The Big Short

Just watched this movie this week, after having read many of the books published on the Great Recession, as well as having served on a National Academy study committee of what happened.  During this study, I had a chance to chat with the second most senior executive at one of the major banks involved, one that disappeared in the aftermath of the crisis.

I asked him if senior executives at his bank understood the questionable assumptions underlying the mortgage-based derivative securities.  He responded, “I understood, but we were making so much money from these securities that it was socially unacceptable to raise any questions.”  Put simply, they wanted to milk the real estate bubble as long as they could.

Of course, the bubble burst and millions of people lost their jobs and their homes.  The assets of the executives in these financial firms were protected.  They even received their usual bonuses, funded by the federal bailout of these firms.  Despite the obvious fraud by financial firms and rating agencies, almost no one was indicted and convicted.  Taxpayers paid, in one way or another, for the $5 trillion of lost wealth.

This movie certainly renews the anger felt in 2007-09.  I felt then, but less so now, that Goldman Sachs, Morgan Chase, Morgan Stanley, et al. should have been forced to fail, with top executives losing all of their personal assets and serving long prison terms, eventually emerging impoverished.  This would have been cathartic, but would it have made a difference in the longer term?  Would greed, fraud, and crime in general have been deterred?

The more fundamental question concerns the nature of value in our society and economy.  I have chaired, or been a member of, a few National Academy committees that wrestled with this question in terms of overarching goals for Academy initiatives.  We eventually agreed on one overarching goal:

To foster and sustain a healthy, educated, and productive population that is competitive in the global marketplace.

This goal is very compelling.  We want people to be healthy and engaged in work and making creative contributions in general.  To do this, we need people to be educated, as that is key to health and readiness for productivity.  People also need to be trained and aided to be productive and educated so they are competitive in the global marketplace.

My earlier post on “Five Million Jobs” outlines how we could accomplish these goals for 3% of the Federal budget.  I also discuss in that post why this obviously highly valuable investment will never happen.  The reason is simple – a sizable portion of our electorate feels that health, education, and productivity are now private goods, no longer public goods.  The idea that we all benefit by everyone being healthy, educated, and productive is no longer par of the national psyche.

So, let’s go back to The Big Short.  Was the financial community focused on improving health, education, or productivity?  More generally, were they providing value to society – and were they rewarded accordingly?  There is certainly value in providing capital to buy homes, start businesses, and develop inventions with potential to become market innovations.  Investors who provide this capital deserve reasonable returns for putting their monies at risk.

The financial community has various mechanisms for decreasing risks, for example, diversifying investment portfolios.  However, the financial players in The Big Short were hiding increasing risks, with the fraudulent compliance of the rating agencies.  These players created toxic portfolios of subprime mortgages.  The risks of default were steadily increasing, in part due to adjustable mortgage interest rates that resulted in payments that many borrowers could not possibly sustain.

The rating agencies helped the banks to hide ballooning risks, but savvy players realized that the bubble must eventually burst and sold these portfolios short. Some of our smartest people found a way to make billions of dollars betting that the marketplace would soon recognize the worthless investment instruments created by the financial community.  In effect, these smart people bet against the economy, against sustained value creation.

It is terrible when the smart money bets on failure.  Greed, fraud, and other criminal activities, in contrast to value, created this situation.  The financial community often talked value creation, but they did not walk it.  Instead, they focused on big paychecks, associated perks, and enormous bonuses.  In the end, they got to keep their windfall earnings while US taxpayers bailed out their enterprises.  Their homes in the Hamptons have kept them safely shielded from the broad loss of confidence they created.

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