The next member of our Masters of Finance series is the contrarian hedge fund manager, Michael Burry. His prescient views on the U.S. housing market’s bust a decade ago earned investors in his Scion Capital fund handsome returns. By some accounts, Burry earned himself around one hundred million dollars.1
Michael Burry will be the first to tell you he hated meeting with people in person and was socially awkward. When Burry was a kid, he lost an eye from cancer. As such, he always felt like an outsider with other kids. But later on, his self-deprecating humor led to possibly the greatest classified ad ever, that Burry posted on the dating website, Match.com.
According to the book, The Big Short, Burry described himself as “a medical student with one eye, an awkward social manner and $145,000 in student loans”.2 Amazingly, the bio led him to his wife.
California-born Michael Burry may be the smartest member of our series, being both a medical doctor and stock market guru. He was a resident at Stanford Hospital by day and leading a double life as a day trader and stock market blogger. From midnight until 3 AM he would be conducting fundamental research on stocks like a research analyst would, only better. Burry was able to see things that most analysts missed.
Burry was clearly burning the candle at both ends and literally fell asleep during a surgery he was observing. He soon realized he would to have to choose between becoming a practicing physician or an investment manager. He chose investing and with a small settlement from a lawsuit and some family money he launched Scion Capital, a reference to a science fiction book he read as a kid, The Scions of Shannara.
Burry had amassed quite a following online had garnered enough interest from some institutional investors to grow in size and become relevant in the hedge fund industry. Burry was a self-described value investor, a bit of an oxymoron investing in technology stocks of the late 1990s. But Burry was able to find value among the sea of highly overvalued stocks. He would read and follow the Graham and Dodd investment advice, ascribed to by Berkshire Hathaway’s Warren Buffett.
Burry invested in the same way he lived his life, on the other side of the crowd.
He soon became convinced that the housing market was going to collapse and tried desperately to find a way to profit from that outcome. Burry became worried about the housing market back in 2003, when ‘interest only’ mortgages were coming on the scene. Credit was easy and people were fudging the truth to get into bigger and bigger homes. Mortgage fraud increased fivefold from 2001 to 2004.3
He soon found a way to make the bet through an obscure derivative known as a credit default swap (CDS). A CDS is an insurance contract that pays out in full if a company goes bankrupt. For example, if a pension fund owned $10 million of Pretendo Industries bonds, it could insure against a wipeout of its bond values in the event that Pretendo went bankrupt. The pension fund could buy a credit default swap (you’re ‘swapping’ or transferring the risk of default) on $10 million of Pretendo bonds from a third-party (often a major bank) who agreed to sell you insurance against Pretendo going bankrupt.
Burry surmised that if he could buy up the cheap insurance now, he could sell it later to those who would need it at much higher prices.
Depending on the company’s credit rating, the insurance premiums were priced typically around 1% of the insured value on an annual basis. So to insure the Pretendo position would cost $100,000 (1% of $10 million) per year. Of course, if Pretendo didn’t go bankrupt the premiums paid are kept by the CDS seller. This is similar to having to pay for homeowner’s insurance even if nothing happens to your home.
Speaking metaphorically, imagine you are a homeowner in Florida without flood insurance and a hurricane is approaching your town. If you tried to buy insurance once danger was imminent, the insurance company would charge you much more than 1% of a premium, maybe 10%-20%. Of course, this is not how homeowners insurance works but it does work this way in financial markets with CDS.
Burry was buying CDS on corporate bonds of companies like AIG and Fannie Mae and Freddie Mac (and on certain mortgage backed securities or MBS) when there was no imminent danger in the housing markets, well before the bubble. As such, the insurance on them was cheap, often around 1% per year. When the financial crisis hit and these entities were on the brink of bankruptcy, the premium costs jumped into the 75% range.
News spread that Burry owned many credit default swamps, so many financial firms, desperate to buy insurance on these toxic bonds for themselves, started calling Burry. They were willing to buy back the swaps at almost any price. So, Burry began selling swaps that he purchased for around $1 for between $75 and $85, raking in millions.4
Burry closed Scion Capital in 2008, but not before achieving returns of 472.40% for investors since inception (2000-2008).5 In 2010, he penned a scathing op-ed in the New York Times titled “I Saw the Crisis Coming. Why Didn’t the Fed?”
Many of Burry’s investors were not happy about the investment strategy, despite amazing profits. After all, they had invested under the impression it was a value fund. Prior to the collapse, the insurance premiums being paid was eating away the funds capital, and thus returns, making investors frustrated. Some demanded their money back.
But there are often clauses in private equity contracts that stipulate that a hedge fund manager can freeze redemptions if there is not a ready market for the underlying securities. Burry invoked this clause and investors were furious.
In the end, it was this refusal to return capital when requested that left a sour taste in people’s mouths, even after making over $700 million for investors.6
Michael Burry Today
Burry runs the reincarnation of Scion Capital (which closed to investors in 2008), Scion Asset Management in Cupertino, California. The fund is geared towards value investments, often out-of-favor sectors of the markets. At the end of Q1, 2015 his major holdings included NexPoint Residential Trust (a REIT), Apple Inc., Banc of America and Citigroup.7
Not surprisingly, Banc of America and Citigroup both have extremely cheap price to book ratios of .60 and .61, respectively.8 This means that they are trading at a deep discount to tangible book value. Unloved stocks trade down to these low levels, which is what probably attracts Scion to them.
This is an interesting story which shows that you don’t have to actually be on Wall Street to profit on the markets. In fact, being an outsider can provide an unbiased, fresh perspective on where the markets stand in relation to outside forces such as the economy or a specific sector of the economy.
2,4Lewis, Michael. The Big Short. New York City: W.W. Norton & Company, 2010. Print.