Getting rich off the subprime mess

Studying the fine print in the prospectuses that banks filed with regulators as a part of every security offering, Burry learned that most subprime loans were sequestered in a "subordinated tranche," or lower level, of securities that inexplicably carried an investment-grade rating. That meant institutional money managers at mutual fund companies and pension funds who were obligated to invest conservatively could still buy these instruments without recognizing their danger.

A willing opponent

He also learned that the big banks and brokerage firms that had packaged the securities provided a lot of information about the subprime tranches, including the percentage of loans that had been taken out on second homes, their average loan-to-value ratio, the borrowers' average credit scores, the homes' locations and the loan dates.

"It's like learning a foreign language in a foreign country," he says of the self-education process. Anything you don't understand right away, he says, you look up or figure out in context.

Leveraging original research on which regions, credit scores and home types were most likely to default, Burry pinpointed hundreds of tranches he believed were most vulnerable to a potential wave of foreclosures and defaults. But there was still no way to easily short-sell these tranches, so he asked the broker-dealers who handled his derivatives accounts to let him know when such a method or instrument was created.

Now enter that phone call. In mid-2005, Burry's contact at Deutsche rang to say that the bank's credit-derivatives desk had decided to offer credit-default swaps on those subprime-mortgage-backed tranches. A credit-default swap is essentially an insurance policy that pays off if its targeted instrument -- a tranche, an entire mortgage-backed security, a collateralized debt obligation or a company -- goes belly-up. Buyers must pay an annual premium, at a rate set by the marketplace, for a contract that pays $10 million, for example, in the case of a default. The buyer can continue to pay the swap premium for years waiting for an expected default, or he/she can sell the swap at a profit to another buyer.

If you're a buyer, your counterparty -- the investor who loses when you win and vice versa -- is a swap dealer representing another investor who has the opposite point of view on the targeted security.

European and Asian pension fund managers hungry for yield at a time of low global interest rates were avid buyers of the type of insurance-premium income that Burry was paying. Because the subprime tranches were rated investment-grade, the buyers thought they were relatively safe and thus were getting money for nothing.

• Talk back: What lessons do you see in the subprime mess?

In contrast, Burry thought it was nuts for someone to take the other side of these trades, believing that in two years enough borrowers would default to make the swaps trigger a payout. If he paid $130,000 a year for the swap for a couple of years, he figured that a $10 million reward was an awesome deal. You could make 12 to 30 times your money -- or more if you borrowed the money that you used to make your payments.

Making his bet

In mid-2005, Burry started buying as many credit-default swaps on tranches of these securities -- with names like PPSI 2005-WLL1 -- as he could afford. He typically paid 1.25 to 1.3 percentage points of the swaps' face value for BBB tranches and 1.7 to 2.25 percentage points for BBB-minus -- which translated to $125,000 to $225,000 per year on a $10 million contract -- and seemed to have little competition when bidding.

"I'm totally at a loss to explain why more people didn't figure this out," Burry said. "I have been to undergraduate and grad school, and I know I'm in the middle of the pack when it comes to intelligence. You really didn't have to be a genius."

That autumn, Burry tried to raise money for a new fund to focus exclusively on these trades but could not convince enough high-net-worth individuals or institutional investors that it was a smart idea. It was lonely as a pioneer. For the first few months, his new swaps, now a large position within his main hedge fund, were priced regularly by dealers. But as the mortgage market encountered turbulence in late 2006, pricing became irregular and inconsistent, and he eventually had to hold the swaps off to the side because their exact value was not known.

Continued: Undeterred despite a big loss

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