by Joseph Coletti
Senior Fellow, Fiscal Studies, John Locke Foundation
Thanks to Michael Lewis and Christian Bale, we all know that ratings agencies got mortgage-backed securities wrong and precipitated the financial crisis of 2008. Juan Ospina and Harald Uhlig at the University of Chicago say that the rating agencies actually tended to be right about AAA-rated residential mortgage backed securities (MBS), which were the great majority of MBS sold before the financial crisis. If you bought early and held on, you came out with gains. What problems there were came in lower quality securities. More recent vintage MBS also tended to perform worse than earlier ones.
In finding that lower grade securities were less safe than their ratings, however, the paper still fits with the rest of the story. Mortgage delinquencies really were a problem because interest rates did not climb with Treasury rates after June 2003, according to a paper by three economists at the Federal Reserve Bank of New York. So too were the bets on those over-rated lower-tier MBS, just not in the way Lewis or the movie interpreted them—Yves Smith, on his site Naked Capitalism, argued when The Big Short first appeared in print that the book’s heroes actually helped provide the fuel to transform the housing fire into a conflagration [profanity] as they “throw Molotov cocktails at it.”
The relevant section in the book describes how Steve Eisman reacts when told his actions make possible the very products he hates:
“Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”
Say that again.
“He says to me, ‘The more excited that you get that you are right, the more trades you’ll do, and the more trades you do, the more product for me.”…
That is when Steve Eisman finally understood the madness of the machine… There weren’t enough Americans with [poor] credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets to synthesize more of them… “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than the just the subprime loans. That’s when I realized they needed us to keep the machine running.”
“Whatever that guy is buying, I want to short it. … Sight unseen.”
The movie depicts the Eisman character’s sudden understanding [profanity] of what he’s betting against but not the role he and his trades have in making them possible.