corruption in the banking industry in the limelight
The 2007-2009 U.S. housing market crash and subsequent global economic recession is one of the greatest examples of bad banking practice, and the catastrophic effects, in history. While many people were deeply affected by the collapse of the housing bubble, few people really understand what happened and what led up to the recession.
“The Big Short” is a 2015 biographical crime dramedy, based on a non-fiction book of the same name, which follows some of the few people who were able to see the housing bubble and forecast its burst. Although the main purpose of the movie is entertainment, it also outlines for the viewer what led to the crash of the housing market and the resulting recession. For that reason, we’re highlighting the film and examining what it can teach us about the biggest banks and the way they’re regulated.
When Michael Burry, portrayed by Christian Bale in the film, looks deeply into the data of what the housing market calls synthetic collateralized debt obligations (or synthetic CDOs), he finds that they’re just a collection of subprime mortgage loans with adjustable rates. Since subprime loans are those granted to people unlikely to repay the loans in full, Burry sees these loans are likely to default in large numbers when interest rates are raised by the Fed. Predicting the housing market crash in the second quarter of 2007, Burry’s hedge fund Scion Capital puts more than $1 billion into credit default swaps (CDS). These swaps, often sold by the same banks which are buying up many synthetic CDOs, insure the buyer in the event of a default. This is the beginning of the eponymous “big short.”
To short an asset essentially means to bet against it, ensuring the investor makes money if the market value of the asset declines. At the time, the housing market was seen as low-risk and incredibly stable, so the banks were more than willing to collect high premiums on CDS betting against the industry, expecting few defaults. Part of the reason the market is seen as so stable is because there is inherent value in land and in homes. However, when you overvalue the subprime mortgages on these homes, and many of them default at once, the value of these loans becomes next to nothing.
Although most in the investment world saw Burry as a deluded outlier, Jared Vennett (a character based on real-world Greg Lippmann) sees the potential in the short. As the global head of asset-backed securities trading, he gets wind of the deal from a fellow banker who sold the swaps to Burry. After hiring a mathematics expert to verify the quantitative data in the CDOs, he decides to participate in the short of the housing market. The high premiums on these CDS lead him to sell a portion, and he reaches out to FrontPoint Partners hedge fund.
This fund is managed by Mark Baum (representing the real-life Steve Eisman), who is completely disillusioned with the financial world and is looking to expose its corruption. Vennett explains to him that subprime loans are being packaged into synthetic CDOs that are receiving AAA ratings from credit rating agencies, but even the incredibly skeptical Baum can hardly believe it. In order to verify, his team goes to South Florida to get a closer look at their housing market, where costs are skyrocketing and many people are receiving subprime loans.
While there, they see that many people are living in homes they can’t afford, enabled by mortgage brokers who are writing subprime, adjustable-rate loans as fast as possible to keep receiving the hefty bonuses that come with them. The people taking out these loans are vulnerable, low-income people with families, with brokers being featured in the film specifically targeting immigrants and sex workers. They then sell these loans to the big banks, who repackage them into synthetic CDOs.
The last group of investors we follow as they successfully short these CDOs is a small fund called Brownfield Fund in the movie, based on real-life Cornwall Capital. After hearing about the housing bubble and investigating, they’re able to short the BB and BBB rated loans, but have to enlist the help of a former securities trader to help them make bigger shorts like Burry’s and Baum’s.
Even as the rate of defaults on mortgages increases steadily, the price of CDOs rises and the ratings stay high. Baum discovers the rating agencies are essentially bullied by the big banks, who threaten to take their business elsewhere if they don’t receive the ratings they want, into giving these products AAA.
Both Brownfield and FrontPoint attend the American Securitization Forum, a conference full of people profiting greatly by contributing to the bubble. Brownfield Fund learns that the SEC considers all mortgage-backed securities stable and, therefore, does not regulate them. Baum talks to a CDO manager who enrages him with the knowledge that the capital in insuring mortgage bonds (many of which are synthetic CDOs) is greater than the value of the faulty mortgages. Everyone involved in the oversight is motivated by their high returns and it has resulted in the extreme overvaluation of the United States housing market. The bankers, insurers and regulators either don’t know or don’t care that this inevitably will cause the bubble to burst.
To make things worse, as the mortgages continue to default, the rating and the value of the bonds stays the same. Brownfield surmises that this is because the banks and ratings agencies are freezing the value while they sell them in anticipation of the crash. In this way, the banks join in on “the big short” to cover their losses and avoid financial consequences. They attempt to leak this story to the press but are turned down by reporters who don’t want to ruin their relationship with Wall Street. Baum’s suspicions are cemented when he learns from an executive at Morgan Stanley that they’ve also been shorting the mortgage derivatives, but have continued to sell them in order to pay for those shorts.
If you’re wholly confused by the economic breakdowns contained in this movie, I assure you, you’re not alone. The movie even makes it a point to imply that these synthetic CDOs are intentionally overcomplicated, so that the people investing in them are unwilling or unable to fully understand what they’re betting on. Alas, this reflects much of the banking industry, where data is often accessible but undecipherable to the average consumer, or even the average financier.
In the end, FrontPoint, Scion Capital, and Brownfield all make a huge profit through their bet against the housing market, able to sell their CDSs before the major downturn in the market. However, they’re haunted by their foresight almost as much as benefit from it; they know better than anyone what this means for the people who were being taken advantage of by this system. The low- and middle-income families who received these bad mortgages would be blamed for not being able to pay for them, even though many of the people that wrote, bought, secured and regulated these loans knew they wouldn’t be able to sustain them in the long term.
The last thing we’re left with is that only one banker was jailed for the bad banking practices which led to the crisis, and that our government bailed out the banks by giving them a huge chunk of our tax money. The responsibility of recovery fell entirely on the backs of low- and moderate-income people. Of course, this lack of accountability signaled to the banks that they could keep doing the exact same thing. They’re still repackaging mortgage loans into what are essentially synthetic CDO’s, now calling them “bespoke tranche opportunities.”
Ultimately, the movie’s goal is to entertain the viewer, and it does a fantastic job, with the performances only enhancing the exemplary character writing. This is why the movie takes the perspective of the engineers of “the big short,” as they’re the only people who truly won in this situation, and every story needs heroes. However, the real-life story is more complex and much more tragic, which the movie hints at but doesn’t expand on. We only see one clip of a man and his family, who they talked to when investigating in South Florida, having to live out of their van. In reality, more about 10 million Americans filed for foreclosure and lost their homes.
This movie is a fun watch for the average viewer, but for the discerning one, there are many lessons to be learned about how our current economic system is flawed. Many in banking and surrounding industries are so driven by the myth of exponential profit that they’re unwilling to see when it’s obviously too good to be true. And indeed, how can we expect any bank to operate honestly when they’re expected to compete with corrupt institutions? This is why the political support of financial regulators is essential, even while it’s rarely discussed outside of financial circles. We need to hold them accountable, making sure they’re on our side like they’re supposed to be instead of representing the big banks’ interests.
Our major takeaway from this movie is that when greed is the major motivator in essential economic institutions, average people are going to get hurt. Banks provide an essential service to our society, by being the conduits through which capital flows. When those conduits are built to funnel money to the top of the food chain, the bottom will eventually weaken and collapse under us all. A healthy economy depends on fair investment in all people, of all classes, so that everyone can contribute and benefit.
To watch “The Big Short” yourself, find it streaming on Paramount+ (as of this article’s publish date on September 20, 2024).
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