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Eccentric genius, yet misunderstood and unappreciated, hedge-fund manager Michael Burry, played by Christian Bale


My favorite movie of 2015 was the Oscar nominated The Big Short. This docu-drama tells the story of how a handful of investors predicted the collapse of the mortgage bond market in 2007, which precipitated the 2008 global financial crisis. They knew the collapse was inevitable because they scrutinized the fundamental economic conditions that undergirded these financial products: bad mortgages that were likely to go into default. Whereas most everyone else in the financial industry glibly accepted that the mortgage market was too stable for the bubble to ever burst, these investors shorted the market by buying insurance (in the form of “credit default swaps”) on the mortgage-backed securities. If the securities collapsed, they would get paid enormous sums.

Throughout the movie, and also while reading the Michael Lewis book it is based upon, I thought about how a poorly educated public is both vulnerable to being exploited by fraud and to being unwitting instruments of fraud in the hands of the masterminds of macro-level fraudulent activity. I plan to process these thoughts in a series of posts that explore the links between financial fraud and the philosophy on which our educational system is based.

The movie begins with a quote from Mark Twain: “It’s not what you don’t know that gets you in trouble; it’s what you know that just ain’t so.” In other words, ignorance is less of a problem for humans than is a false sense of certainty. The need for certainty, which we naively associate with knowledge, as the Twain quote suggests, motivates us to accept uncritically the assumptions of the crowd and the pronouncements of authoritative figures.

The assumptions of the crowd –

Investors, lenders, and borrowers accepted commonplace assumptions that drove the purchase of mortgage-backed financial products and the lending of risky loans.

  1. That the mortgage market is “rock solid”
    For most of U.S. History, the mortgage market was low-risk and predictable. You could count on most people paying their mortgages. Mortgage bonds were low-risk, low-yield. Also, the mortgage market had never collapsed on a national scale; there had only be local collapses. Thus, investors were willing to keep on purchasing mortgage-backed securities.
  2. That it is foolish to bet against housing
    For reasons just stated, people in the financial industry didn’t bet against housing, especially on a wide scale. It was too reliable to place large bets against. Never in history had millions of people stopped paying their mortgages, so how could it happen now? When Michael Burry, a successful but eccentric hedge fund manager, approached the big banks to ask them to create and sell him credit default swaps so that he could short the housing market, they were more than happy to oblige him. Some were so incredulous that they attempted to talk him out of it. They presumed he was the fool, and believed they would get rich off his reckless investments.
  3. That housing prices will continue to go up.
    Such an assumption is what drives a bubble. The reason why average Americans could keep borrowing, taking out home equity loans and multiple mortgages, was that lenders believed housing prices would continue rising, without end. It is also why banks kept buying mortgage-backed investments.
  4. That whatever good is happening now will continue to happen in the future.
    Known as the “hot-hand fallacy,” this is the assumption that allowed collateralized debt obligations (CDOs), which were the vehicle for multiplying the effect of bad loans throughout the economy, to infect the system. I see someone win a couple of bets, so I place a bet that they will win again. Others place bets on my bet, and others on their bets, and so on. Thus the odds of loosing the original bet is multiplied with each bet removed from the original, so if the original bet is lost, the losses are greatly magnified. This allowed, say a 50 million dollar loss, to turn into a 1 billion total loss for the whole system. So as people stopped paying their mortgages, it wasn’t just a loss to the original lender, or whoever held the mortgage, but an even bigger loss to those that bet the mortgages would be repaid (and more to those who bet on those bets). This is why the whole economy was threatened by defaults on mortgages.

The pronouncements of authoritative figures –

  1. Government officials
    One reason why investors had high confidence in the continued growth of the housing market is that authoritative government figures – like Federal Reserve Chair Alan Greenspan and Treasury Secretary Henry Paulson – had been assuring everyone that the housing market was stable and propagating the belief that there was not a bubble (arguably, it was their policies that helped created the bubble). Michael Burry had to disregard these assurances and stand behind the claim that these men were wrong in order to defend his strategy to his investors, who thought he was crazy. One of them asks, “How can you know more than Greenspan and Paulson?” when doubting his ability to identify macro-economic trends. The financial system placed such faith in these figures that those that dared doubt their pronouncements were considered insane, even when these doubts were supported by clear evidence.
  2. Private ratings agencies –
    The rating agencies (Moody’s, Standard & Poors ) are responsible for rating debt-backed securities based on the borrower’s ability to repay debt. They played a major role in enabling the financial crisis by giving the highest AAA ratings to CDOs, even though collectively these included trillions of dollars of loans given to homebuyers with bad credit, thus deceiving investors into thinking that these products were safe. Even when default rates climbed, the value of CDOs kept going up (contrary to fundamental economic logic) because the rating agencies maintained the AAA ratings. The blind trust in the rating agencies of course led to an uncritical acceptance of these ratings, which justified poor investment decisions. As one business journalist put it, investors “weren’t so much buying a security” as they “were buying a triple-A rating.”

The acceptance of the assumptions of the crowd and the pronouncements of authoritative figures as truth, by borrowers, lenders, and investors, enabled a dysfunctional mortgage market that nearly destroyed the world economy. The tendencies of people to believe these things, and not to question them, is a direct result of the kind of education they received. In subsequent posts, I will show how modern education produces people – from the lowest students to the best students – who have these tendencies.