Doubling Down as the Losses Pile Up

The absurd conviction in Michael Burry's 2006 shareholder letter

Above is a picture of a young Michael Burry standing beside the desk where he foresaw the end of the bull market that began in 2003; following the aftermath of the tech bubble a few years earlier. America had just begun to recover from a stock market crash fueled by overzealous optimism. The internet, a spectacle previously thought to be a niche innovation, had infected the globe. While the foresight of investors pouring money into anything with “dot com” in its investor prospectus was correct directionally, as often happens with new technologies, the funding came too hard and too fast. While this period of stock market history is littered with failures, several losers of the dotcom era are some of the most well know corporations today. Moreover, many of today’s largest companies were constructed from the rubble left over after the tech bubble popped. The internet genie was out of the lamp and there was no stopping it.

Greenspan’s Cruel Twist of Fate

In the build-up to the tech bust, Alan Greenspan, then Chairman of the Federal Reserve, spotted what he viewed as yet another bubble on the horizon, much like the one he called out in the mid-1990s. In the summer of 1999, the Fed Funds rate stood at 5%. To cool down what Greenspan saw as an overheating economy, he conducted four successive 25 basis point hikes between June 30th, 1999, and March 21st, 2000. It was too little too late. A month before cementing the fourth rate hike, he commented that “there is little evidence that the Fed's series of short-term interest rate hikes since June 1999 have had much impact on quelling the threat of an overheated economy”. He was lamented for not acting sooner. This was the man who curb-stomped the rampant inflation of the 1970s and 80s. The same man who conducted a successful soft landing just five years earlier. Four days before the peak of the tech bubble, Greenspan would celebrate the technological innovation that ushered in the 21st century, saying “I see nothing to suggest that these opportunities will peter out any time soon”. This stood in stark contrast to a speech Greenspan gave four years earlier, where he coined the term “irrational exuberance” in 1996. In a cruel twist of fate, it was the irrational exuberance that he acted upon too late that was the catalyst for the bloodbath that was the tech bust of 2000. The mandate of the Federal Reserve quickly shifted from trying to prevent a bubble to attempting to stimulate the economy following the collapse of the stock market and technology sector. It would take ~2.5 years for the Nasdaq to find an eventual bottom.

Full Steam Ahead

The tech bubble was an event largely confined to the stock market; it was the outcome of greed and exuberance. The market crash looming in the distance was set to be one of far greater scale, and more systemic in nature. The United States had just started to recover when Michael Burry, then manager at the hedge fund, Scion Capital, began to sense trouble brewing. There are a number of individuals credited with being early in recognising the 2008 financial crisis, but Burry was one of the first. I won’t be diving into the build-up to that event, nor covering the aftermath; as I am certain many of you reading this are already aware. For those who are not, I recommend reading Michael Lewis’s ‘The Big Short’ or watching the film that bears the same name. Instead, I want to highlight a shareholder letter Burry wrote in 2006. In retrospect, one can appreciate how insane he must have sounded to the average onlooker. Here he was, in 2006, when the majority of the market was too caught in the fantastic bull run to care, discussing the importance of diversifying counterparty risk across the nation’s largest and most established financial companies. Voicing his concerns about the ability of household names in the financial industry to pay him when the housing market collapsed.

Burry was early to the trade. Some might say he was too early, having started to make investment decisions to monetarily express his view three years before it would pay off. In Burry’s words, it “felt like I was watching a plane crash”; a plane crash that would drag out over several years, while he lost money and angered his investors in the process. By the third quarter of 2006, the losses had begun to muddy his fund’s pristine track record. Three-quarters of the way through the year, Scion Capital had returned a net loss of 17.36% against the S&P 500’s +8.53%.

Scion Capital, 2006, Third Quarter Letter

“Never before have I been so optimistic” he claimed; optimism fructified by reasons that had nothing to do with stocks. The underperformance was solely due to the credit default swap positions Burry had opened to hedge against the collapse of the US housing market. Burry had begun shorting mortgage-related assets in 2005, and by 2006 the trade was no longer a secret. It remained a contrarian trade nonetheless, but Burry was dismissive of those looking to follow in his footsteps.

“Yes, other funds have begun to attempt to execute this strategy. But man oh man are they the overconfident big boys diving head first into the shallow end of the pool. Despite our mark-to-market losses, we’re short the mortgage portfolio everyone would want if they knew what they were doing. After all, it is not possible to short mortgages themselves. It is only possible to derivatively short mortgage tranches which are part of large mortgage pools. These pools are professionally managed, and not all that run these portfolios are idiots. Even the idiots may have heard by now that the housing market, and in particular the subprime borrower, is in trouble. These managers can make use of tools such as interest rate swaps, mortgage insurance, and more substantial over-collateralization, and they have certainly done so.

This is a point worth emphasizing. Even during March 2005-September 2005, when the housing and mortgage industry was most complacent and home prices were peaking, I found most mortgage pools and their subordinate tranches to be totally unworthy as short candidates. Good luck to all those hedge funds finding the right stuff in 2006. The story has been out for some time, and the structurers of mortgage backed securities as well as the ratings agencies are not exactly clueless regarding the risk. Sooner or later, one of the big boys should really read a prospectus – probably not something they’ve done in a very long time”.

Michael Burry

In Burry’s mind, the market’s tolerance for risk was expanding to new heights, while his remained constant. He waited for the moment the market sobered up and realised the punchbowl was empty. This reminds me of the saying, which no doubt would have caused Burry some anxiety on occasion; “the market can remain irrational longer than you can remain solvent”. I can only imagine this fear of insolvency grew as the clock on the real estate bomb ticked closer to detonation. He knew what he was signing up for, expressing that he “never expected our mortgage short to work within one year. Mortgages by their nature tend to be good for at least the first year”.

“Even in the event of missed payments from the start, it may take a year for these to appear in the form of a write-off. I knew full well we would be subject to the vagaries of a liquidity-drunk and overconfident market in the meantime. At the end of the day, we have the contractual right to receive cash when these tranches deteriorate to the requisite level, and that is a right that grows more valuable every single day”.

Michael Burry

That year national housing prices fell ~3% by August, marking the first year national housing prices had fallen since the great depression. Burry remarked this would not be a one-year blip. Delinquencies were climbing, but still, the S&P 500 finished the year up ~14%. All the while he maintained that Scion’s investment in mortgage shorts was and is a “rational investment shorting the absolute worst quality among borrowers and their mortgages during the most extreme credit bubble ever seen in the housing industry”.

Scion Capital, 2006, Third Quarter Letter

In hindsight the conviction is incredible. He’d continue to suggest the reward for the fund’s patience would be illustrated in the 2007 performance, but it wouldn’t come until the following year. In the final quarter of 2007, Burry signed off suggesting that “2008 is going to be an interesting year”.

“The full impact of the subprime mortgage-induced contagion is hitting Wall Street and Main Street simultaneously. American consumers who had relied upon their everappreciating homes as fountains of cash have neglected to save even a penny for years. What does the American consumer have to spend now? The American dollar ended 2007 in a fast-accelerating descent against most of the world’s commodities and currencies. So prices are rising even as the American consumer is pulling back. Stagflation? No, I worry about something worse, and something somewhat unprecedented. Do I foresee yet another black swan? Damn birds cloud my skies”.

Funnily enough, Burry would soon encounter two kinds of black swans. The first was the one he had been tirelessly chasing for the better part of three years; the collapse of the US real estate market. The second, as he informed his investors in a first-quarter letter in 2008, was a pair of literal black swans.

Michael Burry with a couple of black swans

“Earlier this month, I took my family on our first extended vacation far away from California, and we ran headlong into a flock of black swans. Real, breathing black swans. You’ve got to be kidding me. One cannot make this stuff up. Or so I thought. But, of course, this was indeed predictable. We were visiting Leeds Castle in Kent, England, and if I had done the work, I would have known about the flock of black swans that reside at this castle. And that is about how I view Mr. Taleb’s premise of the Black Swan.

I have found markets to be anything but random, and I find many of the future events that are bound to be dismissed as random or explainable only in hindsight in fact can be foretold in time with the rhythm of history. If one does the work”.

Michael Burry

Regardless of your thoughts on Burry today, he belongs to an incredible part of stock market history. One that details the triumph of rational conviction over all else. For those looking to explore Scion’s old shareholder letters, I found a source which compiles all the letters from 2000 through 2008 in addition to a number of interesting testimonies and hearings that Burry gave following the great financial crisis.

• Scion Capital Shareholder Letters (here)

Thanks for reading,

Conor