Movie ‘Big Short’ long on fiction

Peter J. Wallison

The arrival of “The Big Short” in theaters has reignited interest in the causes of the 2008 financial crisis. If you believe that the crisis was caused by greed and recklessness on Wall Street, you’ll like this film.

We can all agree that the financial crisis was caused by a “mortgage meltdown” mostly among subprime and other risky mortgages. What neither this film nor the greed narrative tells us is why there were so many of these mortgages in the financial system to begin with. The answer is not Wall Street.

In June 2008, just before the crisis, more than half of all U.S. mortgages — 31 million loans — were subprime or otherwise risky. Of these, 76 percent were on the books of government agencies, primarily the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. This shows, without question, that the government — a sophisticated buyer — created the demand for these deficient loans.

The remaining 24 percent of these loans were on the books of private-sector entities, such as banks, investment banks, insurers and investment funds of all kinds.

Because of their government backing, Fannie and Freddie were the dominant players in the U.S. mortgage market, and had been for more than a quarter century. They did not make loans themselves, but acquired mortgages from banks and other lenders. These were held in their portfolios or sold off to investors with a GSE guarantee.

Significantly, before 1992, Fannie and Freddie accepted only prime mortgages — loans in which the borrower made a down payment of 10 percent to 20 percent, had a FICO credit score of at least 660, and debts that were less than 38 percent of income after the loan was closed.

The market was stable with this foundation, but despite many government subsidies the homeownership rate in the United States had been stalled at 64 percent for 30 years. Congress blamed this on the GSEs, particularly their refusal to relax their underwriting standards; by insisting on acquiring only prime loans — it was argued — the GSEs left a vast number of low-income Americans frozen out of the American dream of homeownership.

Thus, in 1992, Congress adopted a program known as the affordable housing goals, which required Fannie and Freddie to acquire an annual quota of loans that had been made to low- or moderate-income borrowers. Initially, 30 percent of all loans the GSEs acquired in any year had to be made to homebuyers who were at or below the median income where they lived.

The Department of Housing and Urban Development was given authority to raise the goals — and it did, aggressively. By 2008, 56 percent of all mortgages the GSEs acquired had to be made to borrowers below median income. Notably, HUD’s relentlessly rising quotas occurred in both Democratic and Republican administrations.

It was difficult for the GSEs to meet these quotas and still acquire only prime loans. Accordingly, between 1993 and 2008, they began to accept increasing numbers of subprime and other risky mortgages. These caused their insolvency in 2008 and their takeover by the government that year.

The connection between these numbers and the financial crisis is unavoidable. Because the GSEs dominated the mortgage market, when they reduced their underwriting standards to meet the affordable housing quotas the rest of the market followed. Soon, borrowers who could have afforded prime mortgages were getting loans with zero down payments. The result was an enormous housing price bubble, the largest in U.S. history.

Government blunders turned it into a financial crisis. First, the government rescued Bear Stearns, a Wall Street investment bank, in March 2007, creating expectations that it would rescue other big firms if they got into trouble. But when Lehman Brothers — a firm much larger than Bear — weakened, the government reversed its policy, letting Lehman fail. This upended the market’s expectations, creating doubt about the safety and soundness of every firm. The result was an unprecedented panic that we know today as the financial crisis.

This is not the kind of story that Hollywood likes — no greed, no evildoers, not even any humor — just very bad government policy combined with serial government blunders. “The Big Short” is entertainment, not the truth.

Peter J. Wallison is the Arthur Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He wrote this for InsideSources.com.