The Big Short: What It Got Right, and What Has Changed Since the Mortgage Meltdown

15 Jan

The Big Short: What It Got Right, and What Has Changed Since the Mortgage Meltdown

By Doug Goelz, Mortgage Services

Recently, I saw The Big Short and was pleased and a little surprised at how well it presented the issues that contributed to the mortgage meltdown, failure of major financial institutions, and the economic collapse in 2008.

Here is my abbreviated review of the movie (everyone’s a critic!): good performances; well-written with a good balance of humor and drama; and the technical aspects of the financial instruments were addressed explicitly and explained in a way that was understandable.Don’t worry: the movie is not completely wonky; if the machinations of financial markets and mortgage lending don’t captivate you, the movie has great portrayals of different quirky characters.

To recap the technical side of the plot (both of the movie and the economic collapse): mortgage-backed securities (MBSs) are financial instruments made up of a lot of individual mortgages. Investors buy shares of the MBSs, and receive interest paid on all the bundled mortgages. In the old days (pre-2005?), MBSs were assumed to be of high quality because everyone used to pay their mortgages without fail.  MBSs became popular with investors because of relatively low risk and good returns; they were popular with investment banks because they generated good fees and commissions.

As the demand for MBSs increased in the early 2000s, there was pressure for more mortgages to make up new MBSs.  Since the pool of qualified borrowers under the traditional rules of lending was relatively stable, the only way to enlarge the pool of mortgage borrowers was to lower the standards for getting a mortgage.   Therefore, to fuel the demand for MBSs, banks started making sub-prime loans.

In the early and mid-2000s, borrowers who never would have qualified for a mortgage suddenly were able to get mortgages with the new sub-prime loans.  “Sub-prime loans” is a broad term; essentially, they were loans available to borrowers whose income, assets, and/or credit scores were not sufficient to qualify them for a conventional mortgage.Rating agencies gave high ratings (e.g., AAA) to the new MBSs ignoring the fact that, on average, borrowers who got sub-prime loans were not in as good a position to repay the loans as borrowers with conventional loans.  Logically, an MBS made up of sub-prime loans should not have been rated as high as an MBS made up of conventional loans.

MBSs had such allure that investment banks started creating derivative products based on hedging and outcomes of underlying MBSs.  These derivative products leveraged (and magnified) the risk of MBSs and were intended for supposedly sophisticated clients.

When borrowers stopped paying their mortgages, MBSs began to fail, and the derivative products based on them began to fail.  Investment banks had such large positions on MBSs and their derivatives that they were unable to absorb losses and pay out amounts due.  Hence, (spoiler alert) failure of some institutions, and chaos in the financial markets.

Some subtle points I thought the movie got right included the concentration of investor mortgages in Florida (they could have included Las Vegas, as well), and the mantra “refinance or sell” as an answer for borrowers who were concerned that their mortgage payments might become burdensome.

The movie also referred to the reset of rates for Adjustable Rate Mortgages (ARMs) and “teaser rates” on loans.  On these points, I think the movie could have been clearer, but, in fact, I find that most reporting on the mortgage meltdown misses distinctions between regular ARMS and loans with teaser rates and negative amortization.

With an ARM, the rate is fixed for a period of time (e.g., 3, 5 or 7 years) and then adjusts to the market, within certain limits, after the fixed rate period.  Market rates increased between 2003 and 2007, so borrowers whoseARMs reset during that period probably were faced with higher mortgage payments.  If they could barely afford the initial payments, the new adjusted payments could have been too much.

More importantly (and more disastrously), though, I believe, were loans with initial “teaser rates” or “optional payments.”  Teaser rates were temporary low rates for the first year or two of a mortgage.  After the teaser rate period, the rates, and payments increased.  With “option ARMs,” monthly payments were calculated on low rates, but interest was calculated at higher rates!  This led to negative amortization where the amount due on a loan actually got larger as borrowers made the required payment.  These loans became disasters because at a certain point where the negative amortization had increased the loan balance to, for example, 120% or 140% of the original loan balance, the lender required fully amortized payments at higher interest rates.  If borrowers could barely afford the initial payments at teaser rates with negative amortization, they definitely could not afford fully amortized payments at higher rates.

Borrowers had no idea what they were getting into with “option ARMs.”  The documentation on these loans was incomprehensible and it was impossible to predict when and how payments would increase because increases depended on how interest rates moved.  If the loan originator (the mortgage broker or the bank loan officer) understood the loans and possible outcome, I doubt the explanation and warning was sufficient when the loan was being made.  The mantra “refinance or sell” was probably offered as salve to borrowers who did realize that payments could become unaffordable.   Of course, selling or refinancing became impossible as prices plummeted and sources of new mortgages for sub-prime borrowers dried up after 2007.

So what has changed since 2007?  MBSs still exist and are popular.  Some financial derivatives still exist, albeit perhaps with some new regulation and tracking.  Most of the changes in the mortgage market since 2007 probably have been about guidelines for issuing mortgages in the first place.   Most sub-prime mortgages are gone now (although new variations of mortgages with limited documentation have begun cropping up recently).  Documentation required from borrowers is more stringent:  yes, you need to have a job and or sufficient documentable income in order to get a mortgage these days.  Mortgages with negative amortization and/or teaser rates are no longer allowed.  ARMs still exist, but the maximum possible payment and when it might occur is more predictable.  All the changes in guidelines for getting a mortgage are meant to make sure borrowers are able to make the necessary payments.

Whether or not mortgage lending and the economic crisis of 2008 interests you, check out The Big Short.  It’s a fun movie with good performances and a good story told against a backdrop of a complex financial and economic subject.

Questions?  Feel free to get in touch with me at 415-730-4665 or