The $100 Data Set That Exposed the Last Financial Crisis
Editor's note: Digging through the data can pay off big time...
Sometimes the clues that foreshadow a crash can be hidden in plain sight. And even Wall Street can miss or overlook them.
In today's Masters Series, editor Corey McLaughlin shares a new essay detailing how one investor saw the signs of the financial crisis while the big firms ignored them and explains how unconventional methods can lead to big rewards...
The $100 Data Set That Exposed the Last Financial Crisis
It was the crisis 'no one' saw coming...
From 2007 to 2009, housing prices plummeted... borrowers defaulted on their subprime mortgages... and a credit crunch rippled throughout the entire U.S. economy.
Many banks became insolvent. The government deemed these banks "too big to fail" and bailed them out.
The U.S. entered a severe recession, which spread globally. And we can still see the scars on the U.S. economy today.
If you ask former Federal Reserve Chair Alan Greenspan, nobody could have predicted the housing bubble or the damage that followed.
"Everybody missed it," he said in a 2010 interview about the crisis.
But that's not true...
We can think of a few people who warned about what would happen... Stansberry Research founder Porter Stansberry warned of mortgage giants Fannie Mae and Freddie Mac failing in 2008.
And Dan Ferris recommended shorting Lehman Brothers five months before its 2008 bankruptcy. Dan also advised subscribers to raise cash before the worst of the crisis to avoid painful losses.
Scion Capital founder Michael Burry also saw it coming.
When asked about Burry's bets against the housing market – chronicled by author Michael Lewis in The Big Short – Greenspan doubled down.
The 1987 through 2006 Fed chair described Burry's bets as a "statistical illusion," closer to a coin flip.
But what Burry did was far from pure luck.
'I saw the crisis coming. Why didn't the Fed?'...
In an April 2010 New York Times op-ed, Burry detailed how he saw the great financial crisis coming... listed examples of how the Fed and other institutions ignored warning signs... and explained why he staked his reputation on the crisis happening with a series of bets against the Wall Street institutions that helped fuel the housing bubble.
As Burry explained in the April 3, 2010 Times piece, he first began "to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans."
In 2004, Burry was managing about $600 million worth of assets for clients through Scion Capital.
As home prices boomed in the early part of the 2000s, the then-32-year-old Burry noted the uptick in subprime mortgage activity. So in 2004 and 2005, he sat down to better understand the bond market and what was going on...
Burry dug through mortgage-bond prospectuses, hundreds of pages each, and built his own spreadsheets.
For about $100, he gained access to the raw data Wall Street was either ignoring or choosing not to highlight.
Burry's concerns were confirmed – and grew – when he realized the scale of the problem...
He found mortgage lenders were increasingly offering a stunning number of subprime, or poor, borrowers interest-only, adjustable-rate mortgages ("ARMs"). These offered a "teaser" interest rate for, say, two years, but would be followed by 28 years of variable rates.
As Burry explained to Lewis in The Big Short, one example was subprime mortgage lender NovaStar, an archetype of the time. The lender originated and sold subprime mortgage bonds. Burry said...
The names [of the bonds] would be NHEL 2004-1, NHEL 2004-2, NHEL 2004-3, NHEL 2005-1, etc. NHEL 2004-1 would for instance contain loans from the first few months of 2004 and the last few months of 2003, and 2004-2 would have loans from the middle part, and 2004-3 would get the latter part of 2004. You could pull these prospectuses, and just quickly check the pulse of what was happening in the subprime mortgage portion of the originate-and-sell industry.
And you'd see that 2/28 [year] interest only ARM mortgages were only 5.85% of the pool in early 2004, but by late 2004 they were 17.48% of the pool, and by late summer 2005 25.34% of the pool.
By summer 2005, the bond prospectuses of the entire industry showed that interest-only mortgages had jumped from 10% to more than 40% of subprime pools in just one year. This was a glaring signal. As Lewis wrote...
It wasn't hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn't understand was why a person who lent money would want to extend such a loan. "What you want to watch are the lenders, not the borrowers," he said. "The borrowers will always be willing to take a great deal for themselves. It's up to the lenders to show restraint, and when they lose it, watch out."
Unlike the good old days when a bank would give someone a 30-year mortgage that they could afford based on their income (which the bank would keep on its books), these lenders weren't incentivized to make quality loans, only a high volume of loans.
That's because after they collected their fee, they went on to sell these loans to Wall Street banks and firms like Lehman Brothers and Bear Stearns, who then found their own use for them.
These firms, in turn, created "mortgage backed" and other complex securities, which they then sold to yield-seeking investors – like pension funds or foreign banks. These investors were essentially buying the right to receive monthly mortgage payments from subprime U.S. borrowers.
Meanwhile, credit-rating agencies didn't indicate that any significant risks were afoot, still applying AAA ratings to the highest level of the securities.
It would all work if home prices kept going up, which they "always" did, encouraged by the Fed's low-interest-rate policy since 2001. So long as housing prices went up and interest rates were relatively low, few seemed to care about or even see the risks at play.
By 2005, given the rising number of poor borrowers, loans, and cyclical risks involved, Burry was convinced big trouble was on the horizon, though it might take a few years to see the fallout... until interest rates moved higher.
Again, all of the information that led him to this conclusion was publicly available (for a small fee).
Burry simply followed the data that others didn't bother to look at.
Importantly, he also created a plan to profit...
In 2005, Burry warned his clients at Scion Capital about the damage the entire U.S. economy would face when the housing market eventually collapsed. But he said it also presented an opportunity.
As Burry wrote in the third quarter of 2005 to his investors...
Sometimes, markets err big time. Markets erred when they gave America Online the currency to buy Time Warner. They erred when they bet against George Soros and for the British Pound. And they are erring right now by continuing to float along as if the most significant credit bubble history has ever seen does not exist.
Opportunities are rare, and large opportunities on which one can put nearly unlimited capital to work at tremendous potential returns are even more rare. Selectively shorting the most problematic mortgage-backed securities in history today amounts to just such an opportunity.
Burry decided to use one of Wall Street's other financial instruments – credit default swaps ("CDS") – to bet against the system. CDS function like insurance against bond defaults. At the time, they existed for corporate bonds but weren't readily available for subprime mortgages.
That's because folks on Wall Street didn't consider the mortgage industry blowing up to be a risk worth betting on or hedging against. It was "unthinkable." So Burry's strategy of betting on it needed to be unconventional.
He asked Deutsche Bank to create CDS contracts he could buy in May 2005. Burry bought six separate mortgage bonds for $10 million each.
Traders at Goldman Sachs, Morgan Stanley, Bank of America, UBS, Merrill Lynch, and Citigroup were also happy to sell Burry CDS contracts to collect the premiums, even if they thought Burry was an idiot.
Burry figured the value of these CDS would rise as more speculators and institutions eventually woke up to how overleveraged banks and firms really were.
By October 2005, Burry's Scion Capital had at least $1 billion in CDS contracts on subprime mortgage bonds. It was costly waiting for the crisis to hit over the next two years. He paid about $100 million in premiums to Wall Street firms.
But as the housing bubble began bursting in 2007, Burry started to see the fruits of his labor.
The banks became obligated to pay Burry when the mortgage bonds failed, and Burry demanded daily collateral settlement in the contracts, unlike many agreements elsewhere.
By the end of August 2007, Burry's profits on the mortgage bets were more than $720 million.
The return would have been much higher, but some of his investors grew impatient waiting for the crisis... and demanded redemptions early.
By early 2008, Burry feared government intervention and exited his remaining CDS positions. Ironically, he auctioned them to the Wall Street banks that were now desperate to buy protection against defaults and limit their losses.
From November 2000 through June 2008, Scion Capital returned around 490% for investors, compared with just over 2% for the benchmark S&P 500 Index. Burry's short strategy was eventually immortalized in a book and movie.
There are many lessons in this story...
Like the follies of greed... the lengths some institutions will go to in pursuit of profits... and how bankruptcies happen. "Two ways. Gradually, then suddenly," as Ernest Hemingway wrote in his 1926 novel, The Sun Also Rises.
But the one lesson we want to highlight today is how Burry (and others) saw what was coming by using data and methods that were unconventional at the time.
It reflects the spirit of a strategy we're revealing on Tuesday, April 7.
In a new, free presentation, you'll have the chance to hear from a former hedge-fund researcher and tech insider who called the rise of the iPhone and bitcoin. Now, he has devised his own alternative-data-based strategy to beat the market.
Make sure you sign up to get all the details.
This strategy doesn't have anything to do with the mortgage industry or Excel spreadsheets (at least directly), but it does employ a unique data set that we haven't seen anyone else in our industry utilize.
The idea is to deliver triple-digit returns in only 90 trading days, and the system has flagged 442 winning trades since 2017.
The man behind this hedge-fund-caliber trading strategy is stepping forward publicly at 10 a.m. Eastern time this Tuesday with the details, and we're excited to share them with you. You can register for the event right now here.
All the best,
Corey McLaughlin
Editor's note: Again, you don't want to miss Tuesday's event.
You'll hear from the man whose system spotted 442 winning trades dating back to 2017. It might be unorthodox, but it has the potential to double your money within 90 days. Click here to sign up for free.