The Big Short: I Smell Money

Fact or fiction?

By and
36

Scott Lincicome, The Dispatch’s economics guru and author of the Capitolism newsletter, joins Sarah to fact check The Big Short’s retelling of the 2008 financial crisis and explain how the movie accurately portrayed finance bros. What actually caused the financial crisis? Is The Big Short a story of extreme luck or extreme expertise? And is Braveheart the best movie of all time?

Show Notes:
–Mercatus Center: Housing Was Undersupplied During the Great Housing Bubble

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Comments (36)
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  1. Avatar photo
    Jimmaryann.hayes

    Scott says that the financial crisis destroyed us and global manufacturing. Can he explain how (in non-economist language), or point to an article that explains this more?

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  2. Austin from Atlanta

    I love, love, love The Dispatch, but it seems that almost nobody in this conversation (the podcast hosts nor the commenters) actually read the book! The podcast had almost no connection to the content of the book. I'd rather you skip a month than put out content that isn't credible.

    This would be like if you guys did a podcast about WW2 and then spent the whole episode talking about Germany when the book was about Japan. Almost nothing in Lewis' book is about people taking out bad mortgages. His book was about characters on Wall Street, credit bureau corruption, and the evolution of risk's role in the financial markets.

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  3. Tgfranzen@gmail.com

    It always drives me crazy when anyone discusses the Great Financial Crisis (a moniker that I've never been fond of; I've always preferred the Panic of 2008) and fails to include mark-to-market accounting in that discussion. The sole reason that the problems of increased subprime lending (hidden from the public markets by the GSEs [see Hidden in Plain Site: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again by Peter Wallison]) turned into an economic panic after Lehman Bros. failed in the fall of 2008, and then became a global economic contagion, was the mark-to-market accounting rule put into place by the Financial Accounting Standards Board (FASB) in late 2007.

    We never would have seen AIG, Bear Stearns, Lehman Bros., and numerous banks fail if mark-to-market accounting hadn't been effectuated by FASB. Or, put another way, there never would have been a panic in late 2008; thus, there never would have been a need, or an argument for the need, for government bailouts.

    The following is quoted from First Trust Advisors' Chief Economist, Brian S. Wesbury's, Monday Morning Outlook email of 2/23/2009 entitled "Don't Nationalize; Suspend Mark-to-Market":

    "Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.
    The history seems clear. Mark-to-market accounting existed in the Great Depression and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
    Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But, when FASB 157 went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
    Two things are absolutely essential when fixing financial market problems – Time and Growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
    Because these accounting rules force banks to write-off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.
    And this affects growth. By wiping out capital, fair value accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It’s a vicious downward spiral.
    In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the US cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed (even though roughly 3000 banks failed); without creating an economic catastrophe.
    In Japan, during the 1990s, the government allowed banks to operate without ever even recognizing bad loans, which certainly bought time. However, Japan increased taxes, which undermined growth, creating an economic catastrophe. The real problem with Japan was not zombie banks, it was that there was no growth. After all, foreign banks were allowed to lend in Japan, but stayed away because the economy was not vibrant.
    Suspending mark-to-market accounting is a cost free way to buy time. It does not allow banks to sweep bad loans under the rug. Bad loans are still bad loans and banks cannot hide from them. Not suspending it, while at the same time interfering in the economy with massive stimulus bills and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more."

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    1. Avatar photo
      JohnF

      This works when the investments that are being held are all standard investment instruments associated with AAA level entities. As we saw with last year's mini-banking crisis, forcing BoA or JP Morgan to value their portfolios of US Treasury Bonds (which they plan to carry to term) quarterly can often distort the value of their balance sheets. $100B of 5-Year T-Bonds might only be worth $80B three years in, but that's only a problem if the bank has to sell them. Otherwise the bank will recover the full $100B at the end of the 5 years. Unless, of course, the US Government defaults (highly unlikely)

      However, Lehman Bros and Bear Stearns (which were brokerage houses, not banks) were not carrying large portfolios of AAA US Treasury Bonds. What they were actually dealing in was large portfolios of complex derivatives (including derivatives of derivatives) that had been given excessively optimistic ratings by the credit agencies. These companies took loans that had been generated by other financial institutions, packaged them up into securities, and sold them on the open market to investors. Companies like AIG (also not a bank) then issued insurance policies (credit default swaps) against the risk that some of borrowers within these securities would default. However, by the time the first signs of crisis started to appear, the problem was that it was exceedingly difficult to accurately assess the underlying value of these investments, the market was turning against them, and the underlying risk was unknown. Companies like Bear Stearns had built their businesses on leverage, relying on short-term loans to buy and trade these investments and offering their own derivative portfolios up as security against these loans. When it became extremely difficult to value this collateral, their lenders stopped advancing the short-term loans. Meanwhile, the instruments they were trading were steadily dropping in price.

      Bear Stearns didn't fail because of mark-to-market accounting, they went out of business because they ran out of money.

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    Abraham.Gerving

    Scott is absolutely correct in saying the Spider Man movie was one of the best from last year!

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    JohnF

    So ... two points:

    1. If you're going to call this a "book club", then it should discuss books. Otherwise, you should call it a "Movie that someone made based on a book" club.

    2. Too much time was spent focusing on the housing market (and deriding it as a cause of the financial crisis) and too little time spent on the derivatives market. The thing that ultimately triggered the collapse of Lehman Brothers, and what threatened to bring other large financial institutions down, was the development of complex securities that were sliced-and-diced so many times that it became impossible to determine what they were actually worth.

    The book goes into more detail on this, while the movie largely covers it using Margot Robbie sipping champagne in a bubble bath (again, see point #1). The problem originally started with Mortgage-backed Securities, which were perfectly fine investments that pooled high-quality mortgages and divided the pool into shares. This allowed investors to earn higher returns and made mortgages more available. So far, so good. However, these things became a lot more popular, which meant that more MBS's were needed, and which ultimately meant that, since the supply of really high-quality mortgages was finite, lower-quality mortgages started being included in the pools. This was still fine, as long as the contents of the underlying funds were visible and transparent.

    Cue the creation of Collateralized Debt Obligations (CDOs), which pooled together various MBS's and then sliced that pool into shares that were sold into the market. CDOs became really popular, which meant that financial institutions wanted to create more of them, which meant they needed more MBS's, which meant they needed to sell more mortgages. Since these mortgages were quickly securitized and moved off of the bank's books, there was less attention paid to the mortgagee's ability to repay the loan (this is where the "stripper with five houses" comes in as an entertaining example). Scott is correct to say that many of the people who were given these mortgages were capable of sustaining them, but the ultimate problem was that - by the time each stripper's mortgage had been sliced and diced and pooled together with other mortgages of varying degrees of quality, 𝒏𝒐 𝒐𝒏𝒆 𝒄𝒐𝒖𝒍𝒅 𝒔𝒂𝒚 𝒇𝒐𝒓 𝒔𝒖𝒓𝒆 𝒉𝒐𝒘 "𝒔𝒆𝒄𝒖𝒓𝒆" 𝒕𝒉𝒆𝒔𝒆 𝑪𝑫𝑶𝒔 𝒂𝒄𝒕𝒖𝒂𝒍𝒍𝒚 𝒘𝒆𝒓𝒆 (even though the bond-rating agencies had initially given them high ratings). This then became further complicated by the invention and issuance of even more complex instruments like synthetic CDOs and Credit-default swaps.

    By 2008, some large financial firms and hedge funds not only had too large a portion of their asset base in these investments, but they had also leveraged themselves heavily to acquire them. Once people really started to look at the composition and creditworthiness of some of these instruments, their price started falling which decreased their value and meant that the assets of these firms were much smaller than had been thought. "The Big Short" was not so much a "bet against the housing market", as it was a bet against the securities that had been created out of the mortgage market.

    There's obviously much more detail to the story, but this comment is already way too long.

    I'm surprised that Scott missed this aspect. Perhaps if he were to read the book?

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    Richard Maxton

    Ya know, maybe do a"Movie Club" if that's what the topic is going to be. I came here for "Book Club" stuff, and y'all mostly talked about the screen adaptation.

    Phooey.

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      JohnF

      Steve needs to implement a firm editorial policy that says that any time an author's work is discussed on a podcast, at least one of the participants in that discussion must have read the author's work.

      I had the same problem with the recent sci-fi discussion between Jonah and David French in which the two of them tried to compare Herbert's "Dune" with Asimov's "Foundation". Unfortunately, neither of them had actually read any of the Foundation books and instead based all of their opinions of Asimov on the Apple TV series of the same name (which bears about as much of a resemblance to the original trilogy as I do to a 19-year-old female track star).

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      1. Austin from Atlanta

        So glad somebody else empathized with the nerd agony I went through during that discussion!! I was all but pulling my hair out as two intellectual heroes made such garbage points on a topic that would be fascinating if they’d just read the books!

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        Richard Maxton

        Sure, but at least that discussion was in The Skiff; this is expressly advertised as "The Book Club".

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          JohnF

          No argument there. I agree that this is a more egregious offense.

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  7. Lindayoder@Hotmail.Com

    Thank you for explaining the "mystery" of the length of the great recession. Had it really been caused by what popular belief held, the recovery would have been robust. A lot of government hubris was involved. Every time an entity as powerful as government thinks it can "solve" a problem, watch out.

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  8. David Koziol

    I've always had a huge problem with the conventional wisdom regarding the 2008 mortgage and financial crises (they are related but distinct). This conventional wisdom is something like:
    1. Deregulation cause the mortgage crisis because it enabled banks to commit fraud and fuel reckless speculation by securitizing mortgage loans.
    2. Derivatives, like swaps, turbo-charged the reckless speculation because nobody knew how to use these complex financial instruments well enough.

    While I enjoyed the movie The Big Short and thought it described a surprising number of things right, ultimately it pushed the above narrative.

    A better explanation of the financial crisis was that it was essentially a bank run. Various debt markets ceased to function when lenders refused to continue lending in those markets because of counter-party credit risk. For example, Lender A won't provide a short-term commercial paper loan to Borrower B because Lender A does not know how much exposure Borrower B has to Lehman Brothers, which was in trouble with too much mortgage backed securities that were tanking. Lehman Brothers did get into trouble due the mortgage market, but it wouldn't have turned into a crisis without Lehman becoming a counter party risk. Economists like John Cochrane have endorsed this view.

    Another problem with the conventional wisdom comes with where the TARP money went. Almost half of the 635 billion in TARP money went to Fannie Mae and Freddie Mac (government sponsored entities), AIG (an insurance company regulated in NY state) and General Motors, GMAC and Chrysler. Hard to see how deregulation of the banks would have caused those institutions to have problems.

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    1. Austin from Atlanta

      Do you believe that the credit agencies provided untrustworthy ratings to Wall Street, who thereby took risks in the derivatives market with unexpected (or unhedged) compounding effects? That was the core of what Lewis argued. Your third paragraph doesn't seem different from Lewis's argument.

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      JohnF

      Re #2. I just posted a long-winded explanation elsewhere, but the gist of it is that it wasn't so much that nobody knew how to use these derivitives well enough, but rather that it became really difficult to say how much they were actually worth. Although the bond-rating agencies had given them high ratings, the reality was that these agencies hadn't done proper diligence, so something that had been rated AAA (with, say, a nominal $100 value) might actually, in fact. have a CCC rating and be more appropriately valued at $60.

      So, when a firm has a large amount of its asset-base tied up in these instruments (which are falling in value), or when it's trying to trade these instruments in a market that has become completely illiquid because the market can't establish a price anymore, things start to go south quickly. Add into that companies like AIG, which was supposed to be a boring insurance company, but had "peppered things up" by writing policies providing insurance against derivatives losses, and things quickly extend well beyond one shaky financial institution.

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  9. Austin from Atlanta

    19:25 - “His Sam Bankman-fried thing maybe proves that it’s been luck, more than it’s been good.”

    What an atrocious take. Michael Lewis is one of the greatest living writers in the English language, if not the greatest. His cadence and formation of sentences is unparalleled. The only modern authors I can think of who come close to Lewis in their mastery of the essence of written English are CS Lewis and Kevin D Williamson.

    Lewis is a romantic (in the philosophical sense) with a heavy progressive technocratic bent. I rarely (if ever?) agree with his conclusions, but I devour his books and columns because he is so much better at writing than everyone else. He makes art of the English language.

    His journalism is pretty good, though often overly sweeping in its conclusions. His political analysis is sub-par and naive. But his writing and storytelling are discredited if merely called exceptional.

    Popular demand is not the most valuable metric, but nobody accidentally produces a half-dozen #1 nonfiction best sellers and the basis for three major motion pictures.

    Admittedly, he’s been in a slump for several years & his last three books have been among his worst. He ventured too far from his home turf to write current events books about Trump and Covid. When he tried to get back on track, the rug got pulled out from under him when events took the story in a completely different direction from the book he was writing.

    He’s far from perfect, but he is a genius and a master.

    And even to address Sarah’s clarifying point that “he keeps picking narratives that aren’t true but feel true to us,” this is again unsupported by the facts. His book Next is about a guy of whom no one has ever heard. Liar’s Poker is largely an autobiography and widely considered his greatest work. Home Game, about fatherhood, moved me to tears. Flash Boys, my favorite book by him, is about a topic most people remain unaware of & people/firms nobody could name.

    It’s not reasonable to discount an author if you’re only familiar with a quarter of his work (seemingly as much from movies as the books) & if the criticism is that they were of the wrong genre (i.e. they should have been Lincicome-esque policy deep dives rather than character stories.)

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      Richard Maxton

      “His Sam Bankman-fried thing maybe proves that it’s been luck, more than it’s been good.”

      --I didn't take her to mean his writing style or topics so much as his (as you admit) often overly sweeping conclusions and sometimes bad analysis. A book can be well done and still wrong.

      Every book of his I've read, I've enjoyed as far as his ability to create an easy-to-follow narrative. But I don't think I'd go so far as to call him "one of the greatest living writers of the English language".

      "Popular demand is not the most valuable metric, but nobody accidentally produces a half-dozen #1 nonfiction best sellers and the basis for three major motion pictures."

      --Yes but at some point, the Name becomes the Brand. Just ask Dean Koontz or Tom Clancy.

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      1. Austin from Atlanta

        I guess I'm reacting to the idea that it is "luck." I just see no basis for that claim at all & given that Sarah is a really sharp thinker, it just kind of shocked me what a miss that was.

        I wouldn't argue that he is one of the most prolific authors in the English language as that is almost always going to be producers of fiction. But from a technical writing perspective: structure, grammar, playfulness, word choice, etc, there really aren't many (if anyone) who do it better than Lewis. He has introduced wholly new turns of phrases like "big swinging dick" into the public vocabulary that are now repeated by millions of people who have never read his work. It's not Shakespeare, but it's an author who knows exactly how to communicate his points to his readers in a way that the written word is an asset rather than a barrier that must be worked through to get to the point.

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          Richard Maxton

          All fair.

          I took the "luck" comment to mean that the narrative Lewis had set up (definitely in the Big Short and at least somewhat in Moneyball off the top of my head) were taken as gospel when the books came out. It took a while before the opposing POV set in and was eventually seen as as correct if not more-so.
          Sarah's mention of SBF book is the counter example on the "luck" thing, where it didn't hold through release.

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  10. IHFraser

    First, I hadn’t realized that this book club was mostly a hit piece on Michael Lewis. I wonder what he did to earn Ms. Isgur’s spleen.
    Second, with great respect to Mr. Lincicome, the analysis in Mr. Erdmann’s article (and in his 2021 book, “Shut Out”) isn't terribly persuasive.
    Let’s take one example:
    In 2005, “[t]he number of single-family home starts, especially single-family homes built for sale, did rise to unprecedented levels. That is a high-profile category, where publicly traded homebuilders operate and where many families become new homeowners. But the other categories were either stagnant or in decline over the long term. The growth in single-family homes built for sale came mostly by taking market share from the other types of units.”
    But wait! The derivatives that fueled the crash weren’t based on “other types of units”. They were created almost exclusively out of mortgage pools financing single family homes—and even Mr. Erdmann notes that single family home starts did rise to “unprecedented levels”.
    Okay, but is there any evidence that these “unprecedented levels” simply represented single family homes “taking market share” from other kinds of housing? Were these other categories “in decline over the long term”? The answers show up pretty clearly in Figure 3 from Mr. Erdmann’s article, and the answers are “No” and “No”—at least if the “long term” is the fifteen-year period from 1990-2005.
    Immediately before the not-a-bubble that didn’t burst, starts of multi-unit dwellings reached their highest levels since the mid-80s. For manufactured homes, shipments had indeed been falling steadily since 1999, but from August 2005 to November 2005, they shot up from 124,000 to 210,000, a level that hadn’t been seen since October 2000.
    Overall, figures from the Department of Housing and Urban Development show that total housing starts had been rising steadily since January 1991 and, in May 2005, reached 1,975,000 units (2,273,000 if seasonally adjusted) the highest level since May 1978 (March 1978 for the seasonally adjusted number).
    Mr. Erdmann thinks that even at these levels, the housing market was undersupplied. That is possible, of course, but demonstrating that would require a much more sophisticated analysis of demand patterns than Mr. Erdmann has offered up to date. However to suggest that the overall number of housing starts hadn’t shot up to its highest point in decades is to ignore the evidence laid out in his own article.
    Yes, regulatory tightening did make refinancing more difficulty for many borrowers, but the real problem for a huge number of them was that they did not have sufficient income to support their debt at anything but the illusory “introductory” interest rates that had originally been charged on their loans. Even if the overall borrowing market hadn’t tightened, a huge swath of sub-prime borrowers were inevitably headed for default on renewal. That is what started the cascading failure of the Rube Goldberg derivative market that had been constructed, in part, on the back of those improvident loans.

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    1. Austin from Atlanta

      Lewis’s argument in the book was that novel securities mechanisms were combined with potentially fraudulent credit ratings, thereby causing Wall Street to make terrible decisions. It is almost wholly unrelated to what Sarah and Scott discussed based on their recollection of the movie.

      The discussion does not come across as if they’ve read the book. Perhaps they have, but if they did, they didn’t bring anything from that experience into the discussion.

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