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One of the most important phone calls of hedge fund manager Mike Burry's professional life came in the parking lot of his son's eye doctor in mid-2005.
For months, Burry had been seeking ways to make money by betting big against the mortgage industry's reckless home-lending practices. And this call from a credit dealer at Deutsche Bank (DB, news, msgs) would finally set his plot in motion.
As of last week, Burry's bet against the lenders had helped him quadruple an initial investment of roughly $80 million, according to my estimates. But these trades of a lifetime were by no means easy. They required the former Stanford University Medical Center neurology resident to combine nerves of steel with the conviction of a federal prosecutor. Not to mention his natural inclination as a skeptic.
"I never believe what I'm told by a company unless I have independent proof," he says, explaining how he bucked Wall Street groupthink to wage his campaign.
Understanding Burry's bonanza is key to deciphering the storm of trouble brewing in the economy, one that has seen financial stocks fall more than 20% and the dollar's value plummet. It pits an investor with little previous experience in credit markets against financial powerhouses staffed with math wizards and mainframe computers.
The fact that Burry came out on top has not dimmed his annoyance with the consequences of their greed and lies. Nor does he think the pain is over for the banks or the economy.
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"I think we're headed into a deep recession, the worst since the Depression, as dozens of banks will fail," Burry says. "With massive foreclosures, there are homes that won't see the prices of two years ago for decades." And with the $500 billion home-equity spigot turned off, the money to pay off credit card debt, student loans and auto loans has evaporated. "We're looking at a lot of pain ahead."
Though many investors may say now that they saw this coming, few actually figured out what to do about it to the extent that Burry did.
Overpriced 'junk'
Burry started his value-oriented Scion Capital hedge fund in 2000 after dropping out of his Stanford residency. His fund performed well right away on purchases of out-of-favor stocks -- netting 45% in 2001, 13% in 2002 and 40% in 2003 -- and more investments started flowing in. But he didn't consider his bet against the lenders until he began to observe both fly-by-night mortgage brokers and major banks taking what he deemed "extremely unsuitable risks," using outlandish interest-only and adjustable-rate mortgages to get customers into houses they could not otherwise afford.After listening to quarterly earnings conference calls by companies such as Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs) and reading real-estate journals, Burry came to realize that home-price appreciation was the assumption behind every decision by borrowers, lenders, insurers and ratings agencies. He figured that once California home prices started to fall, the entire lending apparatus would fail and a credit crisis would ensue.
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"It became clear to me that many people never expected to pay their loans back and depended on a rise in home values every two years to allow them to refinance," he says.
As Burry researched, he discovered that all the subprime, or "junk," loans were being buried in tradable securities that banks were creating. Those securities, backed by the principal and interest on the mortgage loans the banks made, served as collateral to allow them to make even more loans and were a source of fixed-income returns for investors having trouble finding good returns elsewhere.
Continued: Clues were in the fine print
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