Let’s pause from the Blog’s emersion in the depressingly Ptolemaic nature of modern macro research. This week, I want to comment on a movie.
The Big Short must have been recently posted on some streaming service. A non-economist friend went out of his way to tell me he had just seen it and now, finally, understood the Great Recession. I remember enjoying the film but thinking that its success was probably due to the script having very little to do with the nature of the financial crisis and virulent extreme instability that threatened to plunge the U.S. into a second Great Depression. But my friend is smart, so I bit the bullet and just watched, fast-forward in hand, The Big Short for a second and final time.
The exercise was useful. It is pretty scary. It made me think through the implications of smart people – my non-economist friends – believing that what was dramatized comes close to adequately explaining the near-collapse in 2008-09. If people believe that there may be little hope for constructing effective macro stabilization policy to deal with future crises.
This review centers on three of the problems with The Big Short’s script. First, we are supposed to believe that only the stars of the movie, self-identified “smartest people in the room” (SPR), understood that subprime mortgages had substantially higher risk of default than standard residential loans. Wrong. Everybody in the mortgage-security business knew about that outsized risk. I was there when the Fed Board of Governors was briefed on the subprime problems, including the remarkably broad incidence of criminal falsification of borrower income, in 2006. Everybody also knew that the trick to making money on that insight is not the insight itself; it is getting the timing of the predicted subprime default right.
Options used to bet on an asset’s falling price are expensive and expire relatively quickly. Money wasn’t made by identifying underpriced subprime-mortgage risk; it had to be made by figuring out when the mortgages would default. Timing defaults is a much tougher task that had already cost many who had prematurely shorted subprime paper a great deal of money. Our heroes weren’t SPRs; they were instead latecomers to a room populated by a large number of Wall Streeters who already believed subprime-mortgage prices would collapse but did not know how soon. If you can believe the film’s timeline, I believed the collapse would eventually occur well before the film’s SPR even understood there was a problem. But I also knew that I didn’t know enough about when collapse would occur. The reason that our heroes made money was the same reason why ill-informed speculators sometimes make money. They were lucky. (Recall their panic in the film when the subprime-mortgage prices did not fall immediately after the bought their shorts.) There appeared to be a big opportunity in the residential mortgage market; somebody had to get lucky about the timing.
Second, and most important for the rest of us to understand, subprime mortgages did not cause the Great Recession. A big chunk of its audience apparently were convinced that it did. But it didn’t. It didn’t close. The Great Recession, like all economic downturns, is separable into an originating macro shock and its propagation by weakening total spending. That decomposition identifies the two classes of policy that appear available to prevent a recurrence of the huge welfare loss, estimated in the many trillions of dollars, resulting from the 2008-09 extreme instability: (i) prevent future financial crises and (ii) prevent their propagation via. An important message of the GEM Project, closely argued and supported in earlier posts to this Blog, is that the only effective option is the second, restricting the propagation of shocks via effective interventions in total spending.
Third, it turns out that outsized subprime-mortgage defaults did not actually occur during the 2008-09 financial crisis. That is most embarrassing to the self-styled brilliant speculators who inspired the film. They as well as most of Wall Street, the Fed, and many others (including me) got the fundamental bet in The Big Short, what we are supposed to believe made our heroes the smartest people in the room, wrong. Their analysis of the fundamental creditworthiness of subprime mortgages, setting aside timing, wasn’t at all smart. It was wrong. The inescapable conclusion? Those guys were really lucky. Blind luck was the only thing they had going for them.
The Financial Crisis Inquiry Report (2011) identified the actual default behavior of subprime and other exotic mortgages: “Overall, for 2005 to 2007 vintages tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades, only about 10% of Alt-A and 4% of subprime securities had been ‘materially impaired’ – meaning that losses were imminent or had already been suffered – by the end of 2009.” (pp. 228-9) Such losses are way below what our heroes and the rest of Wall Street expected.
The evidence is more than another comeuppance for the movie’s self-proclaimed smartest people in the room. It provides further support for the conclusion that subprime defaults could not have caused the Great Recession. But, even more telling, it shows that subprime borrowers, with their remarkably low default rates, didn’t cut and run as most financial experts confidently predicted. Perhaps the real moral of the film is that our smarmy heroes were fundamentally wrong about the honesty and reliability of subprime borrowers. Alt-A borrowers, a much more wealthy class of home-owners, had a much higher default rate. Perhaps our heroes were simply projecting their own behavior if they were to confront similar circumstances. Cutting and running, sticking someone else with losses if you can, would be the smart thing to do.
Blog Type: Policy/Topical Saint Joseph, Michigan