"It is ludicrous to believe that asset bubbles can only be recognized in hindsight."
In 2008, Dr. Michael Burry sat alone in his office in San Jose, California whilst mortgage borrowers began to default en masse and modern Capitalism began to fray at the seams. He had founded Scion Capital, a hedge fund, in 2000. This was the height of the ‘dot com’ bubble; a craze for internet stocks had swept through America during the late 1990s and had blown share prices into the stratosphere. Hedge funds from San Diego to Manhattan were long on the stocks and pouring in funds at alarming rates, adding kerosene to an already well-stoked fire. It was only a few years prior that Burry had started to make himself something of an up and coming name in the domain of value investing. This eventually became his firm’s investment philosophy. This was bizarre in the context of a financial market bubble. Value investing? In the middle of an asset price bubble that the market was apparently oblivious to? He didn’t believe in the conventional wisdom and saw straight through the facade that was the internet frenzy.
When the dot com bubble eventually burst in 2000, hedge funds began haemorrhaging and internet companies virtually capitulated overnight. Given the web of involvement between investment, retail, and commercial banks, household savings and pensions ceased to be. An estimated $6.2 trillion in household wealth is thought to have been wiped out. To create some chronological perspective, Burry founded Scion in November 2000. Given that the bubble burst in March of 2000 (8 years before the financial disaster of 2008), Burry was given a golden opportunity to implement his value-driven philosophy (inspired by Dodd and Graham) from the ground up. His firm therefore didn’t bleed, as it didn’t even exist yet. 1-0 to Mr Burry. This is an example of how economic disaster can in fact create great opportunity to some, given the right resources and mindset. It also gave Burry the ability to grow the size of the firm consistently with monstrous returns, and meant there were no massive losses to absorb and start again. If this had been the case, it is likely investors would not have had the confidence to facilitate what was to come just less than a decade later.
In 2008, it seemed the whole world economy was teetering on the edge of collapse. Due to callous lending practices employed by banks, consumers with poor credit found themselves being unable to repay their mortgages. ‘Subprime’ mortgages were effectively mortgages for individuals with a credit score below 670. Given subprime individuals were less likely to be able to honour mortgage payments given their history, banks demanded a greater interest rate in order to justify the risk in lending. Given that a fixed-rate mortgage with a high-interest rate is unaffordable for most, even prime borrowers, they had to come up with a way of making borrowing affordable. Variable-rate mortgages seemed to be the answer, where consumers were given the option to refinance when they wanted. In many cases, however, these variable-rate mortgages were actually a masquerade, designed to reel in the desperate and hopeful, preying on their dreams of owning a home. For some, monthly repayments skyrocketed when they refinanced, causing them to default when ‘teaser rates’ expired. The scale and complexity of the origins of this financial disaster are too convoluted and complex to dissect in a mere blog post. Michael Lewis’ The Big Short is likely the most readable of accounts of the financial crisis; I would recommend it for any budding economists or finance-sceptics. To summarise, mortgage bonds and CDOs (Collateralised Debt Obligations) were stuffed with risky subprime mortgages, labelled as AAA-rated bonds by ratings agencies such as Moody’s, Standard & Poor’s, and Finch. Given these were incredibly profitable in the short-term, delivering a greater yield than standard mortgages, funds naturally piled in. As a result, house prices rose seemingly exponentially until they collapsed. The aftermath was of a great multitude more destructive than the dot com bubble; this had struck the foundation that the US economy was built on. Once again, Burry was there. Except this time, he not only delivered solid returns in a time of volatility and uncertainty, but enormous ones.
Mike Burry has always been different. He initially attributed a lifelong accumulation of ‘odd’ behaviours to his glass eye; he had a rare cancer as a child that cost him his eye. Burry was even diagnosed as bipolar when he was a medical student. Although, in the end, it was clear none of these were true. When his son started showing anti-social behaviour in elementary school, Burry’s wife insisted he be ‘tested’. What started with his son being diagnosed with Aspergers resulted in him picking up a book on clinical psychology, only to find many of the behaviours associated with the syndrome to be applicable to himself. One leapt out at him: “may have one or a few very select interests that they are extremely knowledgeable about.” Burry always had incredible powers of concentration when learning about topics that interested him; he sometimes sat for days at a time reading everything under the sun that had to do with investing, shares, bonds, anything. This is perhaps what allowed him to so wholly immerse himself into financial markets, or rather their flaws. It was perhaps after reading thousands of pages of mortgage bond prospecti that he decided something that would change his life and worldview forever: he wanted to short the housing market.
To return to esoteric finance terms, Burry wanted to ‘short’ the housing market. This is to bet, through the use of a financial instrument, that the market would decline in value. If the market increased in value, he would lose money. If the market’s value fell, his position would appreciate. This is how Burry outperformed market indices during the dot com bubble: shorting overvalued internet companies. This is not a complex concept, but I will mention it to provide the foundations for what will be duly discussed. Typically shorting is executed through the purchase of financial instruments called ‘options’ that possess varying properties that determine their price; Fischer Black and Robert Merton were awarded the 1997 Nobel Prize in economics for determining these properties and defining value in the Black-Scholes formula (Aside: Scholes of Black-Scholes had died in 1995, making him ineligible for the award). The problem for Dr Burry was that what he wanted to short (bonds) were not included in options trading. After going to great lengths to decide on his prime shorting instrument, he finally decided on a CDS (Credit Default Swap) that was effectively insurance on the bond; if the bond was defaulted on, those who owned the contracts were left with returns up to 50/1. These were priced cheaply, given how unlikely the market found it that the housing market would collapse. That or people just didn’t know about them. Burry was so confident in his analysis that the short position he held leading up to the crisis came within touching distance of Scion’s liquidity. His investors didn’t share his sentiment, and when they came demanding withdrawal of their funds he remained firm. He exercised a ‘side-pocket’ option that prevented investors withdrawals under the explanation that he believed the market was not functioning properly. This of course incited already angry clients to become flaming balls of rage, all headed in the direction of a man who didn’t recognise or respond to the emotions of others. It’s easy to imagine those figurative fireballs of emotion headed towards Mike Burry sailing by, the Doctor having dipped his head without skipping a beat, his eyes trained on remittance data. Eventually, the bonds that Burry shorted became worthless, his CDSs were offloaded, and he generated a 489.34% return. Yes. That is not a typo.
Following the crisis and investor revolt, Burry closed Scion Capital to focus on his personal investments, which consisted of trading in water, farmland, and gold. However, this didn’t last long. Perhaps it was the joy of generating huge returns whilst his investors became increasingly irritated by him, or maybe the temptation of turning market sentiment on its head in hopes of proving institutions to be wrong, stupid, or criminal. By 2013 he had opened a new fund: Scion Asset Management. The spirit of Scion would remain. He retained his adapted philosophy, by incorporating his aforementioned trading areas into a strategy. By Burry standards, this seemed relatively non-confrontational. Well, once again, that didn’t last long.
Burry has begun prophesying a bubble that incorporates virtually every major blue-chip stock listed on an American market index. His argument goes something like this: there has been in recent years a proliferation in ‘passive investing’, where people with a few spare pounds of disposable income go online and invest it into huge corporations in the hope of generating a stable return, whilst offering the feeling of being a market mastermind. As a result, bigger corporations benefit from a stable status, increasing the funds that are poured into them by everyday consumers. The logic is there. Passive investors act on imperfect information; they pick firms who are more well-known and valuable, assuming that a high share price is indicative of stability and correct value. And if there is one trait that every market bubble possesses, it’s imperfect information. This belief has led Burry to publicly criticise the richest man on Earth, Elon Musk. As mentioned previously, Burry doesn’t care who you are. If you’re wrong, you’re wrong. It is much easier to be honest when you don’t feel the same as other people about honesty.