What You Should Know About Investing After ‘The Big Short’

By Martin Weil

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Many of my clients have told me they were stunned to the point of revulsion by the unethical banking behavior depicted in “The Big Short,” the powerful movie about the subprime loan crisis and the resulting 2008 financial meltdown. It’s an honest, behind-the-scenes look at Wall Street, much closer to the reality than the glamorous version typically portrayed by Hollywood.

The tale of misconduct told in “The Big Short” should be old news by now, some seven years later. Yet this belated recognition by so many of my clients — an educated group, to be sure — suggests that there hasn’t been adequate closure on this sad chapter in America’s financial history.

In the absence of a public reckoning with the behavior that caused the financial crisis, my clients are understandably frustrated, and even angry. This is what I tell them.

The role of leverage

First, most of my clients want to know: Did the banks really behave so unethically in the years leading up to the crisis?

There’s no question that commercial and investment banks, insurance companies (AIG in particular), Fannie Mae and Freddie Mac, the credit rating agencies, and Congress (under both Presidents Clinton and Bush), allowed the financial system to embark on an unchecked expansion of leverage — that is, the use of debt to make investments.

When the mortgage-related investment market failed, institutions that took on these market risks via excessive debt ratios were bankrupted. And a wave of very large institutional failures dominoed throughout the global financial system, bringing it to the brink of ruin.

It wasn’t greed or stupidity on the part of any single player, or set of players, that unleashed the tidal wave of defaults. Greed and stupidity recur throughout our history without crashing the economic system. But excessive leverage turned a routine business collapse into a true disaster. This increase in leverage was caused by deregulation of the banking industry.

The role of deregulation

For the last 100-plus years, the U.S. capital marketplace has been a wonder of the world. It has been envied for its transparency, efficiency and fairness.

Has it ever been perfect? Of course not. Have people tried to take advantage of less astute investors? Of course. But the marketplace was long backed by a system of regulations and regulatory agencies that kept the playing field nominally level.

The unprecedented buildup of financial leverage during the early 2000s was made possible by the dismantling of the Glass-Steagall Act and the passage of the Commodity Futures Modernization Act. Both changes were touted as “modernizations” by Congress and, of course, enjoyed backing from the finance industry. At the same time, Congress reduced funding for the regulatory agencies that police the industry.

Congress essentially relaxed the rules of the road and took away most of the traffic cops for good measure. Is it any wonder that speeding not only occurred under these conditions, but became the norm?

This same story has happened throughout the history of markets. After the Great Depression, which was unleashed by a similar set of excesses in the financial system, Congress enacted the robust regulatory framework that sustained the U.S. capital markets for the next 60 some years.

After living through the 1930s, many of our parents and grandparents developed a lifetime aversion to financial markets. That investors today would arrive at this same conclusion is no surprise. A mistake, I believe, but totally understandable.

The effect on the average investor

So what’s the average investor to do? I’ve spent the better part of the last 18 years talking clients through the inevitable ups and downs of the economic cycle and the markets. I did this confident in the knowledge that the economy and markets trended up in the long term. By participating in the capital marketplace, investors would directly benefit from this upward trend.

I honestly don’t think that fundamental reality has changed. However, my confidence has been severely shaken since 2008. I believe that investors will benefit from long-term engagement with markets, but I’m less confident that the ride won’t be a troubled one. And many investors will find it challenging to hold to the longer view in the face of market participants’ egregious misbehavior.

This hardly makes for the reassuring pep talk most investors crave. The good news is that absent some systemic failure, the average investor with a diversified portfolio is not likely to be much affected by all these shenanigans over the long run. The trend of the economy is up and investment will follow.

Even ruthless behavior in the capital markets may not be reason for undue worry. Many find such behavior deplorable, but it’s simply the human drive to compete at its most unbridled. Adam Smith would approve, and note that it’s this wholly self-interested competition that fosters the best markets and creates the greatest public benefit for all.

Martin Weil is a certified financial planner and president of MW Investment Strategy Group, a financial planning and investment advisor business based in Sonoma, California.