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Who is Michael Burry?
Michael J. Burry grew up in San Jose, California. He studied economics and pre-med at UCLA and earned his medical degree at Vanderbilt University School of Medicine in Tennessee. After moving back to California to do his residency at Stanford, Burry would dabble in financial investing on nights off duty. Soon, without finishing, he left school to start his hedge fund, which he called Scion Capital. Michael Burry was always awkward and anti-social, leading him to later self-diagnose himself with Asperger’s syndrome. And though he was exceptionally brilliant, Burry had few friends and was not yet established in investment circles when he embarked on his career. Recommended video: Michael Burry explains how he shorted the housing bubble Investing for Beginners:
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Michael Burry and the dot-com bubble
Burry has stated that his investment style is built upon Benjamin Graham’s and David Dodd’s 1934 book “Security Analysis,” the core text for value investing, saying: “All my stock picking is 100% based on the concept of a margin of safety.” Accordingly, he was among the first to call the dot-com bubble by analyzing overvalued companies with little revenue or profitability. He began shorting those stocks immediately, quickly earning extraordinary profits for his investors. Burry returned 55% in the first year (2001) even though the S&P 500 fell almost 12%. The market continued to decline dramatically over the next two years, yet Burry’s fund returned 16% (compared to the 22% fall of S&P 500) and 50% (S&P rose 28%), making him one of the most successful investors in the industry at the time. Burry was so successful that he attracted the interest of companies such as Vanguard, White Mountains Insurance Group, and well-known investors such as Joel Greenblatt. As a result, by the end of 2004, he was managing $600 million and turning investors away.
Micahel Burry and the big short
In 2005 Burry’s focus turned to the subprime market. Through his analysis of mortgage lending practices and bank balance sheets in 2003 and 2004, he began to notice significant irregularities in this market, correctly predicting that the housing bubble would collapse as early as 2007. He saw the riskiness of the subprime market as millions of borrowers with low income and no assets bought homes with enormous leverage, in many cases, making no down payments for mortgages that they couldn’t afford when interest rates would eventually rise. Yet, the banking system was valued as if these mortgages were all solid. Burry realized this would be unsustainable long term and that the credit products based on these subprime mortgages would plummet in value as soon as higher rates replaced the original rates. Recommended clip from the famous movie “The Big Short”: Michael Burry realizes MBSs are full of subprime loans and decides to short the housing market. This conclusion led him to short the housing market by convincing Goldman Sachs and other investment banking companies to sell him credit default swaps (CDS) against subprime deals he saw as vulnerable. In short, sell positions on the assumption that housing prices will drop. However, as prices continued surging, Burry’s clients grew nervous and frustrated as he continued his short plays using derivatives. Unfortunately or, instead, fortunately in retrospect, when they demanded to withdraw their capital, Burry simply refused the investors’ pleas (by placing a moratorium on withdrawals from the fund), angering his clients even more. Recommended clip from the famous movie “The Big Short”: Michael Burry and the rest of the teams are confronted with surging MBS and CDO values (the very bonds they are trying to short). Eventually, Burry’s analysis proved correct: in 2007, the market started to turn in his predicted direction as more insiders understood the system’s risks. Then the dominoes began to drop, with Bear Stearns, Lehman Brothers, AIG, and the rest of the financial system behind them. Burry’s bet paid off handsomely, earning him a hefty personal profit of $100 million and more than $700 million for his remaining investors. Ultimately, Scion Capital documented returns of 489.34% between its November 1, 2000, founding, and June 2008. In contrast, the S&P 500 returned under 3%, including dividends over the same period.
“The Big Short” synopsis
“The Big Short” is a character-driven film focusing on the events leading up to the subprime meltdown and the cynical yet shrewd men who foresaw and profited from the crisis. One of those men is Michael Burry: an eccentric ex-physician turned hedge fund manager at Scion Capital. It is 2005, and Burry begins to suspect the booming U.S. housing market is virtually an asset bubble inflated by high-risk loans. Consequently, he proceeds to bet against the housing market with derivative financial instruments. Meanwhile, Deutsche Bank executive Jared Vennett inadvertently gets wind of what Burry is doing and, too, tries to capitalize on Burry’s beliefs. Bennett’s accidental phone call to FrontPoint Partners gets this information into the hands of Mark Baum, a hedge fund manager under Morgan Stanley (NYSE: MS), whose distrust of the financial system leads him to join forces with Vennett. A third plot strand follows two young investors, Charlie Geller and Jamie Shipley, with a $30 million start-up garage company called Brownfield, who get a hold of Venett’s paper on the matter. Wanting in on the action but lacking official credibility to play, they seek the investment advice of retired banker Ben Rickert. In short, all these men have concluded that the housing bubble is out of proportion to the industry’s fundamentals and will ultimately pop and may, in fact, lead to the downturn of the entire U.S. economy. And so, they invest accordingly: by shorting the American housing market. All three groups work on the premise that the banks are blinded by their greed and don’t know what’s coming to them. However, for them to profit, the economy has to collapse, representing the suffering of millions of average citizens who have put their trust and savings into these financial institutions. Best summarized by Ben Rickert, Brad Pitt’s character as he lambasts Geller and Shipley for celebrating their good fortune: Most leading characters in the film take short positions in mortgage-backed securities (MBS), convinced that prices will fall when the housing market collapses.
“The Big Short’s” premise
“The Big Short” recounts how the housing bubble, driven by the growth of the subprime mortgage market and the investment vehicles derived from it, led to the 2008 financial crisis. Illustrated by clips from the film, let’s briefly go over the state of the economy and the housing market at the time.
Subprime meltdown explained
Confronted with the dot-com bubble’s collapse and 9/11, the Federal Reserve lowered the interest rate from 6.5% in May 2000 to 1% in June 2003. This resulted in vast economic growth across the U.S., increasing the demand for homes and mortgages. On the other hand, the real estate bubble that ensued also led to record levels of homeownership in the U.S., leading banks to struggle to find new homebuyers. So, to still capitalize on the home-buying frenzy, some lenders started to extend mortgages to those who couldn’t otherwise qualify by offering subprime loans made to borrowers with poor or no credit histories and thus higher interest rates than other mortgages. Recommended video: Margot Robbie in a bubble bath explains subprime loans in mortgage bonds. The banks then bundled up these loans and sold them to investment banks, which repackaged them into what were advertised as low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations (CDOs) which were, in turn, marketed to investors on Wall Street. But unfortunately, these credit products were only as sound as the mortgages that backed them up, a fact that would become painfully obvious in the years to come. Recommended video: Anthony Bourdain explains how subprime mortgages were tossed into CDOs to hide their risky nature from unsuspecting investors. Many subprime mortgages were adjustable-rate mortgages (ARM), also known as variable-rate mortgages. In short, these loans generally come with a fixed interest rate in the early life of the loan (teaser rate) and are then reset over time, depending on changes in a corresponding financial benchmark (e.g., Prime Rate or the Fed funds rate) associated with the loan. Ultimately, the borrower’s payment will increase or decrease according to the index’s fluctuations. Eventually, interest rates rose, and homeownership reached a saturation point (by 2004, U.S. homeownership had peaked at 69.2%). The Fed began raising rates in June 2004, and two years later, the Federal funds rate had reached 5.25%, remaining as such until August 2007. And so, as expected, during early 2006, home prices started to fall, which for many Americans meant their homes were now worth less than what they paid for them, making it more difficult to refinance their loans. Moreover, if they had ARMs, their costs went up as their homes’ values plummeted, leaving the most vulnerable subprime borrowers stuck with mortgages they couldn’t afford in the first place. Additionally, the eventual recession saw substantial job losses throughout the economy, further increasing the number of loan defaults.
The problem with collateralized debt obligations
Weak CDOs, particularly mortgage-backed securities, were the leading culprits of the subprime mortgage crisis that led to the Great Recession. The goal of creating CDOs is to use the debt repayments as collateral for the investment. In other words, the promised repayments of the loans give the CDOs their value. That’s why banks slice CDOs into various risk levels or tranches. The least risky tranches (senior/AAA) have more certain cash flows and a lower degree of exposure to default risk. In contrast, riskier (equity) tranches have more uncertain cash flows and greater exposure to default risk but offer higher interest rates to attract investors. Recommended clip from “The Big Short” movie: The famous “Jenga” episode visually explains the mortgage bonds and the whole market crash. Unfortunately, the underlying loans of CDOs were often rated incorrectly, inflating the CDO’s value and misleading investors. To complicate matters even more, CDOs could be made up of a pool of prime loans, near-prime loans (called Alt.-A loans), risky subprime loans, or a combination of the above. Recommended video: Mark Baum gets to the bottom of why the value of mortgage bonds is rising if the underlying loans that back them are weak and how the system is rigged to the bank’s favor. On top of asset composition, additional factors caused CDOs to be more complicated. For example, some structures used leverage and credit derivatives that could render even the senior tranche risky, creating synthetic CDOs backed merely by derivatives and credit default swaps made between lenders and derivative markets.
Wall Street crashes
As the housing market collapsed and borrowers could not pay their mortgages, banks were suddenly overwhelmed with loan losses on their balance sheets. And as unemployment soared across the nation, many borrowers defaulted or foreclosed on their mortgages. Unfortunately, because of the recession, banks struggled to resell the foreclosed properties for the same amount they were mortgaged. As a result, banks endured massive losses, leading to tighter lending and less credit access, ultimately culminating in lower economic growth. The losses were so significant for some banks that they were declared insolvent or purchased by other banks to preserve them. Additionally, several large institutions had to take a bailout from the federal government in the Troubled Asset Relief Program (TARP). However, the bailout was too late for Lehman Brothers, the fourth-largest investment bank in the United States, which– succumbed to its overexposure to the subprime mortgage market– announced the largest bankruptcy filing in U.S. history at that time. The fact that Lehman Brothers was allowed to fail by the federal government led to massive repercussions and sell-offs across the markets. Moreover, as more investors pulled capital out of banks and investment firms, those establishments also began to suffer. So, although the subprime meltdown started with the housing market, its shockwaves ultimately devasted the entire financial landscape leading to the Great Recession and massive sell-offs in the markets.
Michael Burry recession warnings 2022 – 2023
More recently, Dr. Michael Burry has started and continues to warn us about the looming recession of 2022-2023. Michael Burry, through his Twitter account named “Cassandra B.C.,” has actively tweeted (most of which are now deleted) about the reasons why and the warning signs. Burry’s Twitter name comes from when Warren Buffett called Dr. Burry “Cassandra,” a Trojan priestess from Greek mythology who delivered true prophecies but, just like Burry and his warnings about the housing bubble, was never believed. Via his tweets, Dr. Burry has commented the US stocks are likely to keep falling further, and warning several investors will incur heavy losses. He has also compared the upcoming market slump to that of the dot-com crash, caused by a bubble in passive investing, which has, in turn, inflated asset prices in the past few years. Several now deleted Michael Burry’s tweets have also been aimed at the Federal Reserve, first for not shrinking its balance sheet enough. In October 2022, Michael Burry’s Twitter thread comment, he notes problems, this time in Treasury bond markets that are becoming increasingly unstable.
In conclusion
Much like “The Big Short” depicted, what was brewing underneath the housing bubble went largely unnoticed. The truth about what banks and their enablers were doing was only evident to a handful of people– the motley crew of investors we meet in the movie. Of whom Michael Burry is the most notable, the hedge fund manager who broke the seal on the big bet on financial catastrophe. The film manages to excel at illustrating and defining high finance’s dry, complex abstractions by employing creative and vivid methods such as celebrity cameos, metaphoric descriptions, and visual aids like a Jenga tower. Overall, “The Big Short” presents us with a wonderfully entertaining and educational look at the build-up and subsequent collapse of the housing bubble. Ultimately, it concludes that Wall Street’s greed sank the global economy for years. But as interest rates started to rise in the mid-2000s, homeownership reached a saturation point, pushing real estate prices to drop and people to default on their loans, effectively rendering these credit products worthless and bursting the housing bubble as well as collapsing Wall Street.
