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Michael Burry – Part 2

F T L
3 minute read

At this point Scion was born. Not just that, it had started in a completely unprecedented way.

Michael Burry had just over a million dollars to play with. His first full year was 2001, and the return on the fund was 55%. This is a large percentage, especially when you consider that the S&P had fallen by about 12% that year.

This return was not an anomaly.  2002 the fund was up 16%, with the market down 22%. 2003 the market went up again, by 28%; Scion was up 50%. By 2004, Scion had around $600 million in it, and was turning away further investors. This is amazing by industry standards. Burry made Scion for investors, not for profit. He had a strong sense for the right way to do things, which he lived and conducted business by.

Michael Burry described his style as “Ick investing”. Burry described this as follows:

“Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.”   -Burry, in a 2001 letter to his investors.

Basically, Burry would find investments that would turn people off on their current reputation but that were actually good value. Investments like this would often first go down as the market sold off the stock, then go up strongly soon after as the trouble settled and the value was noticed by the market.

This idea of Ick investing would take Scion to a whole new level, and into fame. The next level came in the form of credit default swaps (CDSs). A CDS is essentially insurance on a loan. If the loan goes bad, the holder of the CDSs gets a payout. They can be used by the loan holder to hedge risk or by an investor who thinks the loans will go bad. They were created in the mid 1990s, and were not common investments at the time.

Michael Burry started with $60 million in CDSs from Deutsche Bank, $10 million each on 6 different bonds. He would search out the bonds with the worst underlying mortgages; those most likely to default. It also surprised him that Deutsche Bank didn’t care to differentiate these loans. They simply accepted Standard & Poor’s rating, despite a large variance within the rating categories.

When Burry bought his first CDS on mortgage bonds from Goldman Sachs for $5 million, they applauded Burry on being the first to ever buy them. Burry, in typical form, responded with “I am educating the experts here”. Never a truer quote, but this would not clue in Goldman Sachs (or anyone else) until the market proved Burry correct.

Of course, Burry did not stop buying CDSs at this amount. By July he had $750 million worth of CDS sitting in the fund. This was unlike any hedge fund seen anywhere. ….

The use of CDSs can be seen as an interesting twist on Burry’s “ick investing”. It flips the typical pattern of investing against undue negative perception. CDSs on subprime mortgage bonds were reverse ick investments, in that they made money off of undue positive perceptions. In the typical language of traders, this could be called shorting a bubble.

That idea is not new, so why was it so surprising to the market and his clients, that he was shorting this subprime bubble?

The simple answer to that question can be seen in the reactions of Burry’s clients. Not only could they not see the bubble, they could not imagine housing would ever bubble like this. This might be considered a realistic viewpoint, since real estate has been one of the most reliable investments in history. However, this was not just a matter of real estate. It was a matter of subprime loans, which were never before seen en masse. Burry could see their instability easily, and was willing to place a giant bet on it.

Though his clients did not like what he was doing, they were stuck keeping their money in his fund. Scion had a rule that if you invested in the fund, you had to keep the money in for a minimum of one year. This did not stop clients from complaining heavily. This put Burry in the exact position he tried to avoid from the start: dealing directly with his clients. He had specifically told these clients that he made unorthodox bets, and they should not simply evaluate him in the short term, only the long term.

As is often the problem, people did not listen. Or, as Michael Burry is often quoted:

“Early on, people invested in me because of my letters. And then, somehow, after they invested, they stopped reading them.”

The next part of the story is the most exciting. Find out what happens next, once the dominoes have begun to fall.

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