Michael Burry: The origins of the CDS/Sub Prime trade.

Mar. 04, 2010 11:55 AM ETGS3 Comments
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Long/Short Equity, Dividend Investing, Value

Contributor Since 2009

Formerly: John Galt. The majority of my capital is invested in Dividend Growth stocks. I also enjoy searching for the next big thing. To grade my investment decisions: I've usually been able to "buy low", but I've often sold out too early. I'm firmly against losing money. I have no problem with building up my portfolio slow and steady. After the 2008 Financial crisis I've been much more macro focused instead of being more of a stock picker. I love a good stock debate, looking at the best bull case, best bear case and picking my side. I believe in doing your own due diligence! I enjoy reading finance/stock market books among other things. Love traveling, and always have my eye out for the next investment idea when at home or abroad.

Here is a fantastic Michael Lewis article about Michael Burry and his big bet against Sub Prime mortgages. 

In 2004 he began to buy insurance on companies he thought might suffer in a real-estate downturn: mortgage lenders, mortgage insurers, and so on. This wasn’t entirely satisfying. A real-estate-market meltdown might cause these companies to lose money; there was no guarantee that they would actually go bankrupt. He wanted a more direct tool for betting against subprime-mortgage lending. On March 19, 2005, alone in his office with the door closed and the shades pulled down, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit-default swaps on subprime-mortgage bonds.
This really was the birth of the trade.  It might seem real obvious now, but buying insurance from Goldman Sachs & others against crappy loans ( the crappiest) wasn't so obvious back then.  You couldn't short houses, and shorting builders/mortgage companies would eventually work as well, but this was a fantastic vehicle for his theme.
The only problem was that there was no such thing as a credit-default swap on a subprime-mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn’t even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage-bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit-default swaps on subprime-mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.
Funny how it was Goldman that bit.  The wiz kid at Goldman might not have been creative enough to concoct that scheme but they were smart enough to see the significance of it and that they could make money off of it.
His obsession with fairness, for example. When he noticed that pro basketball stars were far less likely to be called for traveling than lesser players, he didn’t just holler at the refs. He stopped watching basketball altogether
That's an interesting side note.  We always saw that Patrick Ewing took 3 steps, Jordan got calls etc.  Later on we had NBA refs literally caught betting on games which destroys the integrity of the sport.  Seems like Michael Burry was early to the party.
In his Match.com profile, he described himself frankly as “a medical resident with only one eye, an awkward social manner, and $145,000 in student loans.” His obsession with personal honesty was a cousin to his obsession with fairness.
Interesting.  A person who doesn't like certain things ( like the NBA) because of their subjectiveness, but would rather pick up something like swimming.  It's interesting that somebody who would prefer cold hard science over art, would be so good at stock picking and medicine which is a blend of the two.
Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied. Indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.…

This was one of the most interesting parts of the story and I agree with him 100%.

I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

It is a blend of Art with Science.  Book smarts with street smarts.  Seeing the forest from the trees.  Creativity, emotional intelligence, being able to bet against the crowd. There are people who have made money by being lucky but there IS a skill to investing just like there IS a skill to poker.  Sure you could get lucky, but you increase your odds of success by improving your skill.

Once he figured out he had nothing more to learn from the crowd on his thread, he quit it to create what later would be called a blog but at the time was just a weird form of communication. He was working 16-hour shifts at the hospital, confining his blogging mainly to the hours between midnight and three in the morning. On his blog he posted his stock-market trades and his arguments for making the trades. People found him. As a money manager at a big Philadelphia value fund said, “The first thing I wondered was: When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He’s showing people his trades. And people are following it in real time. He’s doing value investing—in the middle of the dot-com bubble. He’s buying value stocks, which is what we’re doing. But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up 50 percent. It’s uncanny. He’s uncanny. And we’re not the only ones watching it.”

He's a genius.  People use that word too often, but really is a genius.
The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away.
Impressive results to say the least.
As often as not, he turned up what he called “ick” investments. In October 2001 he explained the concept in his letter to investors: “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’”  A court had accepted a plea from a software company called the Avanti Corporation. Avanti had been accused of stealing from a competitor the software code that was the whole foundation of Avanti’s business. The company had $100 million in cash in the bank, was still generating $100 million a year in free cash flow—and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avanti Corporation than any man on earth. He was able to see that even if the executives went to jail (as five of them did) and the fines were paid (as they were), Avanti would be worth a lot more than the market then assumed. To make money on Avanti’s stock, however, he’d probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.
Ick Investments are a value investor/contrarians dream.
he wrote in May 2003 that the real-estate bubble was being driven ever higher by the irrational behavior of mortgage lenders who were extending easy credit. “You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the [housing] market higher,” he wrote. “I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the U.S.…A large portion of current [housing] demand at current prices would disappear if only people became convinced that prices weren’t rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers.”

Depending on which news source you watch ( CNBC), I think people still underestimate the devastation in real estate, the effect that has on banks, and the effect that has on our economy.

I will leave you to read the rest of the story but it's a good one.  You get to see a guy that truly does his homework, worked his way through the system and struck Gold with the holy grail of all trades... You see Goldman and others get played, and then others try and copy his trade.  Michael Lewis has a talent with storytelling and this story is worth your time as "the trade" originated with 32 year old Michael Burry.

The Author is not long: GS or any of the other securities mentioned in the article.

Disclosure: Author is not long any of the stocks mentioned in this article

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