Michael Burry Speech at Vanderbilt: Transcribed

Earlier in the week, we posted notes from Michael Burry's speech at Vanderbilt. We saw the video and thought it would be a good exercise to transcribe the video. Note: I have been informed that the video does not capture large portions of the speech. Be forewarned and enjoy!

Michael Burry at Vandebilt

Michael Burry: Soon … though my attention … my activities inside the capital, I thought of myself as a value investor. Soon, my attention was caught by this growing importance of the housing sector. The amount and type of leverage, the generation's old acceptance and assumption that prices always went up, and the very broad societal participation, greater than sixty percent, owning homes.

This all called out to me. This was not just a case where a few early adopters made a lot of money, or a few venture capitalists acted badly. The entire economy depended on home price appreciation. The slope. Home Price Appreciation. Consumer spending, jobs, securities markets, all of it.

Soon, I would see financial Armageddon with housing at the trigger point. Now, in predicting how and when the collapse would occur, my focus was again on the actions of our government and the response of the private sector. This was much in keeping with my studies a decade earlier in Chicago.

Let's consider that history. The idea of an American Dream being related to home ownership has been around for nearly a century. Nearly every modern president promoted it, in one way or another, with a named program. The government helped returning G.I.'s after World War II buy homes, and the government was the first to securitize mortgages in the early 70's. Private securitized mortgages followed shortly thereafter, thanks to Lew Ranieri. President Reagan would sign the secondary mortgage market enhancement act, which, among other things, allowed insurance companies and pensions to invest in these securitized mortgages. A short time later, Reagan signed a law that made these types of products much more tax efficient.

To be clear, securitization of mortgages means that there is virtually no limit on the amount of mortgages that can be originated by an institution. They just get sold through to Wall street to investors. But all this was considered harmless. It was a good thing for the American Dream, to almost all concerned, for decades.

The desire to satisfy this dream, though, needed a tool. Something that would make home loans themselves much more affordable for those without the income, credit, or assets, to afford one. Let's step back to 1982 again. The Depository Institutions Act legalized adjustable-rate mortgages for the very first time. These adjustable-rate mortgages were teaser-rate mortgages, and would, in various forms, be the primary mortgage product at the heart of the collapse of our economy two-and-a-half decades later. But, adjustable-rate mortgages did not take off immediately. They really did not take off until additional regulatory and legislative changes in the 1990s, early 2000s, jump started the market for affordability products in the mortgage space.

Specifically during the 90s, the Community Reinvestment Act, of 1977, was reinterpreted several times. By Robert Ruben, the treasury secretary at the time, and Bill Clinton, the president at the time. The general point was to increase pressure on banks to make more loans to less credit-worthy customers, and they did. Sub-prime issuance bloomed about five to six times during the 1990s, and there was a mini-crisis thereafter.

Bill Clinton had a name for this drive, as all presidents did. His name was the National Home Ownership Strategy. Then, in 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933, and officially removed the increasingly leaky separation between the activities of Wall street banks and depository banks.

This freed banks to experiment and to expand into new lines of business. None were fateful in the experiment with derivatives and sub-prime asset-backed securities. The private market therefore gained the capability to mount a massive response to all the government's efforts to stimulate housing. We all remember 1999 very well, but, in fact, our global village underestimated many, many risks throughout the 90s, as is typical of a generally good economic time. And we had to deal with: stock market crash, Enron, 9-1-1, World Com, and eventually war.

The Federal Reserve stepped in, cutting the discount rate of charge lenders from 6% to roughly 1% in order to stave off recession. Other key short-term interest rates followed. Not at all coincidentally, from 2001 to 2003, we saw American home prices, which had largely moved in line with household income over the decades, suddenly accelerate up and away from the household income trend line. Home prices had good reason for such deviation. From 2001 to 2003, rapidly declining short-term rates, to lows not seen since the aftermath of The Great Depression, induced a boom in adjustable-rate mortgages. A homeowner's dollar went farther in that teaser-rate period, and so home prices rose unnaturally. Risk would be low as long as home price appreciation was strong under this paradigm, thanks to refinancing options.

It was a positive feedback loop with the full blessings from the U.S. Government. In fact, amidst early fears that the housing market was getting ahead of itself in 2003, Fed. Chairman Allen Greenspan assured everyone that national bubbles in real estate simply do not happen. As I surveyed the national trends in housing at that time, I wondered where their common sense ought rule against the application of precedent to the unprecedented.

Mr. Greenspan went on to advise, in 2004, that they were under-utilizing the new types of adjustable-rate mortgages. In 2005, he __ specifically the technologies by sub-prime lenders to get sub-prime borrowers into homes. Tragically for all of us, The Federal Reserve actually had authority to block any lending activity it deemed deserving of such treatment, but it had absolutely no will to do so.

In any event, by 2003, the mortgage rates stabilized at 40-year lows, and importantly, plain vanilla adjustable-rate mortgages had already come into widespread use. This was a big problem for public lenders with a growth mandate. They needed to stimulate more loan volume despite stable mortgage rates and inadequate income growth. At this point, if home prices were to rise significantly, they would have to float almost entirely on the back of the type and quality of mortgage that credit provided to the buyer. Critically, interest rates alone would no longer determine affordability.

In my letter to investors at the time, I termed this 'credit extension by instrument', and it took our housing market into a new paradigm. It was the private market's time to overreact. The instrument chosen for sub-prime borrowers, by lenders in 2003, was a relic of the 1920s. The interest-only adjustable-rate mortgage.

Lenders, by implementing a mortgage product they had long avoided, showed for all to see that they were more interested in growth than they were in maintaining credit standards. They were no longer interested in checking excess credit risk at the door. By fall of 2004, I noted from my investors that Countrywide Financial, a very large, national mortgage lender, reported sub-prime mortgage originations of 158%, year over year, despite a 20% decline in overall originations. Evidence was there for manifest. Banks were chasing bad credits, inclusive of housing speculators. The only question was, “How far could they go?”

Ominously, fraud jumped. The point at which the provision of credit was most lax, in my mind, would mark the point of maximal price in the asset. I imagine the top in the housing market would be marked by a mortgage in which home buyers of sub-prime quality were enticed to buy, with teaser-rate monthly payments near zero. I was very aware lenders would take this to the nth degree. Banks to securitization. Any loans that the banks did not want to keep, they could sell through Wall street to investors who were simply ravenous for yield.

Importantly, because sub-prime mortgages were being turned into securities, there were mandatory regulatory filings. This is how I educated myself on the sector. At times, I felt I was the only one reading these things. By summer of 2005, these documents revealed that interest-only mortgages had taken a substantial share in the sub-prime market. Just a year or so later, after they were introduced to that market. More than 40% of sub-prime originations were passing through Wall street on their way to investors. This was up from 10% a year earlier. Simultaneous Second Lean Mortgages ramped up significantly. This was not disclosed in every document I read.

A stated income option available to borrowers inspired a new vernacular: the liar loan. In some mortgage pools, 40% of sub-prime loans were for second or vacation homes; condos in Miami. Yet, as late as 2005, Moody's and S&P, so crucial to the securitization process, Moody's and S&P being the ratings agencies everybody watched, they were not reacting at all.

The top would soon be fast upon us. As a sub-prime, interest-only, adjustable-rate mortgage started to touch maximum sales channel penetration, we saw the introduction of yet another, more extreme, teaser-rate mortgage called the Pay Option ARM, or Cash Flow ARM. In this new type of mortgage, never before seen in a widely standardized format, the borrower could basically pay next to nothing each month. The unpaid interest would simply negatively amortize into the growing mortgage balance. Rampant cash out refinancing had already made the home a magical ATM for most Americans. And now, housing had its credit card.

This was what I had been waiting for, peak credit. Such a mortgage product would only exist as long as home price appreciation was an essential assumption, and home price appreciation was not long for this world, precisely because these mortgage products existed. Some of these mortgages started making their way into the sub-prime channels, too. I knew this because by 2005, as early as 2005, I could see these mortgages being packed into Alt A securitizations. I read those too. Those are between sub-prime and prime. Not all of these, though, were sold … not as many as you would thing were actually coming through this way, though. Most of them were not being sold through the street.

I noticed something else. Incredibly, Washington Mutual and Countrywide, again two national giants in home loans, began to load their own balance sheets with these Pay Option Adjustable-rate Mortgages. Facing yet another slow down in loan volume, these companies saw the negative amortization feature as a way to show loan growth in a slowing market. Yet these companies, in doing so, expressed confidence in home price stability in the event of a slow down in loan origination. Of course this is what the ratings agencies, the Federal Reserve, Congress, the President, and all the president's men believed, as well.

I disagreed. I saw absolutely no chance of home prices going sideways, or stabilizing for any significant length of time. Once home price appreciation was no longer a given, these new types of mortgages would simply disappear. Home prices, starved of peak credit, would fall and fall steeply, as mortgage and financing options crumbled away. The crisis, in my view, would start in 2007, by which time the teaser-rate on the vast majority of these new types of mortgages would expire or reset for a population of homeowners trapped in mortgages they could no longer afford. And on the way down, housing would take consumer spending, jobs, everything, with it. A positive feedback loop of a very damaging variety was set up.

So, seeing the economy on the verge of collapse, I did the logical thing. I sucked the profit from it.

[Audience laughs]

Specifically, I set out to buy credit default swaps on subordinated tranches on sub-prime, residential mortgage-backed securities. And that's where I lost my investors, too.

[audience laughs again]

In fact, in doing so, I gained a new level of insight into how Wall street really works. I called different Wall street firms, banks with which I had prior relationships due to my trading of distress debt. I asked them to trade in this market with me. Initially, I found no takers. This was in March of 2005. The whole effort was complicated because it was important to me that this security, this instrument that I like to use to short the market, would be standardized such that if I bought a credit default swap from one dealer counter party, I could easily trade that credit default swap to another dealer counter party. We spoke, won off contracts, were full of contract counter party risk, but I would not tolerate it.

Nevertheless, by May of 2005, standardized contracts were on the cusp of becoming of reality. In May of 2005, May 19th of 2005, we agreed to our first trades, shorting the sub-prime mortgage market. We worked on these soon-to-be standardized contracts a bit, and the first days of June 2005 were the first trades that officially went through. We would ultimately use nine different Wall street dealer counter parties. To be clear … well, first I would say Leeman and Bear I avoided, for obvious reasons, even back then.

[audience laughs]

Goldmann-Sachs featured very prominently early on. They were a very anxious crew. To be clear, these credit default swaps that I'm buying, that would rise in value as mortgages were written off, and the value of these tranches fell. Goldmann-Sachs, in the spring of '07, appeared to us to want to make it's trade bigger. They wanted a bigger piece of the big short. A lower price, therefore, would benefit Goldmann-Sachs, and that's how Wall street works.

In late June of 2007, credit spread began marching higher, and then it just took off once Goldmann was on my side for the trade. Then it was AIG's turn to complain about Goldmann's marks. Later, it would incredibly be reported that more than 60 trillion dollars in credit derivatives were in effect at the peak. Now hyperbole, we'd say that is more than the gross product of the world. But it's roughly equal, and who really knows what the gross product of the world is?

How could that be? How could it even get close to the gross product of the world? Credit derivatives on an underlying asset could be worth multiple orders of magnitude more than the asset itself is worth because all asset-backed derivative securities settle in cash, pay as you go. That was the secret sauce of the Doomsday Machine. And so the crisis unfolded with the market providing a signal far too late. Even so, Fed. Chairman, Ben Bernanke, treasury secretary, Fred Paulson, continued to underestimate the situation.

I was appli... just like that, apaplicted. Secretary Paulson now claims that even if he knew what was going to happen, he couldn't have done anything about it. Now that may be true. After all, he would say, “I just joined the treasury in 2006.” But he came from the top CEO job at Goldmann-Sachs. And once treasury secretary, he wasn't so impotent. He orchestrated the once-unthinkable government takeovers of AIG, Fanny-May, Freddy-Mac. Absolutely unthinkable, the bailout of Wall street. He was anything but an impotent tool. He had a running start unlike any other. But if he truly felt that way, this is an absolutely devastating commentary on how our government works.

In fact, as books and articles on the crisis proliferate, it becomes clear that nearly every failed institution, and nearly every relevant department of government, there's someone with insight that is every bit as good as mine, and in many cases, better. However, none … zero … were in the top job. That our CEOs, Governers, our Presidents, and our Charimen did not see this coming and adequately prepare their constituencies, is an inditement in the manner in which we choose and enable our leaders. But such would not be the conclusion in 2008. Broadly speaking its the hedge fund's fault. By the second half of the year, with the government targeting hedge fund managers with punitive subpoenas, the global attack on so-called speculator and evil hedge funds. The nationalization of Fanny, Freddy, AIG, etc, and their liabilities. Very importantly, their liabilities, which were now a special-purpose vehicle of the government.

I worried about the future of a nation who would refuse to acknowledge the true causes of the crisis. In my view, a historic opportunity was lost. America had instead chosen it's poison as it's cure, and a second greatest nation would never be born. Today, I expect the government to continue easy-money policies into the next presidential term. Past the meat of the foreclosure crises, and past the corporate and public refinancing humps that are upcoming. With junk bonds, junk bonds incredibly, again at all time highs. Quantitative easing seems to be working, for now. This is an invalid validation of what America is doing.

This is, in fact, a Pyrrhic gamble. We continue to debase our currency. Bernanke says he's not printing money. I, again, I disagree. As it stands, I get an email every day from the Fed, saying, “We just bought another seven, eight billion of treasuries.” Monetizing the debt. I don't know, that's pretty clear to me.

In fact, this program, QE2, not Queen Elizabeth, Quantitative Easing, QE2, it's scope and breadth raises a severe question of the treasury's needs. The government's borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers, and consumers, is a short-sighted easy decision for a population that has not yet learned that short-sighted, easy strategies are the route to long-term ruin.

We never quite achieve the catharsis necessary to stoke a deep reevaluation of our wants, needs, and fears. Importantly, the toxic twins. Fiat currency, and the activist Fed remain firmly entrenched, even more so with the financial reforms last year. In fact, the Federal Reserve, having acquired new powers of regulation, has insisted that nothing in the field of economics or finance was of any help in predicting the crisis, period. No more comment.

It's a worthless conclusion. It guarantees we'll make the same mistake, again and again. So I have a problem with leaders. I should note, I've been overwhelmed with these mistakes they've made. We need better leaders. But, very frankly, this isn't going to happen. A problem cannot be solved if it can never be acknowledged. And it will never be acknowledged. Taxes need to be raised, spending needs to be cut, loop holes need to be shut, if we are to have any hope of returning to a stable base.

Certainly, home ownership should not be a policy of the U.S. Government, and the banking system needs substantial reform and even bank breakups. Glass-Steagall needs a second run, in a strong form. And those 22 and a half million public workers have no business unionizing agianst the taxpayer. The list of things that will happen compared to things that should happen, goes on and on. As citizens of these United States, we should carefully consider what 1 trillion means. All personal income taxes collected in a year do not add up to 1 trillion dollars. By 2020, interest expense on our international debt could very well exceed 1 trillion dollars. When you consider our 1.7 trillion dollar deficit, consider the treasury's inlays are only a little over 2 trillion.

It's quite a loss margin. 2 trillion also happens to be a little less than the amount of bank and government debt now held at our overly-bloated Fed. 2 trillion seconds is 64 thousand years. And what's minimum wage again? Our country's math is scary big, and simply speaking, it does not work. Speaking of math not working, how many of you are checking that math? Pretty sure, 64 thousand years. So arguments on blooming economic recovery must be considered along the fact that all this debt and all the money being printed is very much a real bill, a real tax on our future. It is a debtor's prison for our children. It is not yet come due today except for savers and those on a fixed income. As such, I recommend sober analysis on the part of the individual. This is paramount. We must remember that entire societies do run the wrong path for a very long time. They do run aground. There's nothing wrong with breaking from the social norm to assure good outcomes. Common sense must rule when it comes to career paths and life choices. Though the situation seems to call for it, it is not a time for a responsible individual to tolerate any level of blind faith directed toward any man or woman. It is not a time to follow. So all that said, I might recommend opening a bank account in Canada.



Gemfinder 4/17/2011  

"We spoke, won off contracts"

Maybe "bespoke, one-off contracts"?


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.