Over the July 4th weekend I had the opportunity to watch the 2015 movie The Big Short, which stars Christian Bale, Steve Carell, Ryan Gosling, and Brad Pitt (screenplay directed and co-written by Adam McKay). The Big Short is based on the 2011 book The Big Short: Inside the Doomsday Machine by Michael Lewis(a financial journalist who did a stint at Salomon Brothers). The Big Short chronicles events leading up to and precipitating the housing crash of 2008. The story is told principally through the eyes of several stock market investors who, in the months leading up to the crash, decided to short the housing market in a—as the name suggests—big way. Effectively to short a market is to bet against it, that is to say, to take a position that allows an investor to make money as a particular market goes down. If you are interested in the shorting process, Google the term and you’ll find any number of explanations. If you’re at all interested in the events that ultimately resulted in the erasure of about 8 trillion dollars of stock market value (in the US), I highly recommend The Big Short. By the way, the small band of outsiders who saw what was coming and shorted the housing market ultimately made hundreds of millions of dollars.
As I watched The Big Short I was struck by the similarity between the housing loan bubble and the student loan bubble. By the way, the student loan bubble was mentioned in The Big Short. In this blog post I’d like to point out a couple of similarities.
The causes of the 2008 housing market crash are manifold to say the least. But one factor loomed large: ARMs or adjustable rate mortgages. As the movie talks about, ARMs come with “teaser rates,” mortgage interest rates that are below market. These teaser rates are used to entice people to take on mortgage obligations. At least in the early years ARM payments are low. But once rates adjust upward, ARM payments balloon correspondingly, often putting payments beyond the capacity of household incomes. ARM defaults lit the fuse that detonated the housing bubble bomb. We can see the ARM process in the world of student loans.
Financial aid offices at colleges and universities will often offer freshmen students attractive financial aid packages with teaser mixes, that is to say, high on grants (that do not have to be paid back) and low on loans (that do have to be paid back). But once the student is attached to the programs at his or her school, financial aid offices will switch up the mix: high on loans and low on grants. Some call this “bait and switch.” It’s an unscrupulous practice at best and reprehensible at worst. To add insult to injury, financial aid offices will often “displace” school-based grants if an industrious student is able to secure outside scholarship money. Suffice it to say that financial aid offices are constantly playing with their financial aid pool, a process that is talked about in The Big Short in the context of mortgage-backed bond pools. This leads me to my next similarity.
The Big Short talks about how mortgage-backed bond pools got their start. I invite you to watch the movie if this history interests you. As the housing market bubble began to show signs of bursting, mortgage-backed bond pools contained mortgages that were rated from a high of triple A (very solid mortgages) to a low of double B (very speculative mortgages). It’s a long story (see the movie) but the various ratings agencies found new and creative ways of artificially keeping ratings high. As an example, if a bond pool had a diversity of junk mortgages, it was rated highly simply because it was diversified. I’m sorry but diversified junk is still junk. When the emperor has no clothes, he’s butt naked.
Well, financial aid offices have their own rating system. They typically rate foreign students as triple A or solid aid recipients. Why? Well, foreign students (and foreign students can be out-of-state students as well) are charged full tuition and are looked at as having the financial means to pay full tuition without having to use much if any aid. As you would expect, financial aid offices actively court these triple A students. Financial aid offices will also use attractive financial aid packages to attract star athletes, who, as long as they perform, are considered very valuable. Students with less means are considered to be speculative. For more on this topic, see this 2013 article in The Atlantic entitled How Colleges Are Selling Out the Poor to Court the Rich. Quoting this article (which in turn quotes Stephen Burd of the New America Foundation), we hear, “[I]t’s more profitable for schools to provide four scholarships of $5,000 each to induce affluent students who will be able to pay the balance than it is to provide a single $20,000 grant to one low-income student.”
So, here are but two similarities that I see between the home and student loan bubbles. If you see others, please leave a comment. The home loan bubble burst in 2008. And all of the signs were there (which is why the small band of shorters mentioned above were able to make so much money). The Big Short even draws parallels between the conditions that precipitated the 1929 stock market crash and the conditions that existed just prior to the 2008 crash. Will the student loan bubble burst? Hard to say. But if someone tries to sell you a student loan-backed bond, I’d run.
Home and Student Loan Bubbles from Same Soap: Let’s Take a Bite
Over the July 4th weekend I had the opportunity to watch the 2015 movie The Big Short, which stars Christian Bale, Steve Carell, Ryan Gosling, and Brad Pitt (screenplay directed and co-written by Adam McKay). The Big Short is based on the 2011 book The Big Short: Inside the Doomsday Machine by Michael Lewis (a financial journalist who did a stint at Salomon Brothers). The Big Short chronicles events leading up to and precipitating the housing crash of 2008. The story is told principally through the eyes of several stock market investors who, in the months leading up to the crash, decided to short the housing market in a—as the name suggests—big way. Effectively to short a market is to bet against it, that is to say, to take a position that allows an investor to make money as a particular market goes down. If you are interested in the shorting process, Google the term and you’ll find any number of explanations. If you’re at all interested in the events that ultimately resulted in the erasure of about 8 trillion dollars of stock market value (in the US), I highly recommend The Big Short. By the way, the small band of outsiders who saw what was coming and shorted the housing market ultimately made hundreds of millions of dollars.
As I watched The Big Short I was struck by the similarity between the housing loan bubble and the student loan bubble. By the way, the student loan bubble was mentioned in The Big Short. In this blog post I’d like to point out a couple of similarities.
The causes of the 2008 housing market crash are manifold to say the least. But one factor loomed large: ARMs or adjustable rate mortgages. As the movie talks about, ARMs come with “teaser rates,” mortgage interest rates that are below market. These teaser rates are used to entice people to take on mortgage obligations. At least in the early years ARM payments are low. But once rates adjust upward, ARM payments balloon correspondingly, often putting payments beyond the capacity of household incomes. ARM defaults lit the fuse that detonated the housing bubble bomb. We can see the ARM process in the world of student loans.
Financial aid offices at colleges and universities will often offer freshmen students attractive financial aid packages with teaser mixes, that is to say, high on grants (that do not have to be paid back) and low on loans (that do have to be paid back). But once the student is attached to the programs at his or her school, financial aid offices will switch up the mix: high on loans and low on grants. Some call this “bait and switch.” It’s an unscrupulous practice at best and reprehensible at worst. To add insult to injury, financial aid offices will often “displace” school-based grants if an industrious student is able to secure outside scholarship money. Suffice it to say that financial aid offices are constantly playing with their financial aid pool, a process that is talked about in The Big Short in the context of mortgage-backed bond pools. This leads me to my next similarity.
The Big Short talks about how mortgage-backed bond pools got their start. I invite you to watch the movie if this history interests you. As the housing market bubble began to show signs of bursting, mortgage-backed bond pools contained mortgages that were rated from a high of triple A (very solid mortgages) to a low of double B (very speculative mortgages). It’s a long story (see the movie) but the various ratings agencies found new and creative ways of artificially keeping ratings high. As an example, if a bond pool had a diversity of junk mortgages, it was rated highly simply because it was diversified. I’m sorry but diversified junk is still junk. When the emperor has no clothes, he’s butt naked.
Well, financial aid offices have their own rating system. They typically rate foreign students as triple A or solid aid recipients. Why? Well, foreign students (and foreign students can be out-of-state students as well) are charged full tuition and are looked at as having the financial means to pay full tuition without having to use much if any aid. As you would expect, financial aid offices actively court these triple A students. Financial aid offices will also use attractive financial aid packages to attract star athletes, who, as long as they perform, are considered very valuable. Students with less means are considered to be speculative. For more on this topic, see this 2013 article in The Atlantic entitled How Colleges Are Selling Out the Poor to Court the Rich. Quoting this article (which in turn quotes Stephen Burd of the New America Foundation), we hear, “[I]t’s more profitable for schools to provide four scholarships of $5,000 each to induce affluent students who will be able to pay the balance than it is to provide a single $20,000 grant to one low-income student.”
So, here are but two similarities that I see between the home and student loan bubbles. If you see others, please leave a comment. The home loan bubble burst in 2008. And all of the signs were there (which is why the small band of shorters mentioned above were able to make so much money). The Big Short even draws parallels between the conditions that precipitated the 1929 stock market crash and the conditions that existed just prior to the 2008 crash. Will the student loan bubble burst? Hard to say. But if someone tries to sell you a student loan-backed bond, I’d run.