Real Estate Research

Author's note: This is the first of two posts on The Big Short. This one addresses the overall theme of the book. The next will focus on the book's details—in particular, the question of whether issuers obfuscated or even deliberately misled investors about subprime mortgage securities.

In The Big Short (Norton, W. W. & Company, 2010), Michael Lewis provides a narrative of the subprime mortgage crisis through the stories of a set of unconnected investors, including Michael Burry of Scion Capital, Steve Eisman of Frontpoint, and Jamie Mai and Charlie Ledley of Cornwall Capital, all of whom made a common bet against subprime mortgage bonds and won big. The book is a treasure trove of anecdotes about the crisis and deserves the wide audience it has received. But, in terms of reforming Wall Street or preventing another crisis, The Big Short—the title refers to the controversial Wall Street practice of short selling—could do more harm than good because it perpetuates the idea that it is possible to make large amounts of money in financial markets while taking little or no risk.

A reader might get the impression that the protagonists of The Big Short went to the roulette table knowing exactly where the ball would land. But they actually took a huge gamble when they bet against subprime bonds in 2006. In fact, had they tried their bet in 2005, The Big Short would not have been written.

Composition of pre- and post-2005 mortgages were not dissimilar
To understand the extent of the risk that characterized the bets these investors made, one needs to realize that the high levels of defaults on the loans in the deals that the investors bet against were not inevitable and were, in fact, unprecedented. The difference in performance between subprime loans originated before 2005 and after 2005 is like night and day. Loans originated before 2005 were only half as likely to default as the loans in the pools that Burry and his cohorts invested in. More importantly, while none of the BBB-rated bonds in the deals that originated in 2004 and 2005 defaulted, virtually all did for the deals that The Big Short investors traded on.

What accounts for the differences in performance between pre-2005 and post-2005 loans? None of the variables that Burry or any of the traders in The Big Short focus on. For example, while it's true that 35 percent of subprime loans originated in 2005 and 2006 had reduced documentation, that percentage is only marginally higher than the 30 percent with reduced documentation before 2005. Yes, it's true that 78 percent of the subprime loans originated after 2005 had "teaser rates" that would expire two or three years after origination—but 67 percent of the loans originated before 2005 had the same feature. Sure, 73 percent of the loans originated after 2005 had prepayment penalties, but that was down from the 74 percent that had them before 2004. Plus, the average FICO score had actually risen to 615 from 607.

House prices are the difference
So if the composition of mortgages did not change dramatically between 2004 and 2006, what explains the completely different outcomes? The answer is house prices. House prices are central to mortgage performance. When they are rising, few mortgages default because borrowers who can't make their payments can profitably sell to avoid foreclosure. Lewis's statement that a "person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place" (p. 100) is misleading. In fact, in the pre-2005 pools in which the average FICO score was 607, fewer than 5 percent of borrowers missed a payment in the first year of the loan.

The point here is that the timing of the bet was crucial. Simply betting against deals because they contained loans that were incompletely documented or because the FICO scores were low would have been a losing strategy in 2001 or 2002 or 2003 or 2004 or 2005. Nor was there anything inevitable about the timing of the fall in house prices. By 2003, standard measures of the relationship of house prices to income or to rents already showed overvaluation, and yet house prices continued to rise and even accelerate for the next three years.

In short, the success of the traders in The Big Short was not based on logic and skill but on their willingness to gamble that house prices would fall dramatically in 2006. It's not clear that they understood how much their bet depended on the evolution of house prices.¹

Subprime bulls had an extraordinarily successful run
There is a kind of irony here in that in writing The Big Short, Michael Lewis falls for precisely the same logic that created the subprime crisis in the first place. The logic is that investors who make money are smart and investors who lose money are dumb. The problem is that someone writing in 2005 could and did tell an identical story about the subprime bulls.² Then the smart people were the investors in subprime bonds who made huge returns because the high interest rates on the loans more than compensated them for the surprisingly small credit losses. The dumb ones were the suckers who invested in prime mortgages. What Lewis forgets is that in 2006, the subprime bulls were coming off a string of successful investments no less impressive than that of the heroes of his book. These subprime bulls were the smart ones at that time.

This dissonance is perfectly illustrated in one of the high points of the book when Lewis tells the story of Howie Hubler, a trader at Morgan Stanley:

Some people enjoyed Hubler, some people didn't, but, by early 2004, what others thought didn't really matter anymore, because for nearly a decade Howie Hubler had made money trading bonds for Morgan Stanley (p. 200).

Lewis understands the dangers of Hubler's logic:

Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency (p. 215).

Hubler's subprime bets end up going grievously wrong and he ends up causing the biggest single trading loss, $9 billion, in Wall Street history. Yet in many ways, the heroes of the book have a lot in common with Howie Hubler. Like Hubler, they took big bets. Like Hubler, they thought they were exploiting the stupidity of others. And like Hubler, they made a lot of money. Hubler ended up losing big, which may eventually happen to the stars of The Big Short.

The lesson of the crisis really is that one should be skeptical of any trader or fund manager promising high returns without risk. But for many who read The Big Short, the book will only make them look harder for that big score.

By Paul Willen, research economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kris Gerardi)