Living Through 'The Big Short'

SMITH BRAIN TRUST — Clifford Rossi, executive-in-residence and professor of the practice at the Robert H. Smith School of Business, had a front-row seat at the 2008 financial crisis, the subject of the film "The Big Short," which has been nominated for Best Picture in the 2016 Oscars. Rossi served as chief risk officer at Countrywide Bank, chief credit officer at Washington Mutual (WaMu), and managing director and chief risk officer for Citigroup’s consumer lending group. At Citi, he was responsible for overseeing the risk of a $300 billion global portfolio of mortgage, home equity, student loans and auto loans. He was intensely involved in Citi’s post-crash TARP and stress test activities. He has worked at Freddie Mac and Fannie Mae, and began his career during the savings-and-loan crisis at the U.S. Treasury's Office of Domestic Finance — so he has some perspective, you might say.

He recently answered question about "The Big Short," which makes colorful drama out of no-income loans, mortgage-backed securities and a motley assortment of financial-world figures who saw that an implosion was coming — and made hundreds of millions of dollars on that bet. 

There's sort of a sense of inevitability now about the crisis. We think everyone should have foreseen it, and the general blindness is painful to watch in the movie. From your perspective, what led people to think things could continue on the track they were going — that there was not going to be a reckoning?

The short answer is that in the years leading up to the crisis we had been coming through a very extraordinary period, a period marked by very low inflation, very low interest rates, very rapid home price appreciation and what I would characterize as a very benign economic environment. What that did was it helped inflate residential property values over the period.  And it made people feel that nothing was going to appear that would bring that down over the long term. It's easy to say now, looking back, "How could we have missed it?" But if you put yourself back in 2005 and 2006 it would have been very hard for many people to have seen that we could have had a correction in the housing market as large as we had.

You've told me that you didn't yourself foresee a crash but you did see a slowdown coming. How did that go over when you presented that prediction to people who were making a lot of money off the boom?

Those of us in the risk area, our jobs were to call out problematic areas from time to time — whatever we saw. During that period, we did call for a slowdown in home prices, actually a shallowing out of home prices, or a reversion to the mean. A growth rate in the area of 0 to 2 percent we thought was actually fairly conservative. At that time, presenting that kind of information to senior executives and leaders at the board of directors level, they had a difficult time believing that — because they were looking at the data from the last several years showing rapid and sustainable home price appreciation. So it didn't square with what our predictions were. I like to say that we were "directionally" correct. But certainly even we were off at pegging how big of a drop we actually experienced.

This part might be a refresher for those people who saw the movie. But can you explain how the mortgage problem came to infiltrate the whole banking system and not just one corner of it?

The roles that I had were on the "on balance sheet" side of the bank. A lot of what we are talking about, the risk that was coming for financial institutions, was coming "off balance sheet" in the form of derivative instruments that were tied to the underlying mortgages. So mortgages themselves would be packaged up into a pool, into a mortgage-backed security that was either issued by Fannie or Freddie, which were the safest kind. Or what was happening during this time period was that banks themselves were starting to package up paper, such as what we call "Alt A" and subprime loans, into their own flavor of a mortgage backed security, and selling that off to investors. And then what would happen was those mortgage backed securities would be split off into new securities called CDOs, and things of that nature, and some of those would get rated very high quality even though the underlying assets were subprime and other risky assets. They could still in some cases, for those higher-rated tranches, get triple-A ratings, so people felt okay with that. So investors and banks were manufacturing these assets and feeling that they still had very strong credit quality associated with them when in fact there was definitely a bubble going on in the marketplace that manifests itself around 2008.

The movie makes a lot of the coziness between the ratings agencies and the banks. Was that depiction accurate? Are there more reasons to trust places like Moody's and Standard and Poor's now?

What we're talking about in terms of the ratings agency issue is the "issuer pay" model the agencies have worked under for many, many years. And that creates a conflict of interest between the ratings agency that is putting a rating out there either on security or a tranche of a security, and the issuer. In this case, it could be a large bank, for example. If a bank couldn't get a high enough rating, what they would do is they would shop it to any number of competitor ratings agencies to get another view on it, negotiating to achieve the highest rating on the security, which would create the greatest interest from an investor's standpoint. There was an awful amount of negotiation and a fair amount of pressure by the issuers at the time to try to get the highest rating possible.

Does that problem still exist?

Technically it still does. We still operate under an issuer-pay model today. What you have seen however, is that after a crisis — it's like the old saying, "In war, everybody gets religion" — well I think everybody got religion after the crisis. And the rating agencies in particular have now sort of erred on the side of conservatism in their views of new rated structures, which has another problem associated with it. But, the fundamental issue that was there during the crisis has not been solved at this point with the rating agencies.

Do you think anybody should have gone to jail over this?

I wrestle with that, and while there was a lot of bad behavior out there, and a lot of stupidity — a misunderstanding of what in hindsight they were hearing from people like myself at the time — I personally, and I'm no lawyer, believe that there was no criminal intent at least in the groups that I saw. That doesn't mean that there wasn’t extremely poor decision-making and everything else that goes along with it and they shouldn't bear some sort of responsibility for that. But overt criminal intent? I didn't see that.

The president of the Federal Reserve Bank of Minneapolis, Neal Kashkari, who played  a role in the bailout at Treasury, recently said that "too big to fail" remains a problem, and that banks should be broken up. Is he right? 

Yes and no. There are certainly banks that have come together over time that I would almost characterize as Frankenstein banks: They are so large, so complex that it is so hard for any individual at the CEO level or the chairman level to really know what is going on at that institution. Should they be broken up? It's very possible that in some very isolated cases the institution might be better off if it were put into smaller pieces that were more understandable, more manageable. I guess I'd say, by and large, the idea of too big to fail will continue to be with us for a long time, with no ready solution.