The Big Short: Michael Burry on the Next Financial Crisis

[Bob Malecki]

If anyone who is newer to note investing needs a refresher course on what caused most of the NPLs we buy to be available, read The Big Short or go see the movie. Fascinating how corrupted Wall St. brokers and rating agencies can topple a housing market. 

Dr. Michael Burry, the neurologist in residency turned hedge fund manager with a glass eye (played by Christian Bale in The Big Short) was the first money manager with the vision to see the subprime mortgage meltdown coming and was able to short the CDO bonds and earn his fund over $2 billion. 

In a compelling 2011 lecture for Vanderbilt University, Burry laments that no one has taken responsibility for the subprime financial crisis. He proceeds to name the multiple guilty parties and practices which created the crisis. He calls out Henry Paulson’s convenient change of role, from head of Goldman Sachs – which continued to sell toxic CDOs (collateralized debt obligations) to their clients even as the bank itself was betting against the CDOs itself – to the Treasury Secretary who helped preside over the bailout. Burry defends against the accusation that the money managers who saw it coming were somehow the cause of it.

Watch Michael Burry’s passionate lecture below, “Missteps to Mayhem:”

https://www.youtube.com/watch?v=fx2ClTpnAAs

The Big Short is a fascinating real-life story on how greed and complicity caused a worldwide financial meltdown. This has resulted in an opportunity for us small note investors to help "heal" the wounds of this event, help borrowers if possible and make a profit in doing so. 

[Bob Malecki]

So What DID Cause the Financial Crisis? 

According to Burry and Michael Lewis’s The Big Short, some of the trends, institutions and events that contributed to the collapse include:

Deregulation which authorized the securitization of mortgages. This practice incentivized mortgage brokerages to originate as many mortgages as possible, then sell them off to Wall Street. Banks and brokerages were paid up front for creating loans while being temporarily insulated from the aftermath of failed loans.

The expansion of mortgage products that popularized interest-only loans, only-adjustable rate mortgages, interest-only adjustable rate mortgages, even negative -amortizing “option arm” mortgages that allowed borrowers to actually increase their loan balances, rather than paying their mortgages down.

Second-lien purchase mortgages that allowed borrowers to escape both mortgage insurance and a down payment.

The loosening of credit standards that allowed borrowers with poor credit, few assets, and/or no verified income to buy homes they would not be able to sustain.

Public policy and presidential speeches which created a demand for home ownership even among those who would not ordinarily qualify for mortgages. Just prior to the subprime crisis, the home ownership rate climbed to 69%. Unfortunately, 69% of U.S. citizens could not afford houses. (In 2015, the rate was hovering between 63% and 64%, the lowest rate of home ownership in over 20 years, according to U.S. census figures and a comparatively more sustainable figure than 69%.)

Borrowers who took out mortgages they could not afford, buying the biggest house they could on interest-only and deferred interest loans, turning a blind eye to future rate increases.

Mortgage fraud as high as 90%. “No income verification, no asset verification” loans invited both lenders and borrowers to falsify information to obtain loan approval.

Mortgage brokers and banks who focused on approving buyers for mortgageswithout regard to whether or not they would be able to afford the loans beyond the “teaser rate.”

The expansion of speculators into housing markets. Fueled by easy-lending standards for investors, speculators helped drive up housing prices in certain markets.

Historically low interest rates that ensured housing prices would rise more quickly than income levels as consumer dollars stretched further.

The failure of rating agencies to actually research and rate the safety of mortgage securities, and their unwillingness to act once the problem was apparent.

The Federal Reserve’s unwillingness to stop lending that could jeopardize the economy (even though they had the right to do so).

Rampant cash-out re-financing that made homes “ATMs” for consumers who wished to purchase what they could not afford.

Fiscal policy built on the assumption of never-ending home appreciation, and the dependency of jobs and consumer spending on never-ending home appreciation.

A derivatives market which multiplied the amount of money at risk beyond the value of the underlying assets. At the peak, the derivatives market represented $60 TRILLION dollars – a figure roughly equal to the gross domestic product of the world!

The repeal of the Depression-era Glass-Steagall Act, which separated commercial banks from Wall Street risks after such activities caused widespread bank failure in the early 1930’s.

Wall Street’s ability to conceal the financial sickness that lay beneath until some of the key corporations (such as Goldman Sachs) had purchased credit default swaps to be on the “winning” side of the economic crash.