How-Michael-Burry-predicted-the-2008-financial-crisis

How Michael Burry predicted the 2008 financial crisis

For investors, the government and, even the commoners, homeownership has always been the center of attention. The desire of owning a home has people running around and slaving for years on end. With that said, there is no doubt that the working population will grab every opportunity that they have, to get a house.

In a nutshell, the 2008 crisis occurred because banks lent out mortgages to individuals who neither had the credit nor the assets which made them capable of making the monthly payments. As a result, the fuel that was profiting banks became weaker and weaker each time they sourced out new mortgages. But why did banks make heaps of mortgages firsthand? Before answering that question, you need to know what mortgage-backed securities are. 

Understanding the banking situation and mortgage-backed securities:

What is the first thing that comes to your mind when you hear the word ‘banking’?

Words such as Money, investments, and mortgages may have just broken into your mind. Unlike today, banking wasn’t a sector people would join to earn heaps of money. 15 years ago, they were all filled with old pops who showed little to no interest in their job. The banking industry was just flat-out boring!

Well, that is until Lewis Ranieri showed up. He looked no different than the others, but he brought a revolutionary idea to the table, which has changed banking ever since. Mortgage-Backed Securities are a combination of mortgages that are segregated into various levels (tranches) and each level has a specific type of security that can be bought by investors.

The major advantage of these securities was clearly depicted in the movie ‘The Big Short’, where Lewis Ranieri says that “When you have thousands of them (mortgages) bundled together, suddenly the yield goes up but the risk is still small because well, who the hell doesn’t pay their mortgage?”And let me tell you, the commercial banks weren’t the ones who invented these securities; the investment banks did. Essentially, investment banks bought mortgages from commercial banks (profiting the commercial banks in the process) and used mortgage-backed securities to gather more investors, to make a profit as they have bought those mortgages for an extremely high price. To have an idea of how these securities are structured, look at the picture given below:

How Michael Burry predicted the 2008 financial crisis

Image credit: www.sec.gov

As you can see, the topmost level symbolizes the AAA bonds, which are paid first (and are also the riskiest). Then we have the AAs and As, followed by the BBBs, BBs, and Bs which provide low-interest rates but are safer compared to the As. The last categories house the CCCs, CCs, and Cs. These are known as junk bonds, as they are paid last and provide extremely low interest rates. On the flip side, however, there is little to no risk involved in these bonds. Now that you’ve understood what mortgage-backed securities are, let’s get back to our previously asked question.

Why did commercial banks make heaps of mortgages?

As mentioned earlier, investment banks bought mortgages from commercial banks for a hefty price. And because the investment banks were profiting from this endeavor using the mortgage-backed securities, the demand for these aforementioned mortgages was increasing high! So, instead of keeping the mortgages to themselves, the commercial banks would prefer to sell them. But this couldn’t happen for a long time, right? Since there is only an end number of homes and people, mortgages would be limited and the banks could only create so much.

To counter this problem, banks came up with a new mortgage product known as the ‘interest only negative-amortization adjustable-rate subprime mortgage’ Now that’s a huge term, but essentially it means that your monthly repayment will be added to your principal amount, which you would have to pay after the duration of the mortgage. Yes! This was the point in time that made Michael Burry confident that America was in a housing bubble. He had also taken a look at the mortgage payments made by various homeowners as they were available to the public, and he realized that many of the owners were 30, 60 and some were even 90 days late on their payments! All of these points motivated him to short the housing market using a credit default swap.

Credit default swaps:

 

Britannica defines credit default swaps in simple words, by stating that:

Credit default swap (CDS), a financial agreement that is used to transfer credit risk between two parties. A credit default swap (CDS) contract is bound to a loan instrument, such as municipal bonds, corporate debt, or a mortgage-backed security (MBS). The seller of the CDS agrees to compensate the buyer in the event of the loan’s default until the maturity date of the CDS contract. The buyer in return makes regular premium payments to the seller during this time.

 

Basically, Michael Burry offered insurance on an asset that he didn’t even own! Jared, another investor who was also featured on ‘The Big short’, used the same method to profit from the 2008 crash. Both of them profited in huge numbers; Michael Burry himself made $800 million and got to keep a whopping $100 million all for himself at the end of the crash. 

The housing bubble bursts:

Once most of the homeowners were unable to pay back their mortgages, the Mortgage-Backed securities, along with America’s housing market came crashing down. The debt was higher than the price of the houses alone, so even after defaulting, the banks couldn’t even make a dime, to keep themselves from falling. Although thousands lost their jobs, pensions, and even entire bank accounts, we take advantage of this crisis, by learning from it and being prepared for anything that comes next! 

 

To obtain deeper knowledge on the 2008 financial crisis, I recommend reading ‘ The Big Short: Inside the Doomsday Machine

How Michael Burry predicted the 2008 financial crisis

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What caused the 2008 financial crisis?

In a nutshell, the 2008 crisis occurred because banks lent out mortgages to individuals who neither had the credit nor the assets which made them capable of making the monthly payments. As a result, the primary fuel that was profiting banks became weaker and weaker each time they sourced out new mortgages.

What are Mortgage-Backed securities?

Mortgage-Backed Securities are a combination of mortgages that are segregated into various levels (tranches) and each level has a specific type of security that can be bought by investors. The topmost level symbolizes the AAA bonds, which are paid first (and are also the riskiest). Then we have the AAs and As, followed by the BBBs, BBs, and Bs which provide low-interest rates but are safer compared to the As. The last categories house the CCCs, CCs, and Cs. These are known as junk bonds, as they are paid last and provide extremely low-interest rates.

How much did Michael Burry make by shorting the housing market?

Michael Burry himself made $800 million dollars, and got to keep a whopping $100 million all for himself at the end of the crash. The rest were given out to his investors.

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