The Big Short – Profiting From Distorted Markets

By Capitalist Exploits

Yesterday we discussed how incredibly fragile the global financial system is.

When markets get out of whack the inevitable consequences are typically of an asymmetric nature. Like an elastic band stretched too far, when it inevitably snaps the return to an equilibrium is vicious, violent and rapid.

Markets are like angry divorcees. Neither party wants to settle for half, but instead would rather destroy what’s left than let the other party get it. In the same fashion markets taken to extremes typically don’t merely revert to the mean, but instead go well beyond it destroying much in their path.

This dynamic can prove catastrophic to existing wealth or absolutely positively life changing depending on which side of the fence you are positioned.

The crash of the housing bubble in 2008 provides us with a prequel:

Today, let’s do a quick recap of how it came about since it’s instructive for much of what we’re dedicating our time to here.

What caused the housing crash… really?

You see, the tech bubble and the recession that followed it should have produced a normal market clearing event where the debris of excessive risk, misallocations of capital, and wall street hubris were cleansed from the system.

Instead, the Fed held short-term interest rates at 1%, thereby killing yield in the market and sending yield starved investors into seemingly “safe” mortgage backed securities. As the Fed kept rates low for too long, demand quickly outstripped supply. A problem Wall Street was only too happy to accommodate.

Rating agencies, biased by the fact that their clients are wall street banks were complicit in the game, gleefully rubber stamping AAA ratings on mortgages packaged up and securitized. Mortgages that had little hope of ever being serviced let alone repaid.

By 2006 subprime (which is to say extremely risky) lending accounted for a whopping 23.5% of all mortgage originations.

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Remember “no credit? no problem?”? Ninja (no income, no job) loans proliferated and doing their bit Wall street packaged up the mortgages as “structured products” where not one in a hundred end-buyers knew what meat went into the sausage they’d just bought.

At the end of the day the bubble was a massively corrupt unregulated reaction to the Fed’s policy actions.

Most readers will be familiar with “The Big Short”, both the movie and the book upon which the movie was based, by Michael Lewis.

One of the most publicized participants was physician turned hedge fund manager Michael Burry.

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Burry saw that the market was completely out of whack, spent the time to really understand why this was the case and then positioned himself and his fund to take the other side of the trade.

Specifically he did this by buying credit default swaps (CDS) on collateralized mortgage backed securities (CDO’s). Now CDO’s are basically mortgage backed securities (MBS’s) on steroids, and a CDS is a fancy term for an insurance contract which allows banks and hedge funds such as Burry’s to protect against the risk of CDO defaults.

What made it so attractive was that the hubris in the industry was so great that nobody believed the CDO’s would ever default, which of course was completely deluded.

As a result, the cost of buying this insurance was truly asymmetric, where for an extremely small price paid, the buyer of the CDS could insure against literally billions of dollars worth of CDO’s. Remember nobody thought it possible that math would matter but it always does…always.

When the dominoes eventually fell, homeowners with adjustable-rate mortgages saw their rates skyrocket, defaulting on their loans, causing the cash flows supporting the CDO’s to dry up. As a result CDO managers couldn’t pay their bondholders and the owners of the insurance contracts (the CDS’s) got their payouts. BIG payouts.

How much?

So while millions of investors saw the value of their real estate assets collapse, and S&P 500 investors saw it rise by a mere 2%, for Michael Burry and investors in his fund Scion capital, they saw returns of 489.3% net of fees and expenses between the period of 2000 through 2008.

Interestingly Burry had this to say:

“I don’t go out looking for good shorts. I’m spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it.”
Looking at global financial markets today we as investors are compelled to focus our attention on the truly asymmetric setups that exist as a direct result of unsustainable and oftentimes incomprehensible monetary gymnastics. The level of price distortions and the asymmetry which accompanies them is quite simply too compelling to ignore.

Make no mistake. We do this to profit but importantly we believe it is paradoxically the best possible hedge we can take against the incredible systemic risks that exist.

It is an area which, as we’ll show you tomorrow, while not crowded, is host to some of the sharpest investment minds in the world.

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