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 Burry 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 Burry 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.

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. 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, at 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 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.

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. 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 could write, 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 Burry himself talking about how mortgages changed in order to help more people achieve that classic American dream: "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 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 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 Burry 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 at 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 continued 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 U.S. 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 in 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 to rule against the application of precedent to the unprecedented." So how did Michael Burry 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 standards.

They were no longer interested in checking excess credit risk at the door. By the fall of 2004, I noted for my investors that Countrywide Financial, a very large national mortgage lender, reported subprime mortgage originations up 158% year over year, despite a 24% decline in overall loan originations. Evidence was therefore manifest: banks were chasing bad credits, inclusive of housing speculators.

So at this point, Michael Burry 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 Burry, 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 Burry 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 Burry 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 subprime 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 Burry. 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 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 Burry buys off of another investor. The buyer of the swap makes payments to the swap's 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 Burry 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 Burry was going to profit if the housing market collapsed, and it did. House prices declined, people could no longer refinance, and eventually, the homeowners' 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 Burry 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 Burry 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 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 movie. 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.