Ron Berger —
The Academy Award nominated film The Big Short is an entertaining dramatization of Michael Lewis’s book The Big Short: Inside the Doomsday Machine. Most people have not and will not read the book, and it is my impression that while the film conveys the general nature of the systemic corruption that is endemic to our financial system, the specific mechanisms and broader context of this problem are less clear. In this article I provide some additional explanation of what is portrayed in the film.
Let me begin with a brief synopsis of film, which the logline describes this way: “Four denizens in the world of high finance predict the credit and housing bubble collapse of the mid-2000s, and decide to take on the big banks for their greed and lack of foresight.” Those who have seen the film and/or read the book also know that these finance denizens were not morally virtuous, but were out to make a lot of money.
To this I would add the publisher’s description of Lewis’s book: “The real story of the crash began in bizarre feeder markets where the sun doesn’t shine and the SEC [Securities and Exchange Commission] doesn’t dare, or bother, to tread: the bond and real estate derivative markets where geeks invent impenetrable securities to profit from the misery of lower- and middle-class Americans who can’t pay their debts. The smart people who understood what was or might be happening were paralyzed by hope and fear; in any case, they weren’t talking.”
Perils of the Casino Economy
One of the ways I view The Big Short in broader context is to think of contemporary capitalism in the United States in terms of what Stephen Rosoff and colleagues call a casino economy. “In contrast to industrial capitalism, where profits are dependent on the production and sale of goods and services,” profits in the casino economy of “finance capitalism increasingly come … from speculative ventures designed to bring windfall profits for having placed a clever bet.”
The increasing role of finance capitalism in our economy has been underway for some time. During the decade of the 2000s, depending on the year, profits from the financial sector comprised from 20 to 40 percent of all corporate profits. According to Michael Konczal, these trends have contributed to growing economic inequality in three ways: (1) They have moved “a larger share of the total national wealth into the hands of the financial sector”; (2) They have concentrated “on activities that are of questionable value, or even detrimental to the economy as a whole”; and (3) They have convinced “corporate executives and asset managers that corporations must be judged not by the quality of their products and workforce but by … only immediate income paid to shareholders.”
In addition to comprising a larger sector of the economy, the financial industry itself has undergone greater consolidation, especially since the passage of the Graham-Leech-Blyly Act of 1999, which repealed the Glass-Steagall Act of 1933. Glass-Steagall was a depression-era law designed to create a wall of separation between traditional commercial banks, which receive deposits that are insured by the federal government and lend money to borrowers, and investment banks, which raise uninsured capital for risky high-stakes investments, trade in stocks and other financial securities, and manage corporate mergers and acquisitions. Glass-Steagall aimed to prevent a conflict of interest endemic to a financial institution that lends money to the same companies in which it invests and also to prevent institutions from funneling deposits from their federally-insured commercial sector into their non-insured investment sector.
The repeal of Glass-Steagall was a bipartisan effort: a Republican-controlled Congress and President Bill Clinton and his secretary of treasury and chief financial adviser Robert Rubin. Before Rubin became secretary of treasury, he had been an executive at the Goldman Sachs investment firm, and after leaving public office he accepted a top position at Citigroup, one of the largest financial conglomerates in the world, where he would earn more than $100 million in the following decade.
The repeal of Glass-Steagall facilitated the consolidation of commercial and investment banks, brokerage houses, and insurance companies, creating a new industry of huge financial “supermarkets.” It also put taxpayer money at risk, because if these “too big to fail” institutions became insolvent, the government would have little choice but to bail them out or the entire economy could slide into a depression, as we saw after the crash of 2008.
To make matters worse, Congress passed and Clinton signed the Commodities Future Modernization Act of 2000, which exempted many of the financial instruments known as derivatives from regulatory oversight. These are the types of financial instruments portrayed in The Big Short, although the film did not refer to them as such.
The most commonly known financial securities are traditional stocks and bonds. A stock represents a share of ownership in a company, while a bond represents a loan for which the investor is owed interest. Derivatives, in the words of Les Leopold, are financial products “whose value is derived from something else, called the underlying or referenced stock, bond, or other financial instrument,” and are the consequence of a financial industry looking to attract investors seeking high rates of return.
In general, there are two kinds of derivatives: a collateralized debt obligation (CDO) and a credit default swap (CDS). A CDO is a financial instrument that bundles a pool of similar loans like home mortgages (as portrayed in The Big Short) or car loans into securities that can be sliced and diced and bought and sold at various degrees of risk. A CDS is a derivative that functions like an insurance policy, in Leopold’s words, by shifting “risk from a party that doesn’t want the risk to a party that is willing to accept it … for a price.”
In other ways, however, a CDS is nothing like an insurance policy as is commonly understood, because neither party to the agreement needs to own the item they are insuring. The investment simply involves a bet on the future value of a particular asset. Thus the term “short” in The Big Short refers to a financial bet that anticipates a decrease in the price of a stock that the investor does not actually own. As professor of corporate and securities law Lynn Stout notes, “The most important thing to understand about derivatives is that they are bets. That’s not a figure of speech—they are literally bets. You can make a million dollar bet on a $1,000 horse.”
One problem with the derivative market is that investments are based on speculative assumptions and are so complicated that investors (and regulators) have difficulty estimating the actual value of the assets. Under these circumstances, it is easy for investors to get greedy and take on too much risk. Another problem is not only that the derivative market goes unregulated but that it multiplies the risk of the original asset many times, spreading the consequences of failed investments throughout the entire economy. If the home mortgage market goes bust, for instance, as it did in 2008, it is not only the original lenders and borrowers who are in financial trouble, but also thousands of other non-principals who are invested in mortgages that have been securitized (including those who rely on invested pension funds). Moreover, the interlocking nature of financial institutions that are “too big to fail” means that a problem in one large firm portends problems in other firms as well. When the insurance giant American International Group faced bankruptcy, for example, its collapse (without a government bailout) would have undermined major investment banks like Goldman Sachs that had a stake in AIG’s collapsing derivative contracts.
The Big Short also portrayed the complicity of ratings agencies such as Moody’s and Standard & Poor’s that purport to certify the creditworthiness of the securities that are bought and sold to investors. These agencies are chronically underfunded and short-staffed, and Wall Street banks tend to poach them to become their own (higher-paid) analysts.
In 2010 the SEC filed civil charges against Goldman Sachs for a fraud that bilked investors out of about $1 billion. The civil suit alleged that Goldman Sachs hired a third party, ACA Management, to select pools of risky mortgages that were marketed as good investments, without disclosing to investors that the securities were also crafted with input from another client, Paulson & Co., that took out insurance derivatives betting on them to fail. When the investments did in fact fail, Paulson & Co. made billions of dollars. As SEC enforcement director Robert Khuzami said, “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.” Goldman Sachs settled the suit for $550 million.
In addition, in 2013 the JP Morgan investment bank agreed to a $13 billion settlement with the U.S. government related to charges that it had overstated the value of the mortgages it was selling to investors in the run-up to the 2008 crisis. In agreeing to the settlement, JP Morgan did not admit to a violation of law but conceded that it had repeatedly and knowingly sold mortgages to investors that should not have been sold. The following year Citigroup and Bank of America also agreed to pay $7 billion and $17 billion, respectively, to settle federal investigations of their deceptive mortgage practices.
To be sure, these settlements entail large sums of money, but no one has been criminally indicted or sent to jail or prison and the fines that were issued pale in comparison to the illegal profits that were made, to say nothing of the financial harm to the American people, which amounted to aggregate loses of about $13 trillion. Moreover, it is the banks’ shareholders, who essentially had nothing to do with the wrongdoings, rather than the culpable corporate executives and upper-level managers, who will bear the brunt of the monetary sanctions.
The Dodd-Frank Act
The most significant piece of financial regulation that followed the 2008 crash was the Wall Street Reform and Consumer Protection Act of 2010, also known as the Dodd-Frank Act, which was passed during the brief two-year period when Barack Obama was in the White House and the Democrats controlled Congress.
Dodd-Frank is a 2,300 page bill that is beyond the scope of this article to adequately explain. Wendell Potter and Nick Penniman believe that the legislation “made serious strides … including the creation of the Consumer Financial Protection Bureau, greater oversight of payday lenders, more transparency into derivatives markets,” and a reserve requirement that ensures that lenders maintain a sufficient amount of funds to cover potential losses.
On the other hand, Potter and Penniman note that the bill is riddled with loopholes and exceptions and left it up to regulatory agencies to develop rules that define what the law actually means or prohibits. Moreover, Congressional Republicans have thwarted attempts to implement the legislation, and all the Republican candidates for president have vowed to repeal it if they win the election.
Potter and Penniman do not think that anyone seriously believes that Dodd-Frank “will prevent another crisis in the years ahead.” The likely Democratic nominee Hillary Clinton supports the reforms, but unlike Bernie Sanders she is opposed to the reinstatement of Glass-Steagall. Thus there is little prospect of reversing the current state of consolidation in the financial industry, which is now dominated by just six bank conglomerates.
Ronald J. Berger, Marvin D. Free, Melissa A. Deller & Patrick O’Brien. 2015. Crime, Justice, and Society: An Introduction to Criminology. Lynne Rienner Publishers.
Michael Konczal. 2014. “Frenzied Financialization: Shrinking the Financial Sector Will Make Us All Richer.” The Washington Monthly (Nov./Dec.), http://www.washingtonmonthly.com.
Les Leopold. 2009. The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity. Chelsea Green.
Michael Lewis. 2011. The Big Short: Inside the Doomsday Machine. W.W. Norton.
Wendell Potter & Nick Penniman. 2016. Nation on the Take: How Big Money Corrupts Our Democracy and What We Can Do About It. Bloombury Press.
Stephen Rosoff, Henry Pontell & Robert Tillman. 2009. Profit Without Honor: White-Collar Crime and the Looting of America. Prentice-Hall.
Dean Starkman. 2014. “Wrecking an Economy Means Never Having to Say You’re Sorry.” The New Republic (Aug.), pp. 21-23.