After listening to quarterly earnings conference calls by companies such as Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs) and reading real-estate journals, Burry came to realize that home-price appreciation was the assumption behind every decision by borrowers, lenders, insurers and ratings agencies. He figured that once California home prices started to fall, the entire lending apparatus would fail and a credit crisis would ensue.
"It became clear to me that many people never expected to pay their loans back and depended on a rise in home values every two years to allow them to refinance," he says.
As Burry researched, he discovered that all the subprime, or "junk," loans were being buried in tradable securities that banks were creating. Those securities, backed by the principal and interest on the mortgage loans the banks made, served as collateral to allow them to make even more loans and were a source of fixed-income returns for investors having trouble finding good returns elsewhere.
Studying the fine print in the prospectuses that banks filed with regulators as a part of every security offering, Burry learned that most subprime loans were sequestered in a "subordinated tranche," or lower level, of securities that inexplicably carried an investment-grade rating. That meant institutional money managers at mutual fund companies and pension funds who were obligated to invest conservatively could still buy these instruments without recognizing their danger.
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But there was still no way to easily short-sell these tranches, so he asked the broker-dealers who handled his derivatives accounts to let him know when such a method or instrument was created.
Now enter that phone call. In mid-2005, Burry's contact at Deutsche rang to say that the bank's credit-derivatives desk had decided to offer credit-default swaps on those subprime-mortgage-backed tranches. A credit-default swap is essentially an insurance policy that pays off if its targeted instrument -- a tranche, an entire mortgage-backed security, a collateralized debt obligation or a company -- goes belly-up. Buyers must pay an annual premium, at a rate set by the marketplace, for a contract that pays $10 million, for example, in the case of a default. The buyer can continue to pay the swap premium for years waiting for an expected default, or he/she can sell the swap at a profit to another buyer.
If you're a buyer, your counterparty -- the investor who loses when you win and vice versa -- is a swap dealer representing another investor who has the opposite point of view on the targeted security.
European and Asian pension fund managers hungry for yield at a time of low global interest rates were avid buyers of the type of insurance-premium income that Burry was paying. Because the subprime tranches were rated investment-grade, the buyers thought they were relatively safe and thus were getting money for nothing.
In contrast, Burry thought it was nuts for someone to take the other side of these trades, believing that in two years enough borrowers would default to make the swaps trigger a payout. If he paid $130,000 a year for the swap for a couple of years, he figured that a $10 million reward was an awesome deal. You could make 12 to 30 times your money -- or more if you borrowed the money that you used to make your payments.
In mid-2005, Burry started buying as many credit-default swaps on tranches of these securities -- with names like PPSI 2005-WLL1 -- as he could afford. He typically paid 1.25 to 1.3 percentage points of the swaps' face value for BBB tranches and 1.7 to 2.25 percentage points for BBB-minus -- which translated to $125,000 to $225,000 per year on a $10 million contract -- and seemed to have little competition when bidding.
"I'm totally at a loss to explain why more people didn't figure this out," Burry said. "I have been to undergraduate and grad school, and I know I'm in the middle of the pack when it comes to intelligence. You really didn't have to be a genius."
Getting Rich Off The Subprime Mess
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Originally Posted by bigred
