This method of attracting funds suited Mike Burry. More to the point, it worked. He'd started Scion Capital with a bit more than a million dollars--the money from his mother and brothers and his own million, after tax. In his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. 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. "If he'd run his fund to maximize the amount he had under management, he'd have been running many, many billions of dollars," says a New York hedge fund manager who watched Burry's performance with growing incredulity. "He designed Scion so it was bad for business but good for investing."
"While capital raising may be a popularity contest," Burry wrote to his investors, perhaps to reassure them that it didn't matter if they loved their money manager, or even knew him, "intelligent investment is quite the opposite."
Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a lot less than Buffett did about whether people liked him. Back in 1995, Munger had given a talk at Harvard Business School called "The Psychology of Human Misjudgment." If you wanted to predict how people would behave, Munger said, you only had to look at their incentives. FedEx couldn't get its night shift to finish on time; they tried everything to speed it up but nothing worked--until they stopped paying night shift workers by the hour and started to pay them by the shift. Xerox created a new, better machine only to have it sell less well than the inferior older ones--until they figured out the salesmen got a bigger commission for selling the older one. "Well, you can say, 'Everybody knows that,'" said Munger. "I think I've been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
Munger's remarks articulated a great deal of what Mike Burry, too, believed about markets and the people who comprised them. "I read that speech and I said, I agree with every single word of that," Burry said, adding, "Munger also has a fake eye." Burry had his own angle on this same subject, derived from the time he'd spent in medicine. Even in life or death situations, doctors, nurses, and patients all responded to bad incentives. In hospitals in which the reimbursement rates for appendectomies ran higher, for instance, the surgeons removed more appendixes. The evolution of eye surgery was another great example. In the 1990s, the ophthalmologists were building careers on performing cataract procedures. They'd take half an hour or less, and yet Medicare would reimburse them $1,700 a pop. In the late 1990s, Medicare slashed reimbursement levels to around $450 per procedure, and the incomes of the surgically minded ophthalmologists fell. Across America, ophthalmologists rediscovered an obscure and risky procedure called radial keratotomy, and there was a boom in surgery to correct small impairments of vision. The inadequately studied procedure was marketed as a cure for the suffering of contact lens wearers. "In reality," says Burry, "the incentive was to maintain their high, often one-to two-million-dollar incomes, and the justification followed. The industry rushed to come up with something less dangerous than radial keratotomy, and Lasik was eventually born."
Thus when Mike Burry went into business he made sure that he had the proper incentives. He disapproved of the typical hedge fund manager's deal. Taking 2 percent of assets off the top, as most did, meant the hedge fund manager got paid simply for amassing vast amounts of other people's money. Scion Capital charged investors only its actual expenses--which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors' money grow. "Think about the genesis of Scion," says one of his early investors. "The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of."
Right from the start, Scion Capital was madly, almost comically, successful. By the middle of 2005, over a period in which the broad stock market index had fallen by 6.84 percent, Burry's fund was up 242 percent and he was turning away investors. To his swelling audience, it didn't seem to matter whether the stock market rose or fell; Mike Burry found places to invest money shrewdly. He used no leverage and avoided shorting stocks. He was doing nothing more promising than buying common stocks and nothing more complicated than sitting in a room reading financial statements. For roughly $100 a year he became a subscriber to 10-K Wizard. Scion Capital's decision-making apparatus consisted of one guy in a room, with the door closed and the shades drawn, poring over publicly available information and data on 10-K Wizard. He went looking for court rulings, deal completions, or government regulatory changes--anything that might change the value of a company.
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.'"
The alarmingly named Avant! Corporation was a good example. He'd found it searching for the word "accepted" in news stories. He knew that, standing on the edge of the playing field, he needed to find unorthodox ways to tilt it to his advantage, and that usually meant finding unusual situations the world might not be fully aware of. "I wasn't searching for a news report of a scam or fraud per se," he said. "That would have been too backward-looking, and I was looking to get in front of something. I was looking for something happening in the courts that might lead to an investment thesis. An argument being accepted, a plea being accepted, a settlement being accepted by the court." A court had accepted a plea from a software company called the Avant! Corporation. Avant! had been accused of stealing from a competitor the software code that was the whole foundation of Avant!'s business. The company had $100 million in cash in the bank, was still generating $100 million a year of 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 Avant! Corporation than any man on earth. He was able to see that even if the executives went to jail (as they did) and the fines were paid (as they were), Avant! would be worth a lot more than the market then assumed. Most of its engineers were Chinese nationals on work visas, and thus trapped--there was no risk that anyone would quit before the lights were out. To make money on Avant!'s stock, however, he'd probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.
Burry bought his first shares of Avant! in June 2001 at $12 a share. Avant!'s management then appeared on the cover of an issue of Business Week under the headline "Does Crime Pay?" The stock plunged; Burry bought more. Avant!'s management went to jail. The stock fell some more. Mike Burry kept on buying it--all the way down to $2 a share. He became Avant!'s single largest shareholder; he pressed management for changes. "With [the former CEO's] criminal aura no longer a part of operating management," he wrote to the new bosses, "Avant! has a chance to demonstrate its concern for shareholders." In August, in another e-mail, he wrote, "Avant! still makes me feel I'm sleeping with the village slut. No matter how well my needs are met, I doubt I'll ever brag about it. The 'creep' factor is off the charts. I half think that if I pushed Avant! too hard I'd end up being terrorized by the Chinese mafia." Four months later, Avant! got taken over for $22 a share. "That was a classic Mike Burry trade," says one of his investors. "It goes up by ten times but first it goes down by half."
This isn't the sort of ride most investors enjoy, but it was, Burry thought, the essence of value investing. His job was to disagree loudly with popular sentiment. He couldn't do this if he was at the mercy of very short-term market moves, and so he didn't give his investors the ability to remove their money on short notice, as most hedge funds did. If you gave Scion your money to invest, you were stuck for at least a year. Burry also designed his fund to attract people who wanted to be long th
e stock market--who wanted to bet on stocks going up rather than stocks going down. "I am not a short at heart," he said. "I don't dig into companies looking to short them, generally. I want the upside to be much more than the downside, fundamentally." He also didn't like the idea of taking the risk of selling a stock short, as the risk was, theoretically, unlimited. It could only fall to zero, but it could rise to infinity.
Investing well was all about being paid the right price for risk. Increasingly, Burry felt that he wasn't. The problem wasn't confined to individual stocks. The Internet bubble had burst, and yet house prices in San Jose, the bubble's epicenter, were still rising. He investigated the stocks of home builders, and then the stocks of companies that insured home mortgages, like PMI. To one of his friends--a big-time East Coast professional investor--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."
When he set out to bet against the subprime mortgage bond market, in early 2005, the first big problem that he encountered was that the Wall Street investment banks that might sell him credit default swaps didn't share his sense of urgency. Mike Burry believed he had to place this bet now, before the U.S. housing market woke up and was restored to sanity. "I didn't expect fundamental deterioration in the underlying mortgage pools to hit critical levels for a couple years," he said--when the teaser rates would vanish and monthly payments would skyrocket. But he thought the market inevitably would see what he had seen and adjust. Someone on Wall Street would notice the fantastic increase in the riskiness of subprime mortgages and raise the price of insuring them accordingly. "It's going to blow up before I can get this trade on," he wrote in an e-mail.
As Burry lived his life by e-mail, he inadvertently kept a record of the birth of a new market from the point of view of its first retail customer. In retrospect, the amazing thing was just how quickly Wall Street firms went from having no idea what Mike Burry was talking about when he called and asked them about credit default swaps on subprime mortgage bonds, to reshaping their business in a way that left the new derivative smack at the center. The original mortgage bond market had come into the world in much the same way, messily, coaxed into existence by the extreme interest of a small handful of people on the margins of high finance. But it had taken years for that market to mature; this new market would be up and running and trading tens of billions of dollars' worth of risk within a few months.
The first thing Mike Burry needed, if he was going to buy insurance on a big pile of subprime mortgage bonds, was to create some kind of standard, widely agreed-upon contract. Whoever sold him a credit default swap on a subprime mortgage bond would one day owe him a great deal of money. He suspected that dealers might try to get out of paying it to him. A contract would make it harder for them to do that, and easier for him to sell to one dealer what he had bought from another--and thus to shop around for prices. An organization called International Swaps and Derivatives Association (ISDA) had the task of formalizing the terms of new securities.* ISDA already had a set of rules in place to govern credit default swaps on corporate bonds, but insurance on corporate bonds was a relatively simple matter. There was this event, called a default, that either did or did not happen. The company missed an interest payment, you had to settle. The insurance buyer might not collect the full 100 cents on the dollar--just as the bondholder might not lose 100 cents on the dollar, as the company's assets were worth something--but an independent judge could decide, in a way that was generally fair and satisfying, what the recovery would be. If the bondholders received 30 cents on the dollar--thus experiencing a loss of 70 cents--the guy who had bought the credit default swap got 70 cents.
Buying insurance on a pool of U.S. home mortgages was more complicated, because the pool didn't default all at once; rather, one homeowner at a time defaulted. The dealers--led by Deutsche Bank and Goldman Sachs--came up with a clever solution: the pay-as-you-go credit default swap. The buyer of the swap--the buyer of insurance--would be paid off not all at once, if and when the entire pool of mortgages went bust, but incrementally, as individual homeowners went into default.
The ISDA agreement took months of haggling among lawyers and traders from the big Wall Street firms, who would run the market. Burry's lawyer, Steve Druskin, was for some reason allowed to lurk on the phone calls--and even jump in from time to time and offer the Wall Street customer's point of view. Historically, a Wall Street firm worried over the creditworthiness of its customers; its customers often took it on faith that the casino would be able to pay off its winners. Mike Burry lacked faith. "I'm not making a bet against a bond," he said. "I'm making a bet against a system." He didn't want to buy flood insurance from Goldman Sachs only to find, when the flood came, Goldman Sachs washed away and unable to pay him off. As the value of the insurance contract changed--say, as floodwaters approached but before they actually destroyed the building--he wanted Goldman Sachs and Deutsche Bank to post collateral, to reflect the increase in value of what he owned.
On May 19, 2005--a month before the terms were finalized--Mike Burry did his first subprime mortgage deals. He bought $60 million in 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'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them. In doing so, he likely also 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 the rating agencies, 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 Big Short: Inside the Doomsday Machine Page 6
