Michael Lewis tells the tale of hedge-fund manager Michael Burry:
On May 19, 2005, Mike Burry did his first subprime-mortgage deals. He bought $60 million of credit-default swaps from Deutsche Bank — $10 million each on six different bonds. “The reference securities,” these were called. You didn’t buy insurance on the entire subprime-mortgage-bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He likely became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made.He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans — so that he could bet against them. He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans.
It surprised him that Deutsche Bank didn’t seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime-mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by Moody’s and Standard & Poor’s. If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier, A-rated tranches, he might pay 50 basis points (0.50 percent); and on the even less safe, triple-B-rated tranches, 200 basis points — that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches — the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent — were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next — the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.
Once again they shocked and delighted him: Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. “This was shocking to me, actually,” he says. “They were all priced according to the lowest rating from one of the big-three ratings agencies.” He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop.
The market made no sense, but that didn’t stop other Wall Street firms from jumping into it, in part because Mike Burry was pestering them. For weeks he hounded Bank of America until they agreed to sell him $5 million in credit-default swaps. Twenty minutes after they sent their e-mail confirming the trade, they received another back from Burry: “So can we do another?” In a few weeks Mike Burry bought several hundred million dollars in credit-default swaps from half a dozen banks, in chunks of $5 million. None of the sellers appeared to care very much which bonds they were insuring. He found one mortgage pool that was 100 percent floating-rate negative-amortizing mortgages — where the borrowers could choose the option of not paying any interest at all and simply accumulate a bigger and bigger debt until, presumably, they defaulted on it. Goldman Sachs not only sold him insurance on the pool but sent him a little note congratulating him on being the first person, on Wall Street or off, ever to buy insurance on that particular item. “I’m educating the experts here,” Burry crowed in an e-mail.
He wasn’t wasting a lot of time worrying about why these supposedly shrewd investment bankers were willing to sell him insurance so cheaply. He was worried that others would catch on and the opportunity would vanish. “I would play dumb quite a bit,” he said, “making it seem to them like I don’t really know what I’m doing. ‘How do you do this again?’ ‘Oh, where can I find that information?’ or ‘Really?’ — when they tell me something really obvious.” It was one of the fringe benefits of living for so many years essentially alienated from the world around him: he could easily believe that he was right and the world was wrong.
The more Wall Street firms jumped into the new business, the easier it became for him to place his bets. For the first few months, he was able to short, at most, $10 million at a time. Then, in late June 2005, he had a call from someone at Goldman Sachs asking him if he’d like to increase his trade size to $100 million a pop. “What needs to be remembered here,” he wrote the next day, after he’d done it, “is that this is $100 million. That’s an insane amount of money. And it just gets thrown around like it’s three digits instead of nine.”
By the end of July he owned credit-default swaps on $750 million in subprime-mortgage bonds and was privately bragging about it. “I believe no other hedge fund on the planet has this sort of investment, nowhere near to this degree, relative to the size of the portfolio,” he wrote to one of his investors, who had caught wind that his hedge-fund manager had some newfangled strategy. Now he couldn’t help but wonder who exactly was on the other side of his trades — what madman would be selling him so much insurance on bonds he had handpicked to explode? The credit-default swap was a zero-sum game. If Mike Burry made $100 million when the subprime-mortgage bonds he had handpicked defaulted, someone else must have lost $100 million. Goldman Sachs made it clear that the ultimate seller wasn’t Goldman Sachs. Goldman Sachs was simply standing between insurance buyer and insurance seller and taking a cut.
The willingness of whoever this person was to sell him such vast amounts of cheap insurance gave Mike Burry another idea: to start a fund that did nothing but buy insurance on subprime-mortgage bonds. In a $600 million fund that was meant to be picking stocks, his bet was already gargantuan, but if he could raise the money explicitly for this new purpose, he could do many billions more. In August he wrote a proposal for a fund he called Milton’s Opus and sent it out to his investors. (“The first question was always ‘What’s Milton’s Opus?’” He’d say, “Paradise Lost,” but that usually just raised another question.) Most of them still had no idea that their champion stock picker had become so diverted by these esoteric insurance contracts called credit-default swaps. Many wanted nothing to do with it; a few wondered if this meant that he was already doing this sort of thing with their money.
Instead of raising more money to buy credit-default swaps on subprime-mortgage bonds, he wound up making it more difficult to keep the ones he already owned. His investors were happy to let him pick stocks on their behalf, but they almost universally doubted his ability to foresee big macro-economic trends. And they certainly didn’t see why he should have any special insight into the multi-trillion-dollar subprime-mortgage-bond market. Milton’s Opus died a quick death.
In October 2005, in his letter to investors, Burry finally came completely clean and let them know that they owned at least a billion dollars in credit-default swaps on subprime-mortgage bonds. “Sometimes markets err big time,” he wrote. “Markets erred when they gave America Online the currency to buy Time Warner. They erred when they bet against George Soros and for the British pound. And they are erring right now by continuing to float along as if the most significant credit bubble history has ever seen does not exist. Opportunities are rare, and large opportunities on which one can put nearly unlimited capital to work at tremendous potential returns are even more rare. Selectively shorting the most problematic mortgage-backed securities in history today amounts to just such an opportunity.”