Managed Funds Getting Rich off Subprime

Getting rich off the subprime mess


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A hedge fund manager has made hundreds of millions for his investors by betting against the mortgage industry. He can't understand 'why more people didn't figure this out.'
By Jon Markman

One of the most important phone calls of hedge fund manager Mike Burry's professional life came in the parking lot of his son's eye doctor in mid-2005.

For months, Burry had been seeking ways to make money by betting big against the mortgage industry's reckless home-lending practices. And this call from a credit dealer at Deutsche Bank (DB, news, msgs) would finally set his plot in motion.

As of last week, Burry's bet against the lenders had helped him quadruple an initial investment of roughly $80 million, according to my estimates. But these trades of a lifetime were by no means easy. They required the former Stanford University Medical Center neurology resident to combine nerves of steel with the conviction of a federal prosecutor. Not to mention his natural inclination as a skeptic.

"I never believe what I'm told by a company unless I have independent proof," he says, explaining how he bucked Wall Street groupthink to wage his campaign.

Understanding Burry's bonanza is key to deciphering the storm of trouble brewing in the economy, one that has seen financial stocks fall more than 20% and the dollar's value plummet. It pits an investor with little previous experience in credit markets against financial powerhouses staffed with math wizards and mainframe computers.

The fact that Burry came out on top has not dimmed his annoyance with the consequences of their greed and lies. Nor does he think the pain is over for the banks or the economy.

"I think we're headed into a deep recession, the worst since the Depression, as dozens of banks will fail," Burry says. "With massive foreclosures, there are homes that won't see the prices of two years ago for decades." And with the $500 billion home-equity spigot turned off, the money to pay off credit card debt, student loans and auto loans has evaporated. "We're looking at a lot of pain ahead."

Though many investors may say now that they saw this coming, few actually figured out what to do about it to the extent that Burry did.
Overpriced 'junk'
Burry started his value-oriented Scion Capital hedge fund in 2000 after dropping out of his Stanford residency. His fund performed well right away on purchases of out-of-favor stocks -- netting 45% in 2001, 13% in 2002 and 40% in 2003 -- and more investments started flowing in. But he didn't consider his bet against the lenders until he began to observe both fly-by-night mortgage brokers and major banks taking what he deemed "extremely unsuitable risks," using outlandish interest-only and adjustable-rate mortgages to get customers into houses they could not otherwise afford.

After listening to quarterly earnings conference calls by companies such as Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs) and reading real-estate journals, Burry came to realize that home-price appreciation was the assumption behind every decision by borrowers, lenders, insurers and ratings agencies. He figured that once California home prices started to fall, the entire lending apparatus would fail and a credit crisis would ensue.

Fed watching bank Scrooges
Banks are hoarding cash like Scrooge McDuck. They're afraid to lend because they don't know who can pay them back, and they might need the cash themselves. Count on the Fed to step in as the lender of last resort, says MSN Money's Jim Jubak, as it tries to keep the economy from sinking.

"It became clear to me that many people never expected to pay their loans back and depended on a rise in home values every two years to allow them to refinance," he says.

As Burry researched, he discovered that all the subprime, or "junk," loans were being buried in tradable securities that banks were creating. Those securities, backed by the principal and interest on the mortgage loans the banks made, served as collateral to allow them to make even more loans and were a source of fixed-income returns for investors having trouble finding good returns elsewhere.

Continued: Clues were in the fine print

Studying the fine print in the prospectuses that banks filed with regulators as a part of every security offering, Burry learned that most subprime loans were sequestered in a "subordinated tranche," or lower level, of securities that inexplicably carried an investment-grade rating. That meant institutional money managers at mutual fund companies and pension funds who were obligated to invest conservatively could still buy these instruments without recognizing their danger.
A willing opponent
He also learned that the big banks and brokerage firms that had packaged the securities provided a lot of information about the subprime tranches, including the percentage of loans that had been taken out on second homes, their average loan-to-value ratio, the borrowers' average credit scores, the homes' locations and the loan dates.

"It's like learning a foreign language in a foreign country," he says of the self-education process. Anything you don't understand right away, he says, you look up or figure out in context.

Leveraging original research on which regions, credit scores and home types were most likely to default, Burry pinpointed hundreds of tranches he believed were most vulnerable to a potential wave of foreclosures and defaults. But there was still no way to easily short-sell these tranches, so he asked the broker-dealers who handled his derivatives accounts to let him know when such a method or instrument was created.

Now enter that phone call. In mid-2005, Burry's contact at Deutsche rang to say that the bank's credit-derivatives desk had decided to offer credit-default swaps on those subprime-mortgage-backed tranches. A credit-default swap is essentially an insurance policy that pays off if its targeted instrument -- a tranche, an entire mortgage-backed security, a collateralized debt obligation or a company -- goes belly-up. Buyers must pay an annual premium, at a rate set by the marketplace, for a contract that pays $10 million, for example, in the case of a default. The buyer can continue to pay the swap premium for years waiting for an expected default, or he/she can sell the swap at a profit to another buyer.

If you're a buyer, your counterparty -- the investor who loses when you win and vice versa -- is a swap dealer representing another investor who has the opposite point of view on the targeted security.

European and Asian pension fund managers hungry for yield at a time of low global interest rates were avid buyers of the type of insurance-premium income that Burry was paying. Because the subprime tranches were rated investment-grade, the buyers thought they were relatively safe and thus were getting money for nothing.

In contrast, Burry thought it was nuts for someone to take the other side of these trades, believing that in two years enough borrowers would default to make the swaps trigger a payout. If he paid $130,000 a year for the swap for a couple of years, he figured that a $10 million reward was an awesome deal. You could make 12 to 30 times your money -- or more if you borrowed the money that you used to make your payments.
Making his bet
In mid-2005, Burry started buying as many credit-default swaps on tranches of these securities -- with names like PPSI 2005-WLL1 -- as he could afford. He typically paid 1.25 to 1.3 percentage points of the swaps' face value for BBB tranches and 1.7 to 2.25 percentage points for BBB-minus -- which translated to $125,000 to $225,000 per year on a $10 million contract -- and seemed to have little competition when bidding.

"I'm totally at a loss to explain why more people didn't figure this out," Burry said. "I have been to undergraduate and grad school, and I know I'm in the middle of the pack when it comes to intelligence. You really didn't have to be a genius."

Fed watching bank Scrooges
Banks are hoarding cash like Scrooge McDuck. They're afraid to lend because they don't know who can pay them back, and they might need the cash themselves. Count on the Fed to step in as the lender of last resort, says MSN Money's Jim Jubak, as it tries to keep the economy from sinking.

That autumn, Burry tried to raise money for a new fund to focus exclusively on these trades but could not convince enough high-net-worth individuals or institutional investors that it was a smart idea. It was lonely as a pioneer. For the first few months, his new swaps, now a large position within his main hedge fund, were priced regularly by dealers. But as the mortgage market encountered turbulence in late 2006, pricing became irregular and inconsistent, and he eventually had to hold the swaps off to the side because their exact value was not known.

Continued: Undeterred despite a big loss

He ended 2006 with the first negative return in his fund's history -- an 18% loss -- during a year when the broad market was up 15%. Yet he stubbornly stuck to his belief that the swaps would work out. "There's a real benefit to working largely alone, far away from Manhattan or London," Burry said. "I sit out here in Cupertino, and I don't socialize with anyone who does what I do."

In essence, Burry believed that he had taken out insurance policies on patients who looked healthy on the surface but who he knew were at death's door. He just had to wait.

Last summer, his persistence began to pay. As the hysteria over subprime loans hit a fever pitch, the value of his swaps shot up as much as sixfold, and he was finally able to sell some of his positions for big profits. In addition to the mortgage-backed-security tranches, Burry also cashed in on his timely purchases of default swaps over the past three years on ill-fated bond insurers, which had seen their market values cut by as much as 75%.

Burry has been booking some profits rather than holding out for bigger gains. "It's just a risk-reward balance," he said. "I bought all these things when no one was paying attention and their prices were low, and now there are prices that are really high, and it's time for me to take advantage of that." The fund was up 101% this year, before Burry's fees, through the end of the third quarter, according to a quarterly letter to clients.

Burry remains short the corporate debt of major U.S. financial institutions, as he believes several will collapse under the weight of their write-offs. Optimists believe a Fannie Mae (FNM, news, msgs) or Citigroup (C, news, msgs) may be too big to fail, but Burry asks, "How many too-big-to-fail companies can fail at the same time?"

Good question. Unfortunately, we may not have too long to wait to find out.
Fine print
Longtime MSN Money readers may remember Burry as a writer for our site in the late 1990s and as one of the first Strategy Lab contestants. He caught our eye back then as author of a Web site called Valuestocks.net, a precursor to the thousands of financial blogs today. . . .

Why not just short the equities of the financial companies? Burry notes that if you are short Countrywide at $10 a share, you could wake up the next morning and discover that Warren Buffett has decided to buy it out for $20, and your position is annihilated. By buying the swaps, your exposure is limited to the premium stream you've contracted to pay. . . . Burry still likes some stocks long, all in industries that will rise amid the regime of a lower dollar, including gold, industrial metals and energy.