The Big Short: Chapter Summary (Chapter 2)

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A step beyond the idea: figuring out the logistics--While Eisman was trying to establish himself as a hedge fund manager, Michael Burry, a doctor turned investor who lived in San Jose, California, had already had the idea of short selling subprime mortgage bonds. His only question was how to go about it, and to this end, he was spending his days studying the market in excruciating detail. In his case, that meant countless hours by himself in his office, reading everything he could find on the subject, which included the rare act of poring over the incredibly long and boring prospectuses that accompanied each bond.

The further decline in lending standards--One thing was clear: lending standards had reached an all-time low as banks actually extended loans that required no payment at all. Instead, through the so-called ARM, or adjustable-rate mortgage, the homebuyer had the option of transferring the owed interest to the principal, the unacknowledged problem being that future interest payments could easily become unaffordable. In other words, banks were making mortgage loans to people who couldn’t afford to pay them. Burry had already noticed the decrease in buyer quality by 2003, and two years later, he observed a similar decrease in loan quality. Lenders seemed mainly interested in increasing the volume of loans, and they would then minimize their own risk by selling these substandard loans to the large Wall Street investment banks, who packaged and sold them as mortgage bonds.

The credit default swap--Burry’s investigation had led him to the realization that short selling a mortgage bond was not a logistical option. That would mean borrowing them, which wasn’t possible. The solution was the credit default swap, which Lewis explains as being similar to an insurance policy. The buyer would pay a percentage of the total purchase amount for a fixed period in return for a guaranteed payment of the total by the seller (or insurer) in the event of a default. The advantages were that you could never lose more than the cost of the premiums and that you stood to gain much more if you bet wisely.

According to Lewis, credit default swaps were initially used by banks in the 1990s as a hedge against corporate default, but they rapidly evolved into a means of speculation. Burry had already begun to take advantage of corporate credit default swaps as a way of betting against the real estate market; but in 2004, credit default swaps didn’t even exist for the subprime mortgage bond market, which was his real target. The idea for that had popped into Burry’s head one day while he was studying the subprime mortgage bond situation, and his next step was to call the big investment banks to suggest it. Focusing on those he deemed most likely to survive what he felt was the certain doom of the subprime mortgage bond market, he contacted all except Lehman Brothers and Bear Stearns. Only two—Goldman Sachs and Deutsche Bank—showed any interest; the rest dismissed the suggestion, little guessing that within three years it would prove prophetic to the tune of trillions of dollars.

Glass eye and personality traits--Burry’s foresight was not the only thing that set him apart from his peers. From the age of two, he had had only one eye as a result of cancer, when the removal of a tumor required taking out his left eye as well. Socially awkward, in his view mostly because of his glass eye and the subsequent difficulty he had with looking at people, he was not inclined to have a lot of friends, and the few he did have he knew mostly through e-mail. He married twice, the first time to a Korean woman and the second time to his current wife, a Vietnamese-American woman with whom he has had several children. His character traits, many of which he related to his physical deformity, include an obsession with honesty and fairness. When he noticed that professional basketball coaches had a tendency to be partial toward star players by faulting them less often than others, he completely lost interest in the sport; and when describing himself on Match.com, where he met his present wife, he emphasized his worst rather than his best qualities. Burry has an athletic build and enjoys sports, but partly because of problems caused by his eye and partly because of his discomfort around other people, he dislikes team sports, preferring instead such activities as swimming, which judge participants exclusively on their own performance.

Medical school--Since the time he was a child, Burry has also had an extraordinary ability to focus and learn, the catch being that he has to be obsessively interested in a subject in order to have any interest at all. Given that condition, school came so easily for him that he managed to get himself accepted to the best medical schools without particularly trying. After completing his medical studies at Vanderbilt University, he did his residency at Stanford Hospital. It was there that he realized that he had no real interest in medical practice, which he found either tedious or disgusting.

Fascination with the stock market--One thing he did take an ongoing interest in was the stock market, which had fascinated him ever since his boyhood, when his father had warned him about its dangers. Unable to find any rationality in it, he came to view himself as a value investor, especially with the insanity surrounding him during the 1990’s dot-com bubble. He was familiar with both Benjamin Graham, the father of value investing, and his student, Warren Buffett; and his study of these two extraordinary examples had convinced him that the secret to being a great investor was not to imitate them—just as Buffett had not imitated Graham—but to find his individual style and method of investing based on his own personality and way of doing things.

The miraculous value investor--Another of Burry’s outstanding traits was his remarkable productivity. He was able to sustain fourteen-hour workdays and then stay up two nights in a row disassembling and reassembling his computer to improve its speed. Referring to the army’s claim that its people got more done in the first few hours of the morning than most did in an entire day, he affirmed that he accomplished even more than the army. So the fact that his introduction to Wall Street happened in the wee hours of the morning, between midnight and 3 a.m., while working at St. Thomas Hospital in Nashville in 1996, was not surprising if you knew Dr. Michael Burry. He had studied all he could about value investing, but he wanted more real world interaction and experience, so he logged onto technostocks.com and started a “value investing” thread. Once he had exhausted that source of information, he launched his own value investing blog, where he listed the trades he was making and outlined his reasons. In the middle of the dot-com bubble, he was doing the opposite of most other people’s trades—and he was succeeding. In fact, his winning streak was so spectacular that he soon drew the attention of Wall Street. As Lewis says, they found him, and they were amazed at what they were seeing, in part because he seemed to be accomplishing miracles in his spare time. Lewis quotes one mutual fund manager from Philadelphia as saying that Burry was spotting trends that no one else had noticed.

Scion Capital: From Neurology Resident to Hedge Fund Manager

By the time Burry arrived at Stanford for his residency in 1998, he was already a known quantity on the investing circuit. After a few years of dispensing investing advice over the Internet, he finally admitted to himself that professional investing seemed like a more rewarding and appropriate career for him than medicine. Ironically, it was the money received from a family settlement over his father’s unnecessary death (due to misdiagnosis) that enabled Burry to pool enough capital to quit medicine and start his own hedge fund in San Jose. Another irony was that when Burry founded Scion Capital, he upped the ante for non-family investors by requiring a minimum net worth of $15 million dollars—far beyond anything he or his family and few friends had ever been able to afford. To his surprise, he received some calls from major financial firms offering to invest in his company. Joel Greenblatt of Gotham Capital flew Burry and his wife to New York to personally meet with him and give him a million dollars—something Greenblatt had never done before. White Mountains Insurance Group, which was associated with Warren Buffett through its CEO, Jack Byrne, was next. In a similarly unusual move, the firm called Burry, after first speaking with Gotham Capital, to offer him $600,000. As Lewis notes, within a short time, Burry had gone from being a neurology resident with a large debt to a millionaire hedge fund manager.

Integrity and individuality: a different way of doing things--His personal issue of having to deal with people in the flesh in order to attract clients was solved by the ubiquity of the internet, which enabled him to present his ideas in writing and allow his investors to come to him rather than having to court them personally. Luckily, his utter lack of interest in social interchange was more than made up for by his extraordinary intelligence and insight. In the next few years, Burry would consistently beat the market by a significant margin, and within four years, his company would go from a mere couple of million dollars to a growing fund of $600 million. According to one New York hedge fund manager, had Burry not been turning money away, he would have had billions of dollars under his management.

From the beginning, Burry’s approach with Scion Capital was different from the norm. In line with his sense of honesty and fairness and with an acute awareness of the power of incentives, Burry refused to extract the usual 2-percent fee that other hedge fund managers considered standard, instead charging his investors only for expenses and for actual investment growth. He had no large support teams, preferring to work by himself. He used no secret tools (other than his mind) but spent his days studying financial statements and 10-K Wizard, a digest of Securities and Exchange Commission (SEC) filings of more than 10,000 public companies.

“Ick” investments--Burry’s goal was to stay ahead of fluctuating market opinions and to unearth events and patterns that pointed toward a potential change in a company’s value. His investments often decreased in value before experiencing significant increases, and for this reason, he required at least a year’s commitment from his investors. He typically invested in stocks that showed signs of short-term devaluation (he called them “ick” investments) because of negative company circumstances but that promised long-term improvement. When the stock fell initially, he would buy up large amounts of it, and then, instead of simply watching the market, he would contact the company and attempt to influence it in a positive direction.

Originator of the idea for credit default swaps on subprime mortgage bonds--Given all this, it comes as no surprise that Michael Burry was one of the first to recognize the limited life span of the continued housing price boom following the Silicon Valley dot-com bubble. He could see that it was being largely driven by the irresponsible lending practices in place at the time and by the belief that residential real estate prices would continue to rise. A change in either of those factors could lead to a sharp drop in housing prices. That was why he felt such urgency in relation to setting up the purchase of credit default swaps on subprime mortgage bonds from the large investment banks, a process that included the creation of contracts that would ensure payment by the seller in the event of a default. This was done through the International Swaps and Derivatives Association (ISDA), created by Salomon Brothers in 1986 to deal with interest rate swaps. Burry knew that he was betting against something much larger than a stock or bond: he was betting against an entire system, and he wanted to make sure that he would be paid.

“Ick” credit default swaps and the obliviousness of the investment banks--When he finally bought his first credit default swaps from Deutsche Bank for $60 million in 2005, he had done his homework and singled out the worst ones he could find. What surprised and concerned him to some extent—because he feared the banks would raise their prices if they caught on—was that the banks didn’t seem to care or understand the significance of the choices he was making. They certainly didn’t seem wise to the precarious nature of the overall subprime situation. For instance, Burry likened Goldman Sachs’s mortgage bond prices to being able to buy flood insurance for the same price on any home regardless of its location and risk of damage. What struck him was that the banks seemed unconcerned about the differences between individual bonds and were instead content to take the rating agencies’ decisions on faith, not realizing that their triple-A and triple-B labels (for example) had no specific or absolute value, as was assumed, but that they were intended to be used on a relative scale.

Within weeks, Burry had managed to engage several banks in the new market, amassing hundreds of millions of “ick” subprime credit default swaps in the process. By mid-2005, with $750 million in subprime credit default swaps in his fund’s portfolio, Burry estimated Scion Capital to have the largest percentage of this type of investment at the time. Given his certainty that the subprime mortgage bond market would crash and knowing that Goldman Sachs and presumably the other banks were just brokers and not the ultimate sellers of what was obviously trash, he wondered who would be insane enough to risk so much money on a zero-sum bet that was doomed to go bad. Lewis explains here that the term “zero-sum” means that the same amount gained on side of the bet is lost on the other side. Whoever was on the other side of this bet apparently believed it was worth it.

Worsening of the subprime housing market bubble--Earlier that year, the country had witnessed record credit card delinquencies despite the continued increase in housing prices. That meant that, even with greater financing capability, Americans were having difficulty paying their debts. Within a short period of time, the mortgage bond market had grown to huge proportions, surpassing the other bond markets. The national economy was tied to the mortgage bond industry’s success, and the industry itself was relying on the irrational notion that housing prices would keep rising. Mortgage-related fraud had increased substantially and had become standard even on Wall Street. As Burry tried to explain to his investors, all of this pointed to a bubble—and the bubble was doomed to burst.

Doubtful investors--Burry did not fully inform his investors of his credit default swap activities until late 2005, when he wrote to them of his dim view of the subprime mortgage situation and the remarkable opportunities it held. He knew that this was a rare moment in history, but his investors, who saw him more as a brilliant stock picker, were uncertain of his ability to predict larger economic events and did not take kindly to the idea that he was investing their money in an unpromising financial instrument. In an effort to convince them, Burry countered with the notion that his foray into subprime mortgage credit default swaps was part of the same overall strategy he used when seeking out value under any guise. He had also ascertained that he stood to win even if only a small part of a subprime credit default swap went bad. But what should have spoken most loudly were the fund’s numbers: since the birth of Scion Capital five years earlier, its worth had increased 242 percent. There was no way that the single-digit increases (or decreases) in the S&P 500 index could even begin to compare. Still, except for those who wanted more information so that they could try this new type of investment on their own, his investors couldn’t see past their worries.

Subprime mortgage market delinquencies and an awakening market--Burry’s investors may have been chewing their nails over his latest tactics, but other hedge funds were taking an interest. They were calling Goldman Sachs wanting to know the secrets behind Burry’s trades, something Burry found out by accident from a Goldman Sachs trader who called him requesting information. Next he heard from Greg Lippmann at Deutsche Bank, which had quit dealing with him almost half a year before because of his persistent demands for collateral. Lippmann wanted to repurchase the credit default swaps that Deutsche Bank had originally sold Burry. Burry no longer wanted to deal with Deutsche Bank, so he complied, only to have Lippmann turn around and ask to buy more bonds from him, assuming the bank could name its own price. Burry declined, but the situation struck him as odd. He couldn’t understand how Deutsche Bank even knew about his latest investments. Within days after that, Burry got an unofficial call along the same lines from Goldman Sachs, followed by another similar request from Morgan Stanley. Out of curiosity, he had also checked with Bank of America to see whether they were willing to sell and discovered, not surprisingly, that they weren’t. 

The reason for this sudden change of heart was simple: the loans that Burry had expected to go bad were now doing so at an unprecedented rate. By this time, it was November 2006, and the Wall Street Journal was confirming his earlier predictions. Burry knew now that there had to be an awakening on the part of the lenders, the rating agencies, and the traders. The sloppy practices that had enabled his trades would finally have to change. From what Burry had heard from one of his investors, only one Wall Street trader stood to gain from the situation—and that was Greg Lippmann.