Who is Michael Burry
Michael Burry, an American investor and hedge fund manager, was born and raised in San Jose, California. He earned an economics degree at UCLA and later a medical degree from Vanderbilt. However, he quit his medical path early during his residency at Stanford. In 2000, he founded the hedge fund Scion Capital, where he famously bet on the market collapsing, earning him millions.
The Setup
For years leading up to 2008, lenders gave out subprime mortgages, which are essentially loans to people with weak credit or unstable incomes who couldn’t afford them. Many of the mortgages were issued at teaser rates, which provided the loan at a very low interest rate that would jump higher later. This essentially baited many people into thinking, “Hey, I can pay this now,” but later it would all lead to disaster.
Once they had all these mortgages, banks bundled them into one large package called a mortgage-backed security (MBS), including both the good loans and the shaky ones. These packages were then divided into slices, or “tranches.” The top tranche (investment grade) gets paid first if people pay their mortgages and is usually labeled AAA or AA for super safe. The middle tranche (mezzanine) is assigned ratings A or BBB, while the bottom tranche (sub-investment grade), which contains the most risk and is usually considered junk, has a grade of BB or lower. The way the tranches work is that money from homeowners’ mortgage payments is limited. If some borrowers default (stop paying), there might not be enough to pay everyone in full. Whoever gets paid first (the top tranche) is protected — even if the bottom slices lose everything, the top slice still gets its money. The other two tranches offer higher compensation in return for their risk. Credit rating agencies gave high ratings to these slices despite them being risky, and people believed the AAA rating, assuming it was accredited and safe.
The Insight
Burry was different from other investors; he was a highly analytical man obsessed with the data rather than the market trends. He began examining the U.S. housing market closely and noticed that banks were giving out these subprime loans to people who had poor credit and most definitely couldn’t pay them back. Banks and investors were blindly following the myth of the “housing market always goes up.” Burry knew that once the teaser rates reset, homeowners would not be able to afford their payments. If too many borrowers defaulted, then the bonds would collapse in value. He foresaw this and wanted to bet against the housing market, but how could you do that if you can’t short a house?
The Plan in Action
Burry turned to something called a credit default swap (CDS). A CDS is essentially a type of insurance geared towards bonds: the buyer pays a regular premium to the seller, and if the bond fails or defaults, the seller pays the buyer the difference in value. He was counting on these mortgage bonds failing. He didn’t own them himself; he simply speculated that the bonds themselves would fail. He purchased these contracts from major banks, which were willing to sell them at high prices because the banks believed the mortgage bonds were safe.
In 2007–2008, the housing market collapsed. Once all the teaser-rate and adjustable-rate mortgages reset to higher payments, homeowners defaulted in large numbers. Because Burry had bought CDS contracts, his hedge fund was owed huge payouts from the banks that sold the insurance. He personally earned about $100 million, while the investors in his fund, who had been skeptical and angry at him for putting in the money, earned about $750 million.
Michael Burry’s story became widely known through Michael Lewis’s book The Big Short, which was later adapted into a movie. He is remembered for his meticulous analysis and willingness to go against conventional wisdom, despite others’ opinions.
Links:
Tranche Rating: Behind the Numbers: Understanding Tranche Ratings update - FasterCapital
https://finbold.com/guide/michael-burry-the-big-short-explained
https://www.investopedia.com/who-is-michael-burry-5235600?utm_source
https://verifiedinvesting.com/blogs/education/michael-burry-the-big-short-visionary-who-saw-the-crisis-coming?srsltid=AfmBOoolzgLPhv9dGqTa4QeuISOyP4loSmjCMTjR9pyKVZ1YnNIZ2PND https://www.vanityfair.com/news/2010/04/wall-street-excerpt-201004
Image Source: https://news.sky.com/story/the-big-short-investor-michael-burry-bets-1-6bn-on-stock-market-crash-12940826 (L-R) Michael Burry and Christian Bale. Pics: Plan B/Regency Enterprises/Paramount/Kobal/Shutterstock