Betting on the Blind Side | Vanity Fair

http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt...

Michael Burry always saw the world differentlydue, he believed, to the childhood loss of one eye. So when the 32 year old investor s!otted the hu"e bubble in the sub!ri#e #ort"a"e bond #ar$et, in 2%%&, then created a way to bet a"ainst it, he wasn't sur!rised that no one understood what he was doin". (n an e)cer!t fro# his new boo$, The Big Short, the author charts Burry's oddball #aneuvers, his al#ost co#ical dealin"s with *old#an Sachs and other ban$s as the #ar$et colla!sed, and the true reason for his visionary obsession.
Michael Lewis Jonas Fredwall Karlsson

Excerpted from +he Bi" Short, (nside the -oo#sday Machine, by Michael Lewis, to be published this month by W. W. orton! " #$%$ by the author. n early 2%%& a 32 year old stoc$ #ar$et investor and hed"e fund #ana"er, Michael Burry, i##ersed hi#self for the first ti#e in the bond #ar$et. .e learned all he could about how #oney "ot borrowed and lent in /#erica. .e didn't tal$ to anyone about what beca#e his new obsession0 he 1ust sat alone in his office, in San Jose, 2alifornia, and read boo$s and articles and financial filin"s. .e wanted to $now, es!ecially, how sub!ri#e #ort"a"e bonds wor$ed. / "iant nu#ber of individual loans "ot !iled u! into a tower. +he to! floors "ot their #oney bac$ first and so "ot the hi"hest ratin"s fro# Moody's and S34, and the lowest interest rate. +he low floors "ot their #oney bac$ last, suffered the first losses, and "ot the lowest ratin"s fro# Moody's and S34.

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Betting on the Blind Side | Vanity Fair

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Because they were ta$in" on #ore ris$, the investors in the botto# floors received a hi"her rate of interest than investors in the to! floors. (nvestors who bou"ht #ort"a"e bonds had to decide in which floor of the tower they wanted to invest, but Michael Burry wasn't thin$in" about buyin" #ort"a"e bonds. .e was wonderin" how he #i"ht short, or bet a"ainst, sub!ri#e #ort"a"e bonds. 5very #ort"a"e bond ca#e with its own #ind nu#bin"ly tedious 63% !a"e !ros!ectus. (f you read the fine !rint, you saw that each bond was its own little cor!oration. Burry s!ent the end of 2%%& and early 2%%7 scannin" hundreds and actually readin" do8ens of the !ros!ectuses, certain he was the only one a!art fro# the lawyers who drafted the# to do soeven thou"h you could "et the# all for 96%% a year fro# 6%$:i8ard.co#. +he sub!ri#e #ort"a"e #ar$et had a s!ecial talent for obscurin" what needed to be clarified. / bond bac$ed entirely by sub!ri#e #ort"a"es, for e)a#!le, wasn't called a sub!ri#e #ort"a"e bond. (t was called an ;/.B.S.,< or ;asset bac$ed security.< (f you as$ed -eutsche Ban$ e)actly what assets secured an asset bac$ed security, you'd be handed lists of #ore acrony#s=.M.B.S., .5Ls, .5L>2s, /lt /alon" with cate"ories of credit you did not $now e)isted ?;#id!ri#e<@. =.M.B.S. stood for ;residential #ort"a"e bac$ed security.< .5L stood for ;ho#e eAuity loan.< .5L>2 stood for ;ho#e eAuity line of credit.< /lt / was 1ust what they called cra!!y sub!ri#e #ort"a"e loans for which they hadn't even bothered to acAuire the !ro!er docu#entsto, say, verify the borrower's inco#e. /ll of this could #ore clearly be called ;sub!ri#e loans,< but the bond #ar$et wasn't clear. ;Mid!ri#e< was a $ind of triu#!h of lan"ua"e over truth. So#e crafty bond #ar$et !erson had "a8ed u!on the sub!ri#e #ort"a"e s!rawl, as an a#bitious real estate develo!er #i"ht "a8e u!on >a$land, and found an o!!ortunity to rebrand so#e of the turf. (nside >a$land there was a nei"hborhood, #asAueradin" as an entirely se!arate town, called ;=oc$rid"e.< Si#!ly by refusin" to be called ;>a$land,< ;=oc$rid"e< en1oyed hi"her !ro!erty values. (nside the sub!ri#e #ort"a"e #ar$et there was now a si#ilar nei"hborhood $nown as ;#id!ri#e.< But as early as 2%%&, if you loo$ed at the nu#bers, you could clearly see the decline in lendin" standards. (n Burry's view, standards had not 1ust fallen but hit botto#. +he botto# even had a na#e, the interest only ne"ative a#orti8in" ad1ustable rate sub!ri#e #ort"a"e. Bou, the ho#ebuyer, actually were "iven the o!tion of !ayin" nothin" at all, and rollin" whatever interest you owed the ban$ into a hi"her !rinci!al balance. (t wasn't hard to see what sort of !erson #i"ht li$e to have such a loan, one with no inco#e. :hat Burry couldn't understand was why a !erson who lent #oney would want to e)tend such a loan. ;:hat you want to watch are the lenders, not the borrowers,< he said. ;+he borrowers will always be willin" to ta$e a "reat deal for the#selves. (t's u! to the lenders to show restraint, and when they lose it, watch out.< By 2%%3 he $new that the borrowers had already lost it. By early 2%%7 he saw that lenders had, too. / lot of hed"e fund #ana"ers s!ent ti#e chitchattin" with their investors and treated their Auarterly letters to the# as a for#ality. Burry disli$ed tal$in" to !eo!le face to face and thou"ht of these letters as the sin"le #ost i#!ortant thin" he did to let his investors $now what he was u! to. (n his Auarterly letters he coined a !hrase to describe what he thou"ht was ha!!enin", ;the e)tension of credit by instru#ent.< +hat is, a lot of !eo!le couldn't actually afford to !ay their #ort"a"es the old fashioned way, and so the lenders were drea#in" u! new financial instru#ents to 1ustify handin" the# new #oney. ;(t was a clear si"n that lenders had lost it, constantly de"radin" their own standards to "row loan

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Betting on the Blind Side | Vanity Fair

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volu#es,< Burry said. .e could see why they were doin" this, they didn't $ee! the loans but sold the# to *old#an Sachs and Mor"an Stanley and :ells Far"o and the rest, which !ac$a"ed the# into bonds and sold the# off. +he end buyers of sub!ri#e #ort"a"e bonds, he assu#ed, were 1ust ;du#b #oney.< .e'd study u! on the#, too, but later. .e now had a tactical invest#ent !roble#. +he various floors, or tranches, of sub!ri#e #ort"a"e bonds all had one thin" in co##on, the bonds were i#!ossible to sell short. +o sell a stoc$ or bond short, you needed to borrow it, and these tranches of #ort"a"e bonds were tiny and i#!ossible to find. Bou could buy the# or not buy the#, but you couldn't bet e)!licitly a"ainst the#0 the #ar$et for sub!ri#e #ort"a"es si#!ly had no !lace for !eo!le in it who too$ a di# view of the#. Bou #i"ht $now with certainty that the entire sub!ri#e #ort"a"e bond #ar$et was doo#ed, but you could do nothin" about it. Bou couldn't short houses. Bou could short the stoc$s of ho#ebuildin" co#!anies4ulte .o#es, say, or +oll Brothersbut that was e)!ensive, indirect, and dan"erous. Stoc$ !rices could rise for a lot lon"er than Burry could stay solvent. / cou!le of years earlier, he'd discovered credit default swa!s. / credit default swa! was confusin" #ainly because it wasn't really a swa! at all. (t was an insurance !olicy, ty!ically on a cor!orate bond, with !eriodic !re#iu# !ay#ents and a fi)ed ter#. For instance, you #i"ht !ay 92%%,%%% a year to buy a 6% year credit default swa! on 96%% #illion in *eneral 5lectric bonds. +he #ost you could lose was 92 #illion, 92%%,%%% a year for 6% years. +he #ost you could #a$e was 96%% #illion, if *eneral 5lectric defaulted on its debt anyti#e in the ne)t 6% years and bondholders recovered nothin". (t was a 8ero su# bet, if you #ade 96%% #illion, the "uy who had sold you the credit default swa! lost 96%% #illion. (t was also an asy##etric bet, li$e layin" down #oney on a nu#ber in roulette. +he #ost you could lose were the chi!s you !ut on the table, but if your nu#ber ca#e u!, you #ade 3%, &%, even 7% ti#es your #oney. ;2redit default swa!s re#edied the !roble# of o!en ended ris$ for #e,< said Burry. ;(f ( bou"ht a credit default swa!, #y downside was defined and certain, and the u!side was #any #ulti!les of it.< .e was already in the #ar$et for cor!orate credit default swa!s. (n 2%%& he be"an to buy insurance on co#!anies he thou"ht #i"ht suffer in a real estate downturn, #ort"a"e lenders, #ort"a"e insurers, and so on. +his wasn't entirely satisfyin". / real estate #ar$et #eltdown #i"ht cause these co#!anies to lose #oney0 there was no "uarantee that they would actually "o ban$ru!t. .e wanted a #ore direct tool for bettin" a"ainst sub!ri#e #ort"a"e lendin". >n March 6C, 2%%7, alone in his office with the door closed and the shades !ulled down, readin" an abstruse te)tboo$ on credit derivatives, Michael Burry "ot an idea, credit default swa!s on sub!ri#e #ort"a"e bonds. +he idea hit hi# as he read a boo$ about the evolution of the D.S. bond #ar$et and the creation, in the #id 6CC%s, at J. 4. Mor"an, of the first cor!orate credit default swa!s. .e ca#e to a !assa"e e)!lainin" why ban$s felt they needed credit default swa!s at all. (t wasn't i##ediately obviousafter all, the best way to avoid the ris$ of *eneral 5lectric's defaultin" on its debt was not to lend to *eneral 5lectric in the first !lace. (n the be"innin", credit default swa!s had been a tool for hed"in", so#e ban$ had loaned #ore than they wanted to to *eneral 5lectric because *.5. had as$ed for it, and they feared alienatin" a lon" standin" client0 another ban$ chan"ed its #ind about the wisdo# of lendin" to *.5. at all. Eery Auic$ly, however, the new derivatives beca#e tools for s!eculation, a lot of !eo!le wanted to #a$e bets on the li$elihood of *.5.'s defaultin". (t struc$ Burry, :all Street is bound to do the sa#e thin" with sub!ri#e #ort"a"e bonds,

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Betting on the Blind Side | Vanity Fair

http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt...

too. *iven what was ha!!enin" in the real estate #ar$etand "iven what sub!ri#e #ort"a"e lenders were doin"a lot of s#art !eo!le eventually were "oin" to want to #a$e side bets on sub!ri#e #ort"a"e bonds. /nd the only way to do it would be to buy a credit default swa!.

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