How the American dream turned to disaster

How the American dream turned to disaster
Published: 
February 2016

The movie The Big Short focuses on the events leading up to the financial crisis. However, according to Professor Anne Wyatt  and Professor Peter Wells, the root of the problem lay in US policies introduced decades before.

As the rate of foreclosures rose ominously, investment banks such as Goldman Sachs used short positions to profit from the mortgage market decline.

Reality is the inspiration for many great films, and this is certainly the case with the ‘The Big Short’. The movie is set against the backdrop of the US housing market boom as financial institutions are selling complex mortgage-backed securities to investors largely unaware of the risks.

It focuses on the hedge fund managers who predict the forthcoming crash and bet against the mortgage market. As the financial disaster slowly unfolds, the amount of fraud in the system becomes increasingly evident and even when it is widely known that the securities have lost most of their value, the banks try to keep the information a secret.

But how did the massive information imbalance between the financial insiders and the public come to pass? A US Senate investigation concluded that the 2008 crisis was the ‘result of high risk, complex financial products, undisclosed conflicts of interest and the failure of regulators, the credit ratings agencies, and the market itself to rein in the excesses of Wall Street’.

However, the wider context was a very long term path of failure which started decades earlier. The US has long been obsessed with home ownership as a way to help individuals accumulate wealth and to address social problems. 

As far back as the 1930’s a suite of laws known as ‘The New Deal’ aimed to increase home ownership. The National Housing Act of 1934 gave rise to the Federal Housing Administration and Federal Savings and Loan Insurance Corporation, designed to support mortgage lending. This later became the government-sponsored body known as Fannie Mae, which conveniently allowed the debt to be held off the government balance sheet. Fannie Mae was joined by Freddie Mac, which created mortgage lending liquidity by buying mortgages from financial institutions and selling them as mortgage-backed securities to investors.

In the 1970’s, further initiatives focused on access to finance. They included the Equal Credit Opportunity Act and the Community Reinvestment Act to ensure access to credit for minority groups, as well as the Depository Institutions Deregulation and Monetary Control Act (1980) which expanded the lending capacity of non-bank financial institutions. Financial deregulation rolled on with a raft of innovations though the nineties, and then in 1999, President Clinton announced his dramatic goal ‘to provide $2.4 trillion in mortgages for affordable housing for 28.1 million families’.

President Bush also got on the housing bandwagon in 2002 with a policy to increase home ownership amongst minority groups by a minimum of 5.5 million through various tax breaks and government subsidies, all supported by mortgage securitization and sale to Fannie Mae and Freddie Mac. A critical issue that was consistently overlooked was credit quality - whether those gaining access to loans could afford them.  

There were also changes in financial markets. Holding loans of uncertain quality was historically a constraint on lending practices. However the repeal of the Glass–Steagall Act that required the separation of commercial and investment banking cleared the way for unfettered lending and, perhaps most importantly, the sale of loans or credit transfer.

In the aftermath of the dot.com crash the US Federal Reserve reduced interest rates to 1%, the lowest in 45 years. This not only fuelled a housing market boom, but also created a demand for higher yielding investments in the form of mortgage-backed securities (MBS). Credit standards were rapidly abandoned.

Put simply, they were no longer the lender’s problem because the mortgage was packaged, securitized in tranches and sold – thus generating revenues while taking the risks off the balance sheet. Increasingly risky mortgages were made to home owners with no hope of repaying, then packaged opaquely - with many rated AAA - and sold over and over so that no one knew who held what securities or their value.

Enter the savvy hedge fund managers. They knew that housing prices were inflated and the risk associated with mortgaged-backed securities. They did deals with the banks to bet against the housing market using credit default swap (CDS) insurance. The banks thought they would win the bet, but they were delusional.

The housing market finally slowed in 2005 and tanked in 2006.  As the rate of foreclosures rose ominously, investment banks such as Goldman Sachs used short positions to profit from the mortgage market decline. Problematically, at the same time they were selling securities that allowed them to profit from the same products generating losses for their own clients!

When the subprime market collapsed in 2007, credit markets ground to a halt as financial institutions did not know who held the subprime securities. Some banks collapsed - New Century Financial, American Home Mortgage, Countrywide, and Ameriquest to name a few. The Fed put $41 billion into the system then another $40 billion cash injection about a month later. Lehman’s collapsed. Bear Sterns was bailed out through a takeover.

The housing boom was a bubble of deception that involved multiple players in the finance and property markets, from real estate agents and mortgage lenders to MBS packagers and the ratings agencies.

The boom was fuelled by financial institutions using opaque financial instruments to maximize their profits. However, these instruments carried all the risk of a decline in the housing market. While the institutions should have been aware of the risks, they were probably not adequately disclosed to the purchasers. The lack of regulatory oversight allowed the juggernaut to build unchecked – as did the financiers whose university training enabled them to maximize wealth transfers through percentage skimming of huge amounts of accumulated capital without consideration of ethical practices.

The Big Short exposes fraud and greed at unimaginable levels culminating in a level of corruption that even the hedge fund managers cannot grasp. The movie is a sorry tale of failure in all elements of the housing lending system. There are no heroes to be found in this sad story. However the sub-prime crisis was an accident waiting to happen because the goal as the US tried to implement it was total unrealistic. Putting people into homes is an admirable and worthwhile aim - but making loans to those who cannot repay them is not a viable way to achieve this.

 

Professor Anne Wyatt is Professor of Accounting at UQ Business School. Professor Peter Wells is an expert in financial reporting regulation at the University of Technology Sydney.