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“The fixed income world dwarfs the equity world,” he said.
“The equity world is like a fucking zit compared to the bond market.”
Mike Burry
His obsession with personal honesty was a cousin to his obsession with fairness.
He gave a talk in which he argued that the way they measured
risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. “By and large,” he later put it, “the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar
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“The Psychology of Human Misjudgment.”
said Munger. “I think I’ve been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”
He used no leverage and avoided shorting stocks.
For roughly $100 a year he became a subscriber to 10-K Wizard. Scion Capital’s decision-making apparatus consisted of one guy in a room, with the door closed and the shades drawn, poring over publicly available information and data on 10-K Wizard. He went looking for court rulings, deal completions, or government regulatory changes—anything that might change the value of a company.
If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-rated tranches, 200 basis points—that is, 2 percent.
(A basis point is one-hundredth of one percentage point.)
inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud…. The FBI reports mortgage-related fraud is up fivefold since 2000.” Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature.
“I hated discussing ideas with investors,” he said, “because I then become a Defender of the Idea, and that influences your thought process.” Once you became an idea’s defender you had a harder time changing your mind about it.
The closer you were to the market, the harder it was to perceive its folly.
The other piece of news concerned home prices. Eisman spoke often to a housing market analyst at Credit Suisse named Ivy Zelman. The simple measure of sanity in housing prices, Zelman argued, was the ratio of median home price to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally, to 4:1.
“But the problem wasn’t just that it was four to one. In Los Angeles it was ten to one and in Miami, eight-point-five to one. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.”*
In the summer of 2006, the Case-Shiller index of house prices peaked, and house prices across the country began to fall. For the entire year they would fall, nationally, by 2 percent.
The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. First, the underlying loans were heavily concentrated in what Wall Street people were now calling the sand states: California, Florida, Nevada, and Arizona.
House prices in the sand states had risen fastest during the boom and so would likely crash fastest in a bust—and when they did, those low California default rates would soar. Second, the loans would have been made by the more dubious mortgage lenders. Long Beach Savings, wholly owned by Washington Mutual, was a prime example of financial incontinence.
Third, the pools would have a higher than average number of low-doc or no-doc loans—that is, loans more likely to be fraudulent. Long Beach Savings, it appeared to Eisman and his partners, specialized in asking homeowners with bad credit and no proof of income to accept floating-rate mortgages. No money down, interest payments deferred upon request.
In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.
Nine months after Mike Burry failed to raise a fund to do nothing but buy credit default swaps on subprime mortgage bonds, Paulson succeeded, by presenting it to investors not as a catastrophe almost certain to happen but as a cheap hedge against the remote possibility of catastrophe.
in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. “It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!”
The right to buy Capital One’s shares for $40 at any time in the next two and a half years cost a bit more than $3. That made no sense. Capital One’s problems with regulators would be resolved, or not, in the next few months. When they were, the stock would either collapse to zero or jump to $60. Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions.
It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency—really anything with a price that seemed poised for some dramatic change—and then work backward to the thing the option allowed you to buy or sell.
relationship with his girlfriend ended, Jamie eagerly followed. Theirs was a union of the weirdly like-minded. Ben shared Charlie and Jamie’s view that people, and markets, tended to underestimate the probability of extreme change, but he took his thinking a step further.
markets. Ben walked around with some very tiny fraction of his mind alert to the probabilities of disasters in real life. People underestimated these, too, he believed, because they didn’t want to think about them.
The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn’t use it.
David Burt. It was a measure of how much money people were making in the bond market that the
magazine Institutional Investor was about to create a hot list of people who worked in it, called The 20 Rising Stars of Fixed Income.
the extension of credit by instrument.
atrocious, and closer to the dates when their interest rates would
“One of the oldest adages in investing is that if you’re reading about it in the paper, it’s too late,”
eight ways from Sunday.
The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of “investing” is “gambling with the odds in your favor.” The people on the short side of the subprime mortgage market had gambled with the odds in their favor.
laissez-faire
