# What actually went wrong in the economy as described by "The Big Short"?

Part of my personality is Engineering, so I look for root causes. I suppose that the cause of any bubble is "speculation", which just means pretending that ghosts are real, or that the word "LION" is an actual Lion. (So ironic when it eats you.) But because this has happened before, would someone please explain the chain of causality from people buying houses to the world economy nearly failing, through the sideroads of drinking and strip clubs? Was it just that people were selling the "actual value" of a long term asset like a house or land, and using it to buy immediate disposable things with no value, like drinks and entertainment?

What is the basic human failing that allows people to seem to do this repeatedly and not learn from it? I don't want to hear "greed". Greed is one person acting one time. I mean: how can people believe in ghosts? How can many many people pile on thinking that something holds up the entire scheme, and that it will not eventually come crashing down and crush them inside? How can people make this particular mistake? "Stupidity"?

• At the moment, this question reads like a long rant. I'll revisit it once rewritten to remove the fluff and the accusations are kept at a decent level. Mar 22 '16 at 13:14
• @FooBar Holy Cow, you changed the title to remove the original question entirely? I guess I am wondering how you think? With no reference to the movie "The Big Short" the question makes no sense whatsoever. I was asking how individuals can make poor choices, not investment bankers (who act on behalf of others). You need to rewrite the question properly or revert it.
– user7706
Mar 22 '16 at 23:01
• Calm down. This site is about the science of economics. If you want to ask questions about science fiction, please refer to either movies or science fiction at stackexchange. The question needs no reference to pop culture, and "how do individuals make choices" is still a valid title, without referencing that. Mar 23 '16 at 5:49
• I've reverted the revision on the grounds that it changed the meaning of the post (see meta.stackexchange.com/help/editing). @FooBar, I believe an alternative would be to suggest other ways to improve the post or to recommend closing the post. Mar 27 '16 at 0:19
• I'm voting to close this question as off-topic because it is in its core about a movie, and not economics. Mar 27 '16 at 5:33

The problem at the bottom of the 2008 crash is that the values of multiple instruments were dramatically over estimated because the risk of default in the various underlyings was dramatically underestimated since it was assumed that they were fully backed by the US government.

Although many commentaries focus on the securitization of debt that was not where the real problem lay, in fact the securitization of sub-prime mortgages into CDOs (collateralized debt obligations) covered by CDSs (credit default swaps - a type of default insurance) was as a result of firms wanting to divest themselves of risks surrounding unknown quantities.

In the (first?) Clinton and Bush administrations there was a political will (rightly or wrongly; it isn't important) to help people buy their own homes. This applied particularly to low income families who previously had not been able to buy, in many cases for generations. To do this bills were passed to offer subprime loans with the implicit backing of the US government. Since these people had never been mortgage borrowers before their ability to repay was not well understood or modelled and came with an assumption that they would continue to have jobs and that their homes would be worth at least what they paid for them. These extra buyers put upward pressure on the housing market (i.e. buyers exceeded sellers so prices rose) meaning that it looked like that latter assumption would prove true at least.

The mortgage companies then had a large tranches of debt on their books that, although apparently backed by Sam, were riskier than their previously core business. To mitigate this risk they rolled them up into CDOs which, given that the probability of any one loan defaulting was taken to be independent of any and all others defaulting, supposedly held lower risk than the individual loans. To further reduce default risk these were further rolled up with high credit rating corporate, municipal, and national bonds. In case there was a default in these wrappered securities insurance companies, such as AIG, wrote CDSs that would pay out a sum to cover losses in return for premia (as is usual with insurance).

Then the economy slowed down a little, house prices started to stall, and unemployment rose. As people who were the borrowers in these subprime mortgages had wages cut and lost jobs they began to default on loans and the value of the collateral (the house) fell, sometimes to less than the original value at purchase, as the bubble burst. The assumption that defaults were uncorrelated turned out to be unfounded and, as you can probably guess, that triggered CDS payouts and huge losses for many of the companies holding the CDOs and writing the CDSs. Drinking and strip clubs were basically what the borrowers preferred to spend their money on instead of their mortgages. Slightly less glibly the value of their house counted as an asset to them against which they could take out further debts (credit cards, personal loans etc.) so that they could afford to live outside their means under the assumption that they would pay it back using future months' salaries. When they lost their jobs they could no longer do so. Remember from earlier that these were people who had never been offered credit before and even professionals make mistakes in their finances when it comes to credit and loans so they were doubly cursed by a lack of understanding of credit and a lack of experience.

A major issue in all of this was hubris and people's belief that current trends would never end; the economy had been growing for the longest time in recorded history therefore it would continue to and everyone would always be employed and able to pay their bills. Add to this that the managers of the funds etc. that held these debt based derivatives believed that their models of the risks of holding them, underpinned by the fallacious assumption of the lack correlation of defaults, were accurate and would model potential profits and losses, and that, in any case, they had insurance if anything bad happened and you have the problem.

These were massively leveraged positions in little understood instruments that wrapped around very risky debts for which there were no good models of repayment and default rates, and those models that did exist did so under the fatefully incorrect assumption that defaults would be totally independent.

• Thank you for such a clear, complete and understandable explanation! OK. So, we "let" people buy houses who should not have been able to. In fact, the government pushed that. So, the government bailed out "some of" the people following the projection when it was wrong. But... the government gets its money from people, who hold jobs, etc. Hmm. Still a bit fishy. This little experiment cost many people their jobs and homes who were NOT speculators, around the world! Perhaps we will be loathe to try something like that again? Or not? Did humanity learn anything from this?
– no comprende
Mar 18 '16 at 12:26
• I hate to tell you that it wasn't an experiment; it has basically been policy for both sides of the political spectrum for almost 100 years. This is why house price inflation is so high.
– MD-Tech
Mar 18 '16 at 12:28
• (+1) This is a very good summary of the non-structural interpretation of the 2008 crisis. Mar 19 '16 at 1:04
• This answer, though no doubt written with the absolute best of intentions, is actually dead wrong about a number of basic things and I worry about the future of this site given that an answer with zero references and major errors has received so many upvotes. Mar 22 '16 at 1:29
• @dismalscience This answer was posted before it was migrated here. Mar 23 '16 at 8:54

The answer offered by @MD-Tech is unfortunately profoundly wrong on a number of its core assertions. I will first correct these assertions (and offer references while doing so) and then very briefly offer a few points that should put the 2008 crisis in the proper perspective.

TL;DR: Government guarantees on mortgages didn't play any role in the crisis; CDOs and CDS played a role in keeping the mortgage pipeline running as long as it did but private-label MBS were the security that played the central role in the crisis; and the actual reason that mortgage losses almost destroyed the global economy is that private-label MBS had been heavily funded using repo, which transformed mortgage debt essentially into a form of money, and when the market went south, it led to a run on wholesale bank funding that amounted to a massive contraction of the broader money supply.

First, the errors:

Error One: Implicit Government Guarantees

In the (first?) Clinton and Bush administrations there was a political will (rightly or wrongly; it isn't important) to help people buy their own homes. This applied particularly to low income families who previously had not been able to buy, in many cases for generations. To do this bills were passed to offer subprime loans with the implicit backing of the US government.

This assertion is untrue. No bills were passed in the 1990s to offer subprime loans with the implicit backing of the US government, and government-backed loan channels (including implicit backing) actually lost significant market share prior to the crisis. You might be thinking about the Community Reinvestment Act, which was blamed by some conservatives for the crisis, but this view is not held in high regard by economists. The Financial Crisis Inquiry Commission Final Report has this to say on the matter (p. xxvii):

The Commission concludes the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.

There are two main channels (I am ignoring the VA, Farmer Mac, and other small entities) that offer credit protection on mortgages: the Federal Housing Administration, which insures loans that are then issued as securities through Ginnie Mae (and are explicitly backed by the full faith and credit of the US government); and the GSEs, Fannie Mae and Freddie Mac, whose securities received implicit government backing. Both the FHA and the GSEs do engage in some amount of lending to borrowers who would be considered under some definitions to be "subprime," and have for decades.

However, let's look at the pre-crisis boom period from 2002-2006, during which house prices nationally increased by an average rate of about 14% annually:

And let's see what happened to the government share of mortgage originations:

This should make it very clear that during the boom period, GSE originations fell significantly, while private (that is, no government backing, implicit or explicit) originations expanded from about 50% of the overall market to about 70% of the market. Both of the above graphics are pulled from the Financial Stability Oversight Council's 2013 Annual Report, which notes (page 57):

In 2012, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA) guaranteed 20 percent of originated mortgages. FHA- and VA-guaranteed loans make up a majority of Ginnie Mae MBS issuances. Between 2001 and 2007, FHA lending accounted for less than 5 percent of annual originations. The market share for FHA lending was small at the time because eligible borrowers were primarily receiving non-agency loans funded through securitization. After secondary-market investors retreated from private-label securities after the crisis, FHA lending became the dominant avenue for low- to middle-income mortgage market credit.

Emphasis mine. This graphic also illustrates how after the housing crash that began in 2006 and became acute in 2007, federal lending programs expanded significantly, acting as a safety net for the housing market. Regardless, it should be clear that private lending, not government lending, drove the housing bubble.

Further, while both the FHA and the GSEs saw significant losses during the crisis years, with the GSEs receiving a government bailout under the Housing and Economic Recovery Act of 2008, no investor saw a single dollar loss on debt or mortgage-backed securities issued by Ginnie Mae, Fannie Mae, or Freddie Mac. The fact that no investor lost principal on these securities should be a strong hint that they were not behind the financial crisis. Here's the Financial Crisis Inquiry Commission report on the matter (p. xxvi):

We conclude that these two entities [the GSEs] contributed to the crisis, but were not a primary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis.

So on this point, we've learned two major lessons:

1. Implicit government guarantees did not drive the housing bubble.
2. No investors lost principal on GSE or Ginnie Mae debt or mortgage-backed securities. Put differently, nothing that was viewed as having a government guarantee lost a dime.

Error Two: Confusing Mortgage-Backed Securities with CDOs

The mortgage companies then had a large tranches of debt on their books that, although apparently backed by Sam, were riskier than their previously core business. To mitigate this risk they rolled them up into CDOs which, given that the probability of any one loan defaulting was taken to be independent of any and all others defaulting, supposedly held lower risk than the individual loans.

This description of the crisis completely glosses over the main financial instrument at the heart of the crisis, which is the private-label mortgage-backed security (herefter referred to as PLMBS). These securities, consisting of pools of mortgages that back securities of different risk profiles (often referred to as "tranches"), have no government backing, implicit or explicit. Tranching can render senior tranches of PLMBS safe (and some senior tranches of PLMBS in fact saw no losses in the crisis).

Regarding the use of the word "supposedly," basic statistics can show that PLMBS pools are safer than individual loans so long as default correlations are less than one (one does not need to assume that correlations are zero, as the answer implies); and basic math can show that even under the extreme scenario where default correlations approach one, senior tranches are still safer than individual loans. Correlations mattered significantly in CDOs, but CDOs weren't composed of loans: they were composed of junior tranches of securities backed by pools of loans (often PLMBS), like so:

Additionally, it is inaccurate to suggest that MBS issuance was in response to "large tranches of debt" on the books of "mortgage companies" when in fact subprime mortgages were originated for the express purpose of being securitized. The mortgage loans weren't generally held on the books of financial institutions, they were held primarily in off-balance-sheet ABS warehouse facilities until they were delivered into PLMBS pools.

Demand for PLMBS (the source of which is an interesting story itself but this answer is long enough already) actually drove subprime mortgage originations, as noted by the Financial Crisis Inquiry Commission (p. 87):

When it came to subprime lending, now it was Wall Street investment banks that worried about competition posed by the largest commercial banks and thrifts. Former Lehman president Bart McDade told the FCIC that the banks had gained their own securitization skills and didn’t need the investment banks to structure and distribute. So the investment banks moved into mortgage origination to guarantee a supply of loans they could securitize and sell to the growing legions of investors.

Error Three: CDOs and CDS Did Not Cause the Financial Crisis

This is a subtle, but important point. Derivatives, including CDOs and CDS, certainly played a role in the financial crisis— they played a major role in the failure of AIG, and they kept the mortgage securitization chain running for longer than it would have otherwise, but beyond AIG, no major firm failed as a result of its derivatives exposure.

Here's a list of the major (US) firm failures, in order (I am counting firms that would have failed had they not sold themselves as failures, and excluding a bunch of pretty plain-vanilla banks that all failed primarily due to portfolio mortgage exposures):

• Bear Stearns (wholesale funding run)
• Countrywide (mortgage portfolio/warehouse losses)
• Fannie Mae and Freddie Mac (mortgage portfolio and PLMBS losses)
• Merrill Lynch (wholesale funding run)
• AIG (derivatives exposures)
• Washington Mutual (mortgage portfolio losses; bank run)
• Lehman Brothers (wholesale funding run)
• Wachovia (mortgage portfolio losses; bank run)

Okay, What DID Cause The Financial Crisis?

Well, I kind of gave it away above, but let me slay a couple more bad ideas first.

Mortgage losses alone were probably not sufficient to cause the financial crisis. They were certainly a core part of it, but they, by themselves, were not sufficient to cause, as the original poster asked, the near-failure of the world economy. This might sound crazy, but let's look at the numbers briefly.

Here's the total amount of mortgage debt outstanding in the United States, from the Federal Reserve, via FRED:

It peaks around \$14.8T, and hits bottom around \$13.2T. Being really lazy about it and assuming both that all that decline is due to mortgage defaults and just rounding up a bit, we come to about \$2 trillion in losses on mortgage debt over the entire history of the financial crisis. But here's the market capitalization of a few of the larger US financial firms prior to the crisis: C: \$260B BAC: \$231B JPM: \$168B MS: \$179B WFC: \$118B GS: \$86B ML: \$64B BS: \$19B ~$1.1T.

Which doesn't look good, until you realize that a) many of our mortgage assets were held by foreigners, pension funds, and other entities; b) the GSEs (and ultimately taxpayers) absorbed hundreds of billions in losses, and c) the \$2T figure I started with includes all losses up through the end of the mortgage crisis, and the actual financial crisis occurred only two year in to the mortgage crisis. Then you realize that the mortgage losses alone probably weren't enough to bring down the financial system.

Derivatives also did not cause the financial crisis. To a first approximation, one could say that the financial system as a whole lost no money at all on derivatives, as any one party's loss was another's gain, and the only major firm to fail primarily as a result of derivatives exposures was AIG (and this failure did not cause the failure of any other major firm).

So what was it, really? A bank run, just like every other financial crisis. Not a traditional bank run, but a run on repo, which is the core bit of the story that is omitted above. (To be fair, he does mention leverage in passing, but repo is more than leverage— it's leverage and liquidity transformation)

Repo is essentially a form of collateralized borrowing used by financial firms— you lend me money, and I give you a pile of stuff that you're pretty sure is worth a little more than the money you're lending me as collateral, then later on, we trade back. Unfortunately, one of the "piles of stuff" that was being used heavily in repo was mostly high-quality, AAA tranches of the aforementioned PLMBS, which at first everyone assumed was as good as (actually, sometimes better than) gold, but then once people started seeing losses on PLMBS, because nobody sitting at a repo desk could figure out how to price the stuff, they started lending less and less against it, until they wouldn't accept it as collateral at all.

One problem with this is that it had the same effect as a bank run, but there was no equivalent of government deposit insurance to help stop the run— people ran, and for a number of major financial firms, it was over. A bigger problem with this is that it meant that the entire shadow banking system seized up, causing a significant contraction in the broader money supply— which is what actually almost killed the global economy.

It's this critical link— the fact that people not paying mortgages was amplified through wholesale finance in a way that transformed the mortgage debt into highly-liquid, money-like liabilities, so that the lost wealth actually translated into a contraction of the money supply— that is often lost. Stock market losses in the 2000 "Dot-Com" crash were actually greater than losses on residential mortgages. But it didn't destroy the global economy, because people weren't funding stock market positions with short term debt— if they were, it would look like— wait, now I'm actually just describing the Great Depression.

Almost all the other stuff that @MD-Tech says is true— there were, for example, people who took out no-documentation mortgages with no intention of ever paying them back, borrowing sometimes more than the cost of their homes and blowing the money on stuff (I don't know what, exactly, but Las Vegas saw a lot of the housing boom and bust so gambling and strip clubs were probably in the mix).

And yes, CDOs did play a role in getting to that point, but the role they played was mostly at the end— they were sufficiently complicated that errors in modeling correlations led some to believe that the more senior tranches were safe, while the more junior tranches were actually often purchased by people who were betting against the housing market (these individuals would take out large CDS positions but also buy junior CDOs, which gave them cash flow to fund CDS premiums until everything blew up, at which point the CDS paid out and they were rich(er) and people wrote books about them).

• The government implicitly backs every major institution. Finance majors are not intelligent enough to understand the difference between implicit and explicit guarantees. Also, any solvent retail banks were perfectly capable of expanding credit to cover the shortfall, if the things you describe were the only problems. Mar 27 '16 at 6:33
• So to be clear, your argument is: 1) the government backs all major institutions, where "major" somehow doesn't include Bear Stearns and Lehman, but MBS trusts are apparently "major institutions," 2) you think you're smarter than everyone who works in finance, and 3) an incorrect and unsupported assertion that smaller banks would be able to lend money that they didn't have after secured funding markets had massively contracted. Sure, we will all accept whatever you say, no need to offer evidence or even know what you're talking about. Mar 29 '16 at 2:25
• 1) Just because the government makes a guarantee doesn't mean they have to honor it. 2) It's not hard 3) With fractional reserve banking it's literally a matter of pushing a button. Mar 29 '16 at 3:41
• Okay, you don't understand how banking works, we're done here. Mar 29 '16 at 3:42
• So, do enough people know enough about what went wrong so that it never happens again, in this or any other form? Can we get smarter from this event, or is that unlikely?
– user12110
Apr 18 '17 at 0:45