The Big Short is short on the whole truth. There’s too much vested interest in “Bank regulators can’t be that wrong!”

Paul Krugman, in the New York Times of December 18, 2015 wrote: “You want to know whether the movie [The Big Short] got the underlying economic, financial and political story right. And the answer is yes, in all the ways that matter”

No! I now saw “The Big Short”. It is a very good movie that describes accurately many elements of the crisis that resulted from excessive exposures to AAA and AA rated securities; those that were backed with badly awarded mortgages to the subprime sector.

But, unfortunately, just as I suspected, it remains totally mum on what really propelled the crisis, namely outlandishly bad bank regulations.

In the over two hours movie, we do not hear a single word about that banks in Europe, and investments banks in the USA, thanks to the Basel Committee and the SEC, were allowed to hold these securities against only 1.6 percent in capital… meaning they could leverage their equity, and the support they received from society, a mind-blowing 62.5 times to 1.

The risk-adjusted returns on equity banks expected to make on AAA to AA rated securities by leveraging them over 60 times, blinded everyone. When in the movie it is mentioned that even though the default rate of the subprime mortgages was increasing dramatically, and yet the price of those securities was rising, they ignored among others the runaway European demand for these. These securities, CDO, MBS, ABS or what you want to call them were in fact thought to be the new gold to be found in California, and way over a trillion Euros pursued that gold during less than two years. 

Want to read about it? Here is what happened to little Narvik of Norway in “And then the roof caved in”, page 114. 

Anything that could be traced back to an AAA rated security allowed banks to finance any operation with it against almost no capital. For instance if AAA rated AIG sold you a credit default swap, that was enough… and so everyone bought CDS’s from AIG, who could not resist selling CDS’s on AAA rated securities.

Paul Krugman and others like Joseph Stiglitz, even though bank regulations odiously discriminate against “The Risky” and in doing so increases inequality, cannot find it in themselves, or in their agendas, to accept that technocratic regulators, regulating on behalf of governments, could be so wrong.

The Big Short mentions though a prime driver of the disaster. One broker confesses he would make immensely higher commissions supplying truly lousy adjustable rate mortgages to the packagers of AAA security, than sending them reasonable fix rate prime mortgage. The way the incentives worked, the worse the mortgage, the higher was the added value of the to AAA-ratings conversion process.

PS. And not only The Big Short is guilty of omission. In its 848 pages the Dodd Frank Act, though the US is a signatory, does not even mention the Basel Accord and the Basel Committee

PS. I just looked at the index of Michael Lewis’ “The Big Short again”. It does not mention Basel regulations, risk weighted capital requirements for banks, nor the meeting on April 28, 2004 when SEC decided that the investment banks in the US, would be able to play by Basel rules… and thereby open the way for the minimum capital requirements against anything AAA rated for these banks.

I have not seen “The Big Short” but I am sure it comes up short explaining what happened. If not, I will apologize.

This is the film "The Big Short"

And this is my short explanation of the subprime crisis.

In June 2004 the Basel Committee, with Basel II, decided that any bank that held securities rated AAA to AA (or lent to investors guaranteed with such securities) needed to hold only a meager 1.6 percent in capital (equity) against these. That meant banks could leverage their equity (and the support they received from society) with the expected risk adjusted profit margin of these securities, a mindboggling 62.5 times to 1.

For instance, if banks thought they could earn a reasonable 1 percent expected risk adjusted return on such securities, then they would be expecting to earn a 62.5 percent yearly return on their equity.

Basel II regulations applied to the European banks and, due to a decision taken by the Security Exchange Commission in April 2004, also to American investment banks.

This mother of all incentives set up the mother of all demands for AAA to AA rated securities collateralized with mortgages to the subprime sector.

And it was really not the “good” mortgages that the intermediaries were most after in order to package. The worse they were, meaning the higher interest rates they carried, the larger their profits.

Let me explain the deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with a little help from your friends the credit rating agencies, you could convince risk-adverse Fred the banker that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred that mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.000

I am almost sure that “The Big Short” is based on the growing overabundance of these lousy mortgages packaged in highly rated securities... but not on the cause for their overabundance.

I heard in the film trailer "The banks' got greedy"... but in fact there was and is no rational market in the world, that has the strength to say NO! to the kind of temptations offered by the regulators.

And this is tragic. If the truth does not come out, and there is plentiful of interests in the truth not coming out, for instance among all bank regulators, then we have missed a very good opportunity to learn that we should not leave the regulations of our banks in the hand of a small mutual admiration club of experts.

For a starter, current regulators have not yet even defined the purpose of our banks before regulating these. Is that not criminally stupid?