Ryan Gosling’s Shorts

The new film “The Big Short”–based on the book by Michael Lewis–achieves what I would’ve thought impossible: it makes an American audience root for speculators hoping to make millions betting against the U.S. economy. Ryan Gosling, Christian Bale, Brad Pitt, and Steve Carell are the Hollywood stars portraying the real-life people who had realized U.S. housing was in a bubble, and that the mortgage-backed securities based on them were much riskier than most people realized.

To be sure, the movie gives the impression that the commercial lenders, Wall Street investment banks, and ratings agencies (Moody’s, S&P, Fitch) were infested by rogues who needed stricter government regulation. In that respect, I disagree with the message; I think it was sins of government commission that blew up the housing bubble. In particular, the Fed’s easy credit fueled the boom while various federal programs steered funds into housing.

However, even though “The Big Short” probably will lead many to clamor for more regulation, the movie doesn’t dwell on “solutions” but instead makes sure viewers realize just how perverted things had become.

The real contribution of the film, for those who love liberty and free markets, is that it shows the good side of speculators. If the entrenched interests overlook something huge–such as an unsustainable run-up in house prices and derivative financial products that are ticking time bombs–then their carelessness provides a profit opportunity to a speculator.

In this particular case, a few pioneers fostered the development of credit default swaps issued on mortgage-backed securities. In plain English, a few investment funds early on bought insurance policies on bonds that were built out of thousands of mortgages. If the housing market tanked and mortgage defaults began skyrocketing, then the owners of these credit default swaps should profit handsomely.

The movie tells this story in a surprisingly entertaining way (though concerned parents should be warned that there is salty language). It takes some level of detail to fully relate the hijinks of the period. Loan applicants who didn’t even hold a job were approved for huge mortgages, because nothing mattered so long as home prices kept rising at double-digit rates (in some markets). At one point, even as the subprime loan default rates were booming, the Wall Street institutions continued with their rosy ratings of the assets built upon them. The whole system was rigged.

Nonetheless, the truth will out. Successful stock speculation serves a useful social function. If an asset is undervalued, a speculator will swoop in to buy it, pushing up the price. On the other hand, a speculator will “short” an overvalued asset, pushing down the price. Both actions move market prices toward their more “correct” level, in terms of the “fundamentals.”

The possibility of profits gives money management funds the incentive to hire research staff and to study niche markets. If they uncover a major “trade,” it means they have realized (in their minds) that everybody else systematically missed something important.

It promotes the efficient allocation of resources when firms can profit from correcting mispriced assets. This is yet another reason that the huge bailouts of 2008/09 were poor policy. They weakened the market’s disciplinary mechanism. Laissez-faire capitalism relies on a profit-and-loss system. The financial sector should have moved away from the behemoths (Goldman Sachs, JP Morgan, etc.) that facilitated the housing bubble, and toward those who had correctly foreseen the dangers–such as the people portrayed by the stars in “The Big Short.”