• “A mortgage bond wasn't a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased. This was the single biggest reason that bond investors initially had been reluctant to invest in home mortgage loans: Mortgage borrowers typically repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to invest at lower interest rates. The investor in the home loans didn't know how long his investment would last, only that he would get his money back when he least wanted it. To limit this uncertainty, the people I'd worked with at Salomon Brothers, who created the mortgage bond market, had come up with a clever solution. They took giant pools of home loans and carved up the payments made by homeowners into pieces, called tranches. The buyer of the first tranche was like the owner of the ground floor in a flood: He got hit with the first wave of mortgage prepayments. In exchange, he received a higher interest rate. The buyer of the second tranche - the second story of the skyscraper - took the next wave of prepayments and in exchange received the second highest interest rate, and so on. The investor in the top floor of the building received the lowest rate of interest but had the greatest assurance that his investment wouldn't end before he wanted it to. The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all. The pool of loans underlying the mortgage bond conformed to the standards, in their size and the credit quality of the borrowers, set by one of several government agencies: Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees; if the homeowners defaulted, the government paid off their debts.” → times were changing now with riskier loans… “The mortgage bond was about to be put to a new use: making loans that did not qualify for government guarantees. The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house, but so that they could cash out whatever equity they had in the house they already owned.” - intro

A Growing Subprime Mortgage-Backed Bond Market

• The lead-up to the GFC saw much larger volumes of loans and floating debt: “Thirty billion dollars was a big year for subprime lending in the mid-1990s. In 2000 there had been $130 billion in subprime mortgage lending, and $55 billion dollars worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage-backed bonds in a single year. Subprime lending was booming even as interest rates were rising - which made no sense at all. Even more shocking was that the terms of the loans were changing, in ways that increased the likelihood they would go bad. Back in 1996, 65 percent of subprime loans had been fixed-rate, meaning that typical subprime borrowers might be getting screwed, but at least they knew for sure how much they owed each month until they paid off the loan. By 2005, 75 percent of subprime loans were some form of floating-rate, usually fixed for the first two years.” (Even though banks were offering more of these risky adjustable loans to unqualified borrowers, they rationalized it by selling off the loans to big Wall Street banks who would repackage all these loans into a big bond)

Michael Burry - Spotting the Ticking Time Bomb Before Anyone Else

• Euphoric investing plaguing the financiers… "What you want to watch are the lenders, not the borrowers," he said. "The borrowers will always be willing to take a great deal for themselves. It's up to the lenders to show restraint, and when they lose it, watch out." By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too.” (Michael Burry) → “A lot of people couldn't actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new instruments to justify handing them new money. "It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes," Burry said. He could see why they were doing this: They didn't keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime mortgage, he assumed, were just "dumb money."
• Burry sought out credit default swaps as a way to bet against the subprime lending market: “It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million.” (Asymmetric bet where you could make 50x your money) → he had to bet early in 2005 when no one saw the opportunity: “Subprime mortgages almost always bore floating interest rates, but most of them came with a fixed, two-year "teaser" rate. A mortgage created in early 2005 might have a two-year "fixed" rate of 6 percent that, in 2007, would jump to 11 percent and provoke a wave of defaults. The faint ticking sound of these loans would grow louder with time, until eventually a lot of people would suspect, as he suspected, that they were bombs. Once that happened, no one would be willing to sell insurance on subprime mortgage bonds. He needed to lay his chips on the table now and wait for the casino to wake up and change the odds of the game.” (No banks even offered these so he had to convince them to make it for him!)
• Be different to win: “Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual.” → Buffett learned from the father of value investing Ben Graham but really had his best investments evaluating brand strength, an intangible that Graham never focused on himself

Ick Investing

• The story of Michael Burry is pretty incredible, as he was blogging stock picks in the late 90s during his off hours (midnight to 3am!) from medical school and residency - which led to him being discovered by value investing legend Joel Greenblatt and giving the first outside capital to start Scion Capital fund → “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.” (He followed Munger's advice to set good incentives by limiting any asset management fees to his fund expenses and taking a share of investment profits)
• Variant perception of a value investor: “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." → one bet he made was buying a software company Avant! in the middle of a court case, where they would soon see their execs go to jail and a large fine would need to be paid, but he recognized their market value of $250m was simply too low for $100m cash in the bank and $100m yearly FCF → “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." - bought first at $12 and kept buying at it sold down to $2, then company soon was bought for $22… “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.” (Conventional wisdom produces convention results! - Bill Walsh)

A Level of Preparation Beyond Any of His Peers

• At the time banks saw this sale as an opportunity to make easy money from Burry betting against the entire mortgage market, feeling a fall like that was impossible → this is wild, he is concerned about the health of the banks! - "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.” → just how big did he stretch this?? $1B position in just a few months!
• He went through deep preparation and due diligence unlike any of his peers: “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” - and made conservative bets on the riskiest triple B bonds… “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… 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.”
• Financial recklessness by the banks: “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.” (the banks who originally offered these loans didn’t care because they would just turn around and sell it off after - misaligned incentives!!)
• These weren’t easy trades for Burry to make, as his investors started pushing back at allocating so much of their stock portfolio into these complicated credit default swaps