Understanding The Big Short

The financial background to Michael Lewis' film about the subprime mortgage debacle of 2008.

Peter Smith | May 20 2016 | comment

Image: Rocky Lubbers / Flickr

Chances are, you’ll have heard of Michael Lewis, even if you’ve never read any of his work. You will certainly recognise the headline acts in the latest of his books to be turned into a film, starring inter alia Christian Bale, Steve Carrell, Brad Pitt, and Ryan Gosling.

Lewis left Princeton with a major in art history in the early 1980s and spent some time with a New York art dealer and studying economics at the LSE before joining Salomon Brothers, then the king of the mortgage bond market, as a bond salesman.

Salomon led the way in creating and trading artificial devices for selling the income from mortgages on the wider financial markets. Mortgages were typically held by small savings and loan associations in the US, a bit like our building societies. Those associations were conservative lenders, hardly surprising given the many parcels of loans they made each year and the long lifetime of each mortgage. Salomon realised that each monthly repayment, mainly interest with a tiny slice of capital, was a regularised income whose transfer was fixed even if the value fluctuated. Package up lots of mortgages in one tidy group and financial instruments could be created and, crucially, traded on a new, derivative market.

This was appetising both to loan societies, who could pass on the risk of their mortgage book at a profit, and to institutional investors, who wanted an asset that could generate a return higher than other asset classes such as the dividend on stocks and shares or the yield on property investment.

Such money was not free. The risk in the bonds was that mortgagors would default and not pay their monthly dues. That risk was offset by the fact that each bond was a package of differing types, or tranches, of mortgage. At one end were high risk (or ‘subprime’) loans to people who had little chance of making their monthly payments. These were in theory offset by dead certs at the other end, people who would be wealthy enough to weather any economic storm, like a rise in mortgage interest rates or sudden unemployment. Furthermore, underlying each mortgage was the physical home or office secured against it.

Provided property prices kept rising (a big if), mortgage defaulters (divided into foreclosures, where the property was sold, and forbearances, where the mortgage was restructured and payments reduced or delayed) were of little risk to the financial markets.

Liar’s Poker, Lewis’ account of his time in London as a bond seller, is perhaps the classic account of the wild, heady days of 1980s financial capitalism. New products like mortgage bonds hit the markets, and were snapped up by investors who could enter complicated markets like those for derivatives.

His descriptions of the idiot traders, rapacious managers and dupe clients of the mortgage bond market are well beyond the parody of films like Wall Street, with Michael Douglas’ repugnant Gordon Gekko and his infamous, “Greed, for want of a better word, is good”.

The Big Short picks up where Liar’s Poker left off. In many ways, it is a shame that Liar’s Poker didn’t reach the big screen first, because LS is the mise en scene for the financial machinations of TBS.

The growth of the real property market continued exponentially in the 1990s despite the hiccup of a crash and accompanying recession in 1991-1992 which contributed directly to George HW Bush’s unseating by Bill Clinton. Clinton happily continued his predecessor’s policies of easy money and homes-for-all, aided by a grossly-compliant US Federal Reserve.

By the early Noughties, government policy in across much of the developed world, and particularly the Anglo-Saxon, was for every citizen to own their own house. In the US, government policy was to lend to even the poorest, in a bid to give them a place they could call their own. Interest rates were grossly depressed and extremely cheap lending flooded the property market. Not only could casual workers suddenly afford pent-house condominiums, they could buy for their children, their ex-wife and to let as well.

Just as the real property market grew, so did the markets for the financial instruments parasitical on them. Mortgage bonds became mortgage backed securities where the traded instrument lost contact with the underlying mortgages. MBS were traded by their technical or exchange utility, estimated and perceived in the eyes of other buyers and sellers, rather than a mathematical consideration of the actual loans supporting it. MBS spawned collateral debt obligations, where low-quality MBS were repackaged and rated as higher-quality investments, and CDOs were themselves repackaged to form ‘CDO squared’ or ‘CDOs of CDOs’. Complicit in all this were the originating banks, who created (originated) the products, their brokers who sold and traded them, and the ratings companies who, in a desperate scramble for fees from the originating banks, were content to give five-star ratings to any old rubbish.

As with so many bubbles, actors in the market became captured with positive feeling about the rising value of property, the safety of mortgages and financial instruments built on top of them. Heretics were few and far between, and The Big Short follows disparate characters as they come to realise that the MBS market is going to implode. Christian Bale plays a former doctor with Aspergers who realises that the banks who construct the MBS have no clue as to the resilience of the underlying mortgages. He finds a bank to offer him a bet that the MBS market will collapse. The banks think it is he who is a dupe, and are all too willing to create further financial products that swap risk between the two parties either side of the contract, which they justify as insurance contracts on the MBS values. As the MBS market goes up, Bale’s hedge fund looks like a loser as it pays ever higher amounts over each month. It is he, of course, who wins in the end.

The Big Short does a good job of explaining the individual concepts through amusing and visually-effective ways: a chef cooking in his kitchen or a model sipping champagne in her bath, breaking the fourth wall as they speak directly into the camera to tell the viewer sardonically about the techniques for weaponising dull mortgages. The whole style of TBS is of overplayed, fast-paced drama with the hard didactic storytelling slowed down for explanatory asides. Many people left the cinema I attended, decrying TBS as boring. They had come presumably expecting something akin to The Wolf of Wall Street, with its depiction of financial capitalism as a coke-snortin’, hooker-shaggin’, anythin’ goes party. TBS is in many ways much more stylish: it links the personal stories to the national ramifications of the unfolding disaster. As Brad Pitt’s character, a former trader who quit in disgust at the immorality of his work, says, “If we’re right, people lose homes. People lose jobs. People lose retirement savings, people lose pensions. You know what I hate about *&^$# banking? It reduces people to numbers. Here’s a number—every 1% unemployment goes up, 40,000 people die, did you know that?”

I particularly liked the section where Baum and his motley crew head to Florida to see acres of new housing foreclosed by the banks and abandoned by its owners, where the remaining tenants only just manage to hang on each month even before interest rates start to rise. They meet permatanned mortgage brokers who are incentivised by large bonuses to sell mortgages to everyone they meet, regardless of their ability to pay. The role of the brokers shows the fragmentation in the mortgage industry, where sellers sell as much as possible, and lenders lend as much as possible and then sell on the loans to pension funds and insurers like AIG, once the world’s largest insurer, who needed a huge bailout from the US government when the scale of their subprime MBS losses became known. In this system, and TBS could have done a little more to drive this home, no one individual person, firm or institution is to blame, as they are all bit-part-players in a much bigger story. No one can quite see the wood for the trees. The scene gives a feel for the compartmentalised negligence that allowed the MBS bubble to inflate and burst.

This brings me to two criticisms of the story as told by the film (I have only one quibble about its execution: Adam McKay, the director, used too much shaky cam for my liking, and left me a little queasy in places). There are two big elements of Lewis’ story missing from TBS.

First, the innocent explanations of why the mortgage market grew so big are missing. It was birthed in a co-ordinated attempt by governments, national banks, institutional investors and house builders to build more houses for ordinary people. Including this would have leavened the plot, adding balance but, of course, undermining the lopsided polemic anger in the film. Yet surely the viewer is entitled to see at least some of the real complexity of the issue? And it would have provided a segue into explaining the role of government whose job was to see the wood for the trees and supervise and regulate adequately the MBS market as it spiralled out of control.

TBS is aimed squarely at provoking the viewer into agreeing that the ‘one percent’ messed it all up for the rest of us through sheer avarice. But the film doesn’t explain the link between the subprime mortgage crisis and the systemic collapse of the banking industry. It alludes to it: without revealing too much of the plot, it turns out that one of the principal shorters of the vast MBS bubble is betting against the very bank who owns his fund and facilitates its trading; the bank had been a counterparty to the fund’s short position. Because the banks lent vast sums to each other through mind-numbingly complicated arrangements, they found it incredibly difficult even to price (or ‘mark-to-market’) the values of the financial instruments they held. Those instruments were themselves complicated mathematical and legal structures that existed only on paper. The financial nexus linked everyone to everyone else with few degrees of separation—and no one, bar the few figures at the heart of The Big Short, knew how it really worked.

In short, TBS is an enjoyable film. It doesn’t quite have the acting of the first of Lewis’ books to be turned into a film, the excellent Moneyball, about the application of statistics to baseball and the subsequent turn-around in fortunes of the Oakland Athletics, but it does have a better pace to the plot. Lewis’ own follow-up to TBS, Boomerang, follows the MBS saga beyond the US to Europe. In many ways it is an even more cracking book, and I hope the Lewis film series continues.

Peter Smith is a lawyer living and working in London. This article has been republished with permission from Quadrapheme. Follow Peter Smith on Twitter

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Mother Teresa of Calcutta is to be canonised in Rome on September 4. Although her name is a byword for generous service to humanity, the Albanian-born nun has attracted some criticism. Gëzim Alpion, also Albanian, a sociologist at the University of Birmingham, has become an expert on her life, writings and reputation. His bookMother Teresa: Saint or Celebrity? was published in 2007 and another book is on the way. Michael Cook asked him why he is so interested in Mother Teresa, and his answers are intriguing.

Alpion does not follow any religion but describes himself as a “spiritual-rationalist”. He says he is interested in Mother Teresa not because she was particualrly enlightened, rather, because "she was in the dark all her life" -- a reference to her experience of spiritual desolation. He concludes:

Mother Teresa’s hagiographers and friendly biographers should not be afraid that she could become less appealing if we know more about her. On the contrary, the more we uncover about her as an individual, the more her personality and legacy as a missionary would appeal to Catholics, followers of other faith, as well as those who profess no religion.

That must surely be the case.