How Did Michael Burry Predict the 2008 Housing Bubble? (The Big Short Explained)

home ownership has long been the classic american dream and throughout the decades banks have continued to make new home loan products to help as many americans as possible achieve that dream not to mention that governments as well have also been very supportive of these measures as at the end of the day it helps more americans get what they want however one man by the name of michael barry saw big problems evolving within this system in the early 2000s and ultimately these big problems would be left completely unchecked so much so that it would eventually decimate the housing market and the american economy so how did michael bury see this coming how did he bet against the american housing market how did he bet against the american dream and come out on top well let's find out [Music] first things first we need to understand the fundamental building blocks of this great american house of cards and that is the mortgage-backed security or mortgage bond now when we think about it home loans typically aren't really too hard to understand right we want to buy a house that costs a million dollars or say we need to take out a loan for a million dollars we go to the bank we say hey we'd like to buy it traditionally the bank will give us that million dollars okay and then it's our job over the next 30 years to repay that loan plus we have to pay interest payments along the way that money would go directly to the bank and if at any stage we can't keep making those payments on our mortgage the bank will come around and take our house off of us now banks obviously repeat this process thousands and thousands of times because in reality there are thousands of thousands of us that need big loans to be able to buy houses that we can't afford so in reality there's heaps of us signed up to these 30-year mortgages and over the course of those 30 years we're repaying these loans plus our interest payments however what happens these days is a big investment bank will come along to that little commercial bank and say hey we're going to write you a check a big fat check right now if you sell all of those mortgages to us the commercial bank says you know what that sounds fantastic i want the money now and i can get rid of that risk and as long as i make a healthy profit in the process that sounds like a pretty good deal to me so essentially what's happened is the commercial bank has just sold those mortgages to the investment bank so now all of us homeowners with mortgages are no longer paying our principal payments and our interest payments back to our commercial bank in fact all of that money is now going to the investment bank that bought all of those mortgages now here's the interesting thing what happens is that the big investment bank bundles up all of these mortgages into what's called a special purpose entity or a special company that company will thus receive a certain amount of cash flow each year from all of us plebs simply just paying back our mortgages now here's the interesting thing what this investment bank does is it cuts up this special company into lots and lots of little pieces these little pieces are the shares of that special purpose entity and investors can then go and buy those shares so what are you actually buying if you're an investor in one of these special purpose entities well you're buying a slice of all of the mortgages in that special purpose entity that are slowly being repaid over time and that right there is a mortgage-backed security now one of the interesting things about mortgage-backed securities is that obviously we're dealing with real people with real mortgages and not all mortgage holders are going to go the journey right some of them might pay off their mortgage early finalize that and other people might not be able to pay off their mortgage and they default on their loan as has always been their house will then be taken off of them but it might be put through as a distressed sale so the bank might only be able to recover say 50 of that original loan amount now that is the risk that you take on when you buy a mortgage-backed security you as the investor have to try and figure out how many people are going to end up defaulting on their mortgages and overall dragging your real return down from the investment that you've made now one thing to also know about these special purpose entities or these special companies is that they will further divide the shares up into different sections or different slices which are called tranches now say the shares of this entity were grouped into three tranches let's call the tranches senior mezzanine and equity now remember what we're talking about before at the end of the day this whole special purpose entity is just a big collection of mortgages and as we were talking about before the end of the day some of those people maybe not all of them but some of them are going to default on their loans in this scenario with the entity structured into three tranches they've decided that the equity tranche is going to be the first tranche of shares that is going to take on the defaults then if there are enough defaults out of this pool of mortgages to completely wipe out the the equity tranche then the mezzanine tranche will start taking on defaults after that and then finally if there are enough defaults in this pool to take out the mezzanine tranche then the defaults will hit the senior tranche now because of this risk structure the riskier equity tranche will start off offering a higher yield to investors and on the flip side the senior tranche will offer the lowest yield because it's the least risky and this is the basic principle behind a collateralized mortgage obligation but the point here is that no matter what tranche you buy no matter what mortgage-backed security you end up investing in you would hope that the bank only lends money to those that are extremely likely to pay back their mortgage huh let's hold that thought so it was in the 70s that the securitization of mortgages began but it wasn't until president reagan signed the secondary mortgage market enhancement act in 1984 that things started to get really interesting because what this allowed is it allowed things like pension funds and insurance companies to buy mortgage-backed securities these securities were popular because of their promising yield but seemingly low risk because at the end of the day these products were just thousands and thousands of mortgages bundled together and to quote the big short well who the hell doesn't pay their mortgage it was a classic case of safety in numbers diversification so that's the mortgage-backed security and ultimately what the securitization of mortgages meant for banks is it meant that they could essentially write as many home loans as they wanted because even if it was a tiny bank they and they wrote say a million home loans they could just bundle them together and sell them off to an investment bank that would then sell it onto wall street this fact plus the popularity of the american dream to own your own home meant that banks could start getting creative so they started creating lots of new mortgage products that would help more people get into their own homes now that sounds great for those people right they achieve that american dream they get to own their own homes but it's also really good for the banks because it means that they are writing heaps more loans every quarter here's michael bury himself talking about how mortgages changed in order to help more people achieve that classic american dream the desire to satisfy this stream 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 or teaser rate mortgages 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 adjustment mortgages did not take off immediately they really did not take off until additional more additional regulatory and legislative changes in the 1990s and early 2000s jump started the market for affordability products in the mortgage space and it was in the early 2000s where michael bury started to see this horrific situation forming banks could essentially lend money to whoever they wanted regardless of their credit history and the government was in full support because the end of the day it meant that more people were getting into their own homes and this wasn't risky at all for the banks because at the end of the day they could just grab this big pile of mortgages and sell it onto wall street what was getting riskier however was the mortgage-backed securities themselves which were now being filled up with riskier and riskier loans so basically at this point anyone could get a loan and with interest rates falling in the united states from 2001 to 2003 from six percent down to one percent borrowing money or taking on home loans became very popular particularly adjustable rate loans declining interest rates plus teaser rate periods on adjustable rate loans meant that borrowing money was really really easy so naturally people did a lot of borrowing this inflated house prices naturally because everyone was buying but as long as house prices continued to go up and interest rates to continue to come down then there was no problem because at the end of the day people could just go and refinance their homes they would replace their old pre-existing loan with a new one they might get a better deal on the interest rate but they would also go into more debt but hey don't worry about that debt you won't have to worry about that debt for ages and plus when you do have to worry about it your house is probably going to be worth heaps more so now we have banks that are offering loans to essentially anyone we have people that want to take on those loans because it seems as though it's basically free and plus if you don't get in now well then you're missing out because in a year's time your house is probably going to be worth more but all of this hinges on house prices continuing to appreciate it was a positive feedback loop with the full blessings of the us government in fact amidst early fears that the housing market was getting ahead of itself in 2003. fed chairman alan greenspan assured everyone that national bubbles and real estate simply do not happen as i served and surveyed the national trends in housing at that time i wondered whether common sense ought rule against the application of precedent to the unprecedented so how did michael bury figure out that all this was going to end in tears what was the tipping point for him well for him he says that it was the introduction of the interest only adjustable rate mortgage in 2003 mortgage rates stabilized and banks decided to take the leap and offer interest only adjustable rate mortgages to help stimulate more loans and to drive house prices up lenders by implementing a mortgage product they had long avoided showed for all to see they were interested in growth more than they were interested in maintaining credit cred credit standards they were no longer interested in checking excess credit risk at the door by fall of 2004 i noted for my investors that the countrywide financial a very large national mortgage lender reported subprime mortgage originations up one hundred and thirty fifty eight percent year over year despite a twenty four percent decline in overall loan originations evidence was therefore manifest banks were chasing bad credits inclusive of housing speculators so at this point michael bury was well aware of what was going on and he hypothesized that the top of the market would be a point in which non-creditworthy borrowers would be able to get a home loan where their monthly repayment was basically zero now remember that all of these dodgy mortgages were just at the end being piled up and sold onto wall street they were being turned into mortgage-backed securities now that was a very big advantage for michael bury because they were being turned into securities that means that they had mandatory regulatory filings that they had to put in with the sec which meant that this was all public information and michael barry could go and read about them so that's exactly what he did and that's how he realized the true extent of the problem but even when michael bury thought that things couldn't get more severe they certainly did banks were now offering a new type of loan the worst of the worst it was the interest only negatively amortizing adjustable rate sub prime mortgage now that's a mouthful but what it means is that borrowers of subprime quality were able to take on big loans where they didn't even have to pay a monthly repayment they could choose to pay nothing and all that happened was the amount that they should have paid that month would be added on to the principle of the loan amount now what sort of borrower do you think would be attracted to that sort of loan yep it's a borrower with absolutely no income and this was it for barry it was now that he realized this was a mortgage product that the only chance it had of not going bad was if house prices continued to appreciate he said himself that this type of product simply would not exist unless house price appreciation was the central assumption and in his own words he said that home price appreciation was not long for this world precisely because these mortgage products existed 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 refinancing options crumbled away the crisis in my view would start in 2007 by which time teaser rate periods 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 feedback loop of a very damaging variety was set up so what did he do next well he effectively shorted the housing market with something called a credit default swap specifically i set out to buy credit default swaps on subordinated tranches of subprime residential mortgage-backed securities now there's a lot to unpack there so firstly what did he buy he bought a credit default swap this is a contract that michael bury buys off of another investor the buyer of the swap makes payments to the swaps seller until the maturity date of the contract in return the seller agrees that in the event that in this case the subordinated tranches of the mortgage-backed security fails then the seller will pay barry the securities value as well as all interest payments that would have been paid between that time and the securities maturity date simply put michael bury was going to profit if the housing market collapsed and it did house prices declined people could no longer refinance eventually the homeowner's debt caught up with them default rates skyrocketed because at the end of the day a lot of people's homes were worth less than their debts and this was a big problem because when those repossessed houses were sold they didn't recover anywhere near the original loan amount this mess destroyed mortgage-backed securities which were at the heart of the american financial system so overall by buying insurance on an asset that he didn't even own michael bury was able to profit personally a hundred million dollars and he made 700 million dollars for his investors scion capital ended up posting returns of 489.34 between its november 1st 2000 inception and june 2008. in that same time period the s p 500 returned just under three percent and that's including dividends and overall that is how michael bury saw the collapse of the american economy coming and profited from it anyway guys that is it for this video today i hope you enjoyed this video i put a ton of effort into this one so if you wouldn't mind i'd really appreciate it if you hit the like button if you enjoyed the video or if you found it useful thanks very much for watching all the way through to the end leave a comment below let me know what you think actually one uh idea that i had recently was i was thinking about sitting down and watching the big short and perhaps recording say a commentary of what's going on throughout the movies so if you wanted to maybe see that we could kind of all sit down and watch the big short and kind of work our way through it together if you'd like to see that then let me know down in the comment section below and of course check out profitful if you haven't done so already links are in the description if you'd like to learn about how i personally go about my investing either passive investing or active investing then definitely check out those links down in the description also help support the channel if that's something that you're interested in anyway guys that's it from me i hope you enjoyed it and i'll see you guys in the next video [Music] all

Channel: New Money

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Keywords: stock market, the big short, michael burry, big short, michael burry the big short, michael burry investments, housing bubble, financial crisis, michael burry stocks, the big short explained, credit default swaps, the big short movie, michael burry stock portfolio, the big short explanation, subprime mortgage crisis, financial crisis 2008, the big short michael burry, 2008 housing crisis explained, 2008 housing bubble, mortgage backed securities, mortgage crisis

Id: qL-CZWc3RME

Length: 19min 8sec (1148 seconds)

Published: Sun Sep 20 2020