If anyone hasn’t seen “The Big Short” yet, it comes highly recommended. Not only just it uncover the absolutely fraudulent nature of Wall-Street, in the years prior to the Financial Crisis, but it breaks down the various financial technicalities into easily palatable and understandable metaphors.
The tale revolves around several fund managers who took a contrarian bet against the US Housing Market prior to the Sub-Prime Mortgage Crisis. The main characters are mostly real: Michael Burry, (played by Christian Bale) the hedge fund manager in charge of the now unwound Scion Capital LLC. in California. Mark Baum, (played by Steve Carrell) who headed a small hedge fund under the umbrella of a major Wall Street bank. Brad Pitt and Ryan Gosling also have starring roles.
The movie was co-produced by Brad Pitt’s Plan B Entertainment Inc. and was Directed by Adam McKay, who also directed Anchorman and Talledega Nights.
The movie is a fairly accurate portrayal of the events surrounding the initial financial shock which culminated in the 2008/09 Financial Crisis and excels in mixing humor and serious candor to communicate its message.
How accurate was the subject matter of the movie? Pretty accurate really, and it is much better than reading the scathing 663 page report from the US Government on the subsequent crisis.
What would Economists make of the Crisis?
Tens, if not hundreds of academic papers have been brought examining every single aspect of the Financial Crisis in painstaking detail. From the role of Special Purpose Vehicles (legal constructs which were also utilized in the Enron Scandal), to the role of Collateralized Debt Obligations (CDOs), Government involvement in Fannie Mae and Freddie Mac, Credit Default Swaps (CDS) and the role of the globalized financial system. One thing all economists can probably agree with was the Moral Hazard created by President Bill Clinton’s repeal of the Glass Steagall Act which was put in place in 1933 following the events of the 1929 Great Depression to rein in the banks.
What is Moral Hazard?
A moral hazard is a specific type of situation which arises between two parties, the principal (in this case the investors) and the agent (the investment banks). As the theory goes, the agent works on behalf of the principal, but has more information about what they are doing. This informational asymmetry between the two leads to a mismatch in incentives. The agent has the incentive to mislead the principal as to the true nature of what they are peddling.
In this case, the partition separating investment banking and commercial (traditional) banking was removed, allowing previously stable commercial banks to invest in a vicious mix of low-grade, high yield investments. Investors did not properly understand the risks introduced into the system by the banks, as many were international, which allowed US invesment banks to offload many of the high risk pools of invesments for liquidity, growing a tremendous bubble in the US housing market.
If there is one general lesson which we can take from this debacle, besides the government’s willingness to prop up these fiscally profligate institutions, it is the risk of moral hazard. Wherever moral hazard occurs fraud tends to happen.