mark Baum, stumbled upon Burry’s move after a trader (Jared Vennett) accidentally phones in directly to Baum’s office instead of the Morgan Stanley main line and ends up convincing Baum to join in the “short.” Besides Baum, the storyline features two other young investors who managed their own money and after hearing of Burry’s investment, decide to go all in with the help of a (retired) ex-banker who had previously left the banking world in disgust.
As the film neared the infamous day of the Lehman bankruptcy, we see the fraudulent behavior of the ratings agencies on full display. As the underlying mortgage assets that made up the bonds began to fail, therein making the bonds themselves junk, the ratings agencies kept the “investment grade” stamp exactly where it had been during the early years of the boom. After being confronted by an angry Mark Baum, the employee at Standard and Poors bluntly explains that, if the ratings agency changed their tune, the banks would simply seek business “down the street” at Moody’s.
As the film progresses, one is able to see the slimy culture of the Wall Street world: it’s moral depravity, it’s shady wheelings and dealings, its unwillingness to step back and consider the sustainability of the boom era’s excesses. Thus, the first lesson to be had is always the toughest for financial advisors and investors in general: betting against the flow is a difficult move. Those participants in the “short” immediately become the laughing stock of their circles; the objects of mockery and dismissal. Indeed, the emotional train ride that they had to go through as they, in the short run, found their positions to be down 9, then 11, then around 20% down. The toll was especially and visibly difficult on Michael Burry, who was constantly flooded with furious investors via phone call and emails, demanding their money back.
In the end, of course, the bet was a major success. The banks realized they were in deep trouble and began to seek out the film’s short investors to buy out their positions. But of course, when the banks buckled in this way, the end was obviously near. Bankruptcy was imminent as millions of mortgages went into default. As a result of their short position, Baum hit $1 billion in profits, the two young investors $205 million, and Burry achieved a 489% return. But here is the thing about winning the jackpot at such historical levels: you may win so big that no one can afford to pay you. Of course it’s bad for the losers like Morgan Stanley and Lehman and Bear Sterns; but guess what happens if the losers owe you hundreds of millions of dollars? For example, the two young investors managed to unload only $85 million worth, a majority of which went to UBS. Of course that’s a nice profit from their original $30 million, so they took what they could and bailed.
But as Brad Pitt’s character (who was the ex-banker helping out the two young guys) pointed out right before the crash: they were betting on the downfall of the housing market; which meant, if they were right (which they were), they would be profiting as millions of American felt the pain. While this wasn’t meant to criticize the profit opportunity that the investors took, it does express the type of resentment that main street began to have for Wall Street. Of course, this resentment, and really the fuel for the current populous sentiment against “the 1%,” was exacerbated by the stunning announcement that the Federal Government, in cahoots with the Federal Reserve, that disastrous engine of the American banking system, was going to bailout the financial system. Which leads me to my final set of observations.
The film did a great job of simplifying the mysterious concepts of financial instruments and educating the viewers as to what was going on in the technicalities of the trades and investments. It was entertaining, sprinkled with humor throughout, and succeeded in “humanizing” the world of investing. While overall the film was excellent in demonstrating the culture of Wall Street and the bravery of those who bet against the market, it is in the “lessons learned” area of the film where most of my criticism lies.
For one, the entire business cycle, the boom and bust cycle with times of artificial and unsustainable “prosperity” followed by painful depressions, is created by the Federal Reserve system and its various monetary expansion schemes. And yet, there is not one mention of the Fed. All the bad loans created during this time came from the expansion of the money supply and yet this entire part of the story, unsurprisingly, was not mentioned. All the MBSs and CDOs that the film makes the center of the story would not have been possible without the cheap credit encouraged by the various “monetary tools” (which are basically various means of money creation) of the Fed. The banks then, while rightly portrayed as manipulative and destructive agents of the monetary system, have been given their power as a result of the Federal Reserve system itself. That is, under a free market, “the banks” would not have taken on all the speculative risks and morally dubious financial shenanigans.
It must never be forgotten that investment banking and speculation is an important role of the market process. The corruption of these aspects of the modern economy is a result of government intervention into the banking sector. Thus, blaming “speculation” and “greed” for the crisis ignores the root problem. These do not have the ability to actually explain the cause of this tragedy.
Second, the film’s implied “solution” to these events is more regulation, more government oversight of the banking system. But this is not what is needed at all. Contrary to popular opinion, lack of regulations are not the problem. The Fed is. More regulations is like putting on a bandaid to cover up the patient’s internal bleeding.
Third, it should never be forgotten that the excesses on Wall Street during this time, followed by the years of pain experiences on main street, and also the bailouts of the largest financial institutions, have nothing to do with capitalism and free markets. Capitalism is about profit and loss, therefore bailouts are excluded from a capitalist system. Moreover, free markets are not such that there is a government granted monopoly of the banking system and a government mandated fiat currency. It is due to the Federal Reserve system (which is arguably socialistic [at least in one sense of the word]) that commercial banks are encouraged to fraudulently create unbacked currency (known as fiduciary media— see my taxonomy of money) for the purposes of extending loans, which results in
- the lowering of interest rates;
- the investment in projects which the economy is not ready to take on;
- the grand misallocation of scarce resources;
- the eventual realization of said misallocation;
- the defaults and liquidation of the bad debt; and
- the resulting depression.
This is not a failure of capitalism. It is a failure of socialism that should invigorate us to give capitalism and free markets a true chance.
The bailouts, however, while certainly absurdly unfair and crony, are bad for a whole other set of reasons as well; namely, they represent a declaration to the world that the Federal Reserve is not done. It wants to continue inflating the money supply. It wants to continue operating under the assumption that it’s wise policy decisions can bring prosperity in our time. Unfortunately, this means the bubble is back. The central bank refuses to let the economy normalize on its own, it refuses to “let the market system work.” And the medicine it has offered since 2008 is the very drug that sent the patient to the ER in the first place: inflation.