Michael Burry’s bet against the housing bubble began with WorldCom bonds. Had he never learned from his WorldCom bet, it’s unlikely his housing bubble bet pays off so big.
Here’s the thing, Burry made money on WorldCom bonds. But he missed out on a lot more. So he asked why?
I was onto WorldCom pretty early and they went from investment grade to bankrupt overnight. And so, I ended up doing okay with their bonds on the way back up. But, I wondered why didn’t I make more money on this? And so, I wasn’t a short. I don’t like to short equities… So I basically noted though, it went investment grade to bankrupt overnight. And it hit me. That’s the way to short companies that you think look so gilded now, but you think might tumble, as a result of asymmetric risk taking — so, especially leveraged companies. And I noted that there were a lot of these highly-rated, super leveraged companies where you could buy credit — because you can’t buy credit default swaps on junk or stuff that’s below investment grade. So, that was how I came to investigate CDS’s. So I bought books.
The right question drove Burry to learn about credit default swaps. Then he sat on the information.
As he explained in his FCIC interview, a look into home builders was the next thread that eventually led to his big short:
The way I got involved in housing at all was by — I was a stock picker, pretty much a long-oriented stock picker. And I started looking at home builders which were all in the press. A lot of people were saying that these were undervalued securities. So I looked at them and I decided that I didn’t think they were terribly attractive because they were benefiting tremendously from the increase in land values on their inventory and this was contributing to a great extent to their returns. And it led me to — So I didn’t think too much of the home builders and I let them go, but I wasn’t really thinking that housing was gonna collapse.
In looking them, I started thinking about how housing is financed. This was 2002-ish. And I started looking at the mortgage insurers and PMI in particular. Then I compared it to MGIC, which is another mortgage insurer, and I just read their filings. I noted that they were getting involved in so-called insuring negotiated transactions or bulk transactions. So, at the time I didn’t even know what they were. So I said OK what are these? But I know insurance — I like to study insurance. So I did notice that their strength, from their typically line of business to go into the auction — basically insure through an auction process that doesn’t guarantee them any unusual knowledge that might advantage them in their underwriting.
So, I moved to looking at the mortgage pools and starting to understand how they work. This was ’03, by spring of ’03. What it did is, it lead me to start getting involved in the credit default swap markets. Well, partly, so that’s another story. But in understanding RMBS, it wasn’t information that I used too much other than to just monitor the market for a while. I actually instead moved to purchasing some credit default protection on certain financial companies and that was a result of something else. So that’s — 2003 is when I first started credit derivatives and I learned a lot about the credit derivatives market over the year or two leading up to 2005. That’s when we did all these ISDAs and that sort of thing.
I was particularly interested in the history of the housing or the history of the derivatives market and how it developed. And so that’s also another part… And after the tech crash, 9/11, WorldCom, the interest rates obviously fell and there was other mechanisms used, as well, to put credit into the system. And I noticed that it was affecting the housing markets through the types of mortages that were being introduced. So I termed that “extension of credit by instrument” because once rates had fallen to a certain level — mortgage rates were already at forty year lows, they weren’t going any lower — how do you stimulate demand? And one way is to create different mortgage products or affordability products to essentially allow home prices to rise.
So on the back of this easy credit, there’s also this whole issue of how mortgages are being originated, typically through a mortgage broker into an originate and sell model — mortage originator that would then sell off the mortgages to Wall Street, increasingly so. And I saw all kinds of problems with agency risk, moral hazard, and adverse selection throughout that whole process. And when you piled all these things up, what I came to have significant worries about the housing market in ’03. And what I turned to investors — it’s a basis for concern. I didn’t think that — warn that these were multi-decade cycles and that we shouldn’t jump to any conclusions.
2003 saw the introduction of interest only mortgages. I watched those with interest as they migrated down the credit spectrum and into the subprime market. And when they had migrated down the credit spectrum about as far as they could go, to the extent they could, other products were created. Notably, in my view, the option ARM or negatively amortizing mortgage, which I viewed as the most toxic mortgage that could ever be imagined. And, I thought at that point since home prices had been rising at a rapid rate, essentially on the back of easy credit, with virtually no accompanying rise in our wages or incomes, that I came to a judgment: in 2007, 2 years hence, there would be a final kind of judgment on housing when those people taking out those two year ARMs, go to seek refinance. So I was watching these mortgage pools, and it came to a point where I paired my understanding of the derivatives market to what I saw in the mortgage pools.
To be clear, a lot of things had to come together for Burry to get the outcome he got.
A simple question about WorldCom bonds led studying CDS’s. Later, homebuilders led to CDS’s too, after winding through mortgage insurers and mortgage pools. And that’s just his own investigating over a couple of years. It also required the confluence of events in the financial system that produced a housing bubble. And don’t forget the fortitude on his part, to confidently sit on the positions for over 2 years despite the cost of sitting, the constant fighting with counterparties on valuation, and major pushback from clients the entire time.
The lesson from all this is that he followed a thread with no clue where it would lead. He investigated and studied and learned, not knowing if there was a financial payoff in the end. That particular thread just happened to work out spectacularly.
Unfortunately, hindsight makes these bets look so easy and obvious when it was never easy or obvious at the time. It paints a false picture of investing.
The only guaranteed payoff is you learn something because most threads likely end in no action taken. Whatever is learned, is packed away, to be used later on. Maybe. Because you just never know what opportunities that info might unravel in the future.
FCIC Interview with Michael Burry (audio)
- How We Should Bust an Investing Myth – J. Zweig
- Is There a Reason Why US Profit Margins Remain So High? – Klement On Investing
- Why Use One Value Factor When You Can Use Many – ValIdea
- WeWork Lessons That Apply To Lots of Stuff – M. Housel
- WeWork and the Great Unicorn Delusion – D. Thompson
- The (Un)Expected Link Between the Human and the Artificial Mind – D. Ariely
- A Wandering Mind: How Travel Can Change the Way You Think – Farnam Street
- Novelist Cormac McCarthy’s Tips on How to Write a Great Science Paper – Nature
- The Man Who Would Kill Horse Racing – Deadspin
- A New Theory of Obesity – Scientific American