"The Big Short" by Michael Lewis

"The Big Short" by Michael Lewis. 22 January 2016.

Mike Callen has been very kind to ghost write my book review, though his review is of the movie (scroll).

I picked this book up at a bookstore in Los Angeles in transit to India a month ago. I just completed it in New Delhi, yesterday, 22 January 2016.

Mike Callen has been very kind to ghost write my book review, though his review is of the movie (scroll).

I endorse Mike's comment that Lewis' omission of government venality (Frank, Dodd et al.) playing a major role in precipitating the 2007 financial crisis is a major omission from the movie/book.

And I would add quasi/government player agency head Jim Johnson to the list of perps. Read Gretchen Morgenson's "Reckless Endangerment" to get a sense of Johnson's active role in deteriorating agency mortgage buying standards in the financial crisis build-up.

The stage was set for wholesale abandonment of mortgage credit standards when strict enforcement of the Community Reinvestment Act (CRA), enacted in 1977, was ramped up in the early 90's, in the wake of the S and L crisis.

I was CEO of a publicly held thrift in the early 90's and felt the CRA enforcement pressure.

CRA was designed to prevent "redlining," but augmented enforcement of the act drove many institutions to deteriorate credit standards in their quest to become CRA compliant. Noncompliance with CRA could result in new enforcement actions or in delays in exiting various punitive levels of regulatory oversight.

The precedent was, therefore, set with CRA: government intervention into mortgage credit standards intended to reduce "racial discrimination" could be applied to stimulate home buying by anyone who couldn't ordinarily afford a home because of a poor credit record.

I don't deny that there may have been redlining by mortgage lenders... though our bank did not engage in this practice. The government conflated redlining with disparate impact and easily spun the practice as racist in its intent. Studies were pulled out, later debunked, to prove this was true. I remember the Boston Fed was responsible for one highly touted study on the matter.

Yet, it is undeniable that there were few creditworthy borrowers in some neighborhoods. In hindsight, a better approach than heavy handed, government enforced threats - leading to deteriorating credit quality - might have been to provide incentive, not penalty, for lenders to increase lending in loan starved areas. Regulators could have given "extra credit" to banks who introduced mortgage education programs in targeted areas, for example.

As CRA enforcement came down hard on my bank, I thought, perhaps idealistically in those days, why would I as a lender ever want to turn down a loan that otherwise qualified, for reasons of racial discrimination. But the Feds would see to it that I lent to residents of so-called disadvantaged neighborhoods whether they were creditworthy or not. I remember we went through all sorts of credit analysis legerdemain to justify some of the loans made to assure CRA compliance. Without CRA compliance we, then a troubled institution, would have been held hostage in regulatory limbo, notwithstanding our bank's significantly improved operating performance.

CRA's role as a catalyst to the virtual elimination of lending standards for subprime lending standards several years later and the resultant 2007 financial crisis cannot be ignored.

Not to let greedy - and ignorant - bankers off the hook, but by omitting government's role in facilitating the financial crisis, "The Big Short" is an incomplete account of same.

SDT



Steve:

Just came from the movie. I assume that most readers have seen it or read Lewis' book. Several observations:

1) Lewis is a good writer, but no one should think that he was motivated by a desire to be an objective history-minded scribe devoted to truth and balance. Michael concluded that John Gutfreund was evil incarnate, a man who destroyed his career at Salomon's. I started to write a treatise about Citi in 1992 with the encouragement of James Stewart. A month into the project I came to realize that my view of John Reed was excessively and impossibly personalized. I dropped the effort. Lewis didn't and we got Liar's Poker.

2) This account of the crisis is inevitably Hollywood-ized. The major flaw is the absence of any mention of Barney Frank or Jim Johnston at Fannie Mae. At Frank's behest Fannie changed their underwriting rules and commenced buying massive amounts of subprime paper in order to promote the ownership society. I've never believed that the degradation of underwriting standards would have been nearly as drastic without the enthusiastic involvement of Fannie and Freddie. The absence of any mention of their roles amounts to an invalidation of the entire thesis, in my judgement.

3) There was a confluence of realities that brought about the outcome. Greedy, genetically flawed bankers, the major story line of the movie, isn't even the major one. Bankers didn't suddenly transform themselves into monsters. They've always been monsters. Low interest rates were damaging for pension funds everywhere as their liabilities couldn't be met without higher returns. The development of software and hardware in the late 90's enabled the MBS and other securitization vehicles. A CDO squared, for example, could not have been structured in 1985. What was not appreciated when all of these instruments were being sold was that fundamental incentives were being changed profoundly. Originators with no skin in the game were motivated to produce volume for a fee. Guess what? They produced volume for a fee. Remember back in the days when originators retained the risk or a lot of it?

4) Much maligned rating agencies are useful targets, and they can be held responsible for using models that did not take into account the changed incentives surrounding mortgage origination. The law of large numbers and diversity principles indicated loss rates in various stressed economic environments. When origiantors were rewarded for throwing away the risk manual and just create mortgages like Carter produces liver pills, the models were made invalid.

5) Much is made in the film of the behavior of the eager bankers once the fan was hit and the place started to reek. As Chairman of Ambac during this period I was a firsthand observer of this behavior. Here I differ with the consensus in Washington and academia. People behave badly when panicked. Easy as it is to calmly critique the players after the fact, I think we'll always see human beings be human beings in these circumstances. Nothing new here.

6) Did anybody benefit from the subprime programs. I believe there were many beneficiaries. Let's remember that 15 to 20% of these loans went into default. That means 80% of the subprime borrowers managed to keep their homes and build equity in them. I don't think there's another country in the world that could have provided those benefits to that many of its citizens. Talk about a silent majority.

7) There will be another financial crisis in 15 years, maybe sooner. Another set of thoughts will surround those villains, too. By that time, I think a clearer and more useful perspective will have emerged, but it won't emanate from the West Coast of the USA. By the way, those rotten bankers who profited from all this could have raked in a 100 million in speaking fees. Then they'd be honest hard-working citizens, right?

[Mike Callen, 22 January 2016]