Interview with Michael Burry, Real-Life Market Genius From The Big Short
nymag.com
nymag.com
1. Nowadays, options are priced in such a manner that the expected value of buying OTM hedges is almost always negative. This is due to the inflated volatility for out-of-money put options and other factors.
2. It just so happened that the subprime mortgage meltdown coincided with his career; for the period between 1935-2007, his strategy would not have worked. It also would not have worked between 2008-present. (maybe it worked have worked in 1987, so we're talking three instances out of a century). Right now, the evidence suggests bank have reformed their lending practices, with higher credit scores for new homeowners, so the odds of another financial meltdown are slim.
3. The fed balance sheet is big, but interest rates are very low.
The fed has posted a large profit , a 30% gain in 2015 for a profit over over $100 billion, which is sent back to the treasury
http://money.cnn.com/2015/03/20/investing/fed-profit-balance...
And the evidence due to the mathematics of the yield curve and the composition of the fed's holdings suggests the the odds of the fed losing money on it holdings is very low:
http://blogs.wsj.com/economics/2011/04/11/odds-of-fed-losing...
“Short-term interest rates would have to rise rapidly to quite high levels — in the neighborhood of 7% — for the Fed’s interest expenses to surpass its interest income. Such an outcome appears very unlikely,” the paper said. In the event that the Fed did face a loss, it could simply hand no money back to the Treasury and, “in the most extreme case, future remittances would also be reduced (and recorded as a change in deferred credit), but the Fed’s capital base and financial position still would remain completely secure.”
Japan has a much bigger debt, they seem to be doing fine. Low interest and srong dollar is due to reserve currency status, flight to safety, emerging market weakness, commodity weakness, petro dollar, the large size of the US economy, and other factors.
So, I had all kinds of lucky things.
-Warren Buffett, 4 Oct. 2011 [1]
Certainly Michael Burry had enormous luck. But there were plenty of others with the same amount of luck who did not see the crisis coming or who did nothing about it.
[1] http://fortune.com/2011/10/04/warren-buffett-at-fortunes-mos...
Buying options is buying insurance. From the point of view of the purchaser, the expected value of buying insurance is always negative (otherwise insurance sellers would be out of business). However, insurance is not bought due to its EV, it is bought due to its variance-minimizing properties.
The same with lottery tickets. People don't buy them because they're stupid, but because they value $100M far more than 50M times the value of $2.
Some people buy just because other people tell them to, some because they are afraid of losing something, and so on, there are a thousand reasons why individuals do it. But the general trigger of insurance for people is the non-linear utility function.
I would respectfully disagree. Homeowners insurance is a great example. Most people buy it and never make a claim, and they "lose" insofar as their premiums are gone for no monetary return. But some people who buy it "win" and get to collect enough money to roughly replace their house, belongings, etc when a hurricane, tornado or whatever destroys it all.
Not all insurance is the kind where you pay the same amount whether you make 1000 small payments or one big one.
But I never said that! It's just like the lottery, the payout of the lottery is smaller than the price divided by the odds (that's why a lot of people call it a tax on people who don't know math), but as the utility function of money isn't linear, for most people a small chance of gaining a lot of money is more valuable than a little bit of money.
The same is valid for insurance. The value of losing a lot of money is far more negative than the cost of it, even when taking the risk in account.
That's because the utility function doesn't depend only on the gain, but also on how much you have. A billionaire might not care about home insurance for a 100k shack.
EDIT: I'll clarify this to mean; even if the EV of insurance was exactly neutral, I'd still buy it for smoothing. And even if the EV was negative, I'd still buy it for smoothing. There's a difference between smoothing and loss aversion.
If people would buy it to minimize variance, they would also pay an insurance against winning the lottery.
Yes, those are profits on assets they have on their balance sheet. How much QE had to be done to achieve that profit. It's like the invisible negative side of the balance because the cost is socialized and delayed by years, by the time the damage is done few will correctly identify it as the dominant source of the problem.
It's easy to post a profit on select assets when you're pumping it up with the other hand.
"The caveat is that it is technology that should be a tool making lives better in the real world, and in line with the American spirit of getting better and better at something, whether it’s curing cancer or creating a better taxi service. I am less impressed with the market values assigned to technology that enhances distraction."
What has happened instead is that money has been packed out of circulation, mainly due corporations and the wealthy hoarding massive amounts of cash (and investing in stuff like junk bonds in trying to chase yields). This has created massive asset-price inflation, which has distorted the economy to the point of oblivion.
What is going to happen now is that consumer spending will remain really low, and to spur spending the Fed is going to make policies to ease borrowing, which will push people into debt, thereby creating a perpetual debt enslavement of the masses to the wealthy classes. That's the future. Either a massive asset price crash, or debt slavery for most of us.
There is still a way out of it. The government should impose a wealth tax - take back the money that was gifted to the rich. They shouldn't have a problem with it because they didn't earn it in the first place - it was an artifact of monetary policy. Invest that money in building infrastructure, life sciences research, and forgiving student loans. Only a massive redistribution will correct this farce of an economy.
TL;DR The Fed has created huge asset price bubbles, which has distorted the economy into comical levels of inequality. We need massive wealth distribution if we don't want the masses to be debt slaves.
1) Some kind of dollar, global reserve crisis that rocks the global economy for a while. Spurred on by the US debt and projected near future large budget deficits due to welfare and entitlement spending.
2) Broader bond market. I think this is a well understood threat, and doesn't require much elaboration.
3) A specific junk corporate debt crisis. About half of the major corporate defaults in 2015 were US companies, which have levered up significantly on the back of the Fed's super easy money policies.
4) Another significant drop backwards in the asset bubbles the Fed just got done re-inflating. If the Fed's policies fail to provide enough to sustain those huge asset classes (real estate and equities primarily), then when they tip over it'll pull the US economy down into a protracted recession. The global economy is practically in a rolling recession as it is, if the US goes next it would cause a lot more global pain (including amplifying the problems in China and Japan, both big exporters to the US). There's a real debate to be had about whether the Fed can ever actually create a scenario in which the intentionally inflated assets can sustain (stand alone without Fed props), or if they have to always deflate backwards with a hefty penalty for the market manipulation / forced capital misallocation (which then prompts even more dramatic action at each turn, to try to re-inflate).
The article is a short read, and the guy makes IMO prescient observations. E.g. here's one of them:
The zero interest-rate policy broke the social
contract for generations of hardworking Americans
who saved for retirement, only to find their
savings are not nearly enough.
But the evidence actually shows that a better returns can be had with stocks than cash (bills). Even with rates at 4%, stocks way outperform cash:
http://www.skepticmoney.com/wp-content/uploads/2011/05/1802-...
Putting cash into a bank is a poor way to save for retirement, if past performance is any clue.
The 'hardworking person' saving for retirement by stashing all his money in the bank may more myth than reality.
The majority of Americans have little savings, so the difference between 0% rates and 4% is immaterial if your expenses exceed your income.
http://www.gobankingrates.com/savings-account/62-percent-ame...
The problem is not that interest rates are too low, but rather people suck at personal fiance. But on the other had, the Paradox Of Thrift suggests that it's 'good' for the economy that too people don't save too much.
Those who have more wealth put it in stocks, bonds, or index funds. They seldom keep it in cash.
How old are the people? All I can give you is anecdotal evidence of quite a few older people I know. People aged between 50 and 80. Many have the bulk of their money in bank deposits. Quite a few people don't own a single stock or mutual fund. That's today.
And if you go back perhaps 50 years, then hardly anyone invested in stocks. The vast majority of people kept money in the bank or in real estate (their house or farm). I'm of course not talking about millionaires, I'm talking about average middle class people.
Would they have been smart to have more in stocks? Of course, but that's hindsight.
Even now I don't blame anyone for staying away from equities. In October 2007 the S&P 500 hit 1576. Then it bottomed at 666 in March 2009 (hard to forget that number!). Now it's 2056. It's easy to overlook that volatility if you have a steady six figure income. But when you're retired, when you'll never earn another dollar of income in your life, you tend to be more cautious.
I personally have almost all my money in equities and in real estate. Nothing in bank savings. But I'd never try to talk anyone into taking money out of the bank and putting it into the stock market. If they make money, they think they're geniuses. If they lose money, I'm a schmuck for giving them bad advice!
Just verbal speculation of course, but it remains hard to swallow that Italy borrowing for 10 years at 1.61% or Japan at 0.27% accurately reflects the full long-term risk of the single-point-of-failure policy of central bank buying.
that's the spu's total pe ratio, and it's about half what it was in 2000.
Median of S&P500 price/sales (not quite the same as median of price/earnings of course): http://mebfaber.com/2015/03/13/stocks-are-the-most-expensive...
Median of price/earnings for the broad NYSE universe: http://www.hussmanfunds.com/wmc/wmc150112.htm
I don't think it's controversial to state that high valuations in equities are more broadly carried. (Hussman's weekly column is an interesting source of opinions on where these broad valuation measures stand at any given time.)
Obviously, that doesn't automatically imply that any sort of deep loss is imminent. I believe it does say something about what you can reasonably expect in terms of long term total returns.
Article is worth a read despite the clickbait headline.
If it was harder for banks to supply subprime loans, then that would have tempered the fire feeding the bubble, and the crisis could have been smaller.
Of course, you could also take a more liberal viewpoint and not blame it on under-regulation of the government, but instead on mistakes of the big banks. I'm not that liberal though, so perhaps someone else can explain how liberals think debt crises should be averted. If I'd have to guess the simple answer would be that they would say the banks should've fallen so that the healthy banks would be the only ones left standing, so the whole event could be a proper free market process (so they also would say the government failed by bailing out some of the banks).
I think it warrants mentioning that Michael Burry had a very successful career before nailing the credit swaps trade. I think the sentiment that he's a perma-bear that just happened to get lucky is very unlikely. First, Michael Burry manufactured the credit swap trade that he is known for. What I mean by that is that Burry didn't trade options regularly. Rather, somewhat like Elon Musk, he reasoned from first principles. Burry started from the fact that certain housing markets were deteriorating and loan standards had been massively relaxed. Then figured out exactly what loans were in which CDO's and which tranches would be impacted by bad loans. Then he went out and bought credit default swaps against those specific tranches. There was very little luck involved.
In addition to that, prior to the credit default swaps trade, Burry had been running Scion very successfully using a value strategy (wikipedia quotes Michael Lewis as follows in his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. That is amazing performance.
Burry really is worth listening to. I went back and read his Scion Capital letters and IMO he actually is a genius wrt investing. I don't know quite how to express it other than its got the same feel as Warren Buffett's letters. He doesn't get swayed by fear or greed, he's just incredibly logical.
"Buy an appropriate index fund and wait, and don't pay any attention to what the market does" is far better advice for just about everyone.
I understand the reasoning behind "water cannot be easily transported".
But this part:
What became clear to me is that food is the way to invest in water. That is, grow food in water-rich areas and transport it for sale in water-poor areas. This is the method for redistributing water that is least contentious, and ultimately it can be profitable, which will ensure that this redistribution is sustainable.
With such a broad definition of "investing in water", my understanding is that his strategy becomes "invest in nearly everything". Water is needed for food production (which is already a very broad area for investment) but also in countless industrial processes: paper production, silicon chip, anything that uses water a solvent or as a way to cut through things...
My reasoning can not be right because it would basically mean "invest in anything". Can someone please help me make sense of this?
what I find interesting is that seems to be the converse of the historical trend of the last 30 years or so
Rust Belt places like Michigan and Upstate New York, actually have a lot of water and have been losing population to places like CA, AZ, and Las Vegas which don't
it seems like more people are less connected to water than they ever have been
maybe there is a correction coming, maybe there isn't, I don't feel confident asserting a guess either way as to that
I agree that it's hard to know if a correction is coming. I suspect that it eventually will happen, but how far away that eventually is I don't want to speculate. Might be a couple of years, might be a couple of decades.
> What makes you most nervous about the future? Debt. The idea that growth will remedy our debts is so addictive for politicians, but the citizens end up paying the price.
> What, if anything, makes you hopeful about the future? Innovation, especially in America, is continuing at a breakneck pace, even in areas facing substantial political or regulatory headwinds.
EDIT: I came back from reading the article a second time and was relieved to see that the speculative title had been changed.
A classic case of a "short/crash/doomsday personality" hitting his perfect moment.
Kudos to him, but I'll look elsewhere for insight on the next cricis/opportunity.
Where?
Wow, use some periods maybe?
"The next crash looks to be housing-related. Fannie Mae is in trouble. But not because of their accounting irregularities. The problem is more fundamental. They borrow short, lend long, and paper over the resulting interest rate risk with derivatives. In a credit crunch, the counterparties will be squeezed hard. The numbers are huge. And there's no public record of who those counterparties are.
Derivatives allow the creation of securities with a low probability of loss coupled with a very high but unlikely loss. When unlikely events are uncorrected, as with domestic fire insurance, this is a viable model. When unlikely events are correlated, as with interest rate risk, everything breaks at once. Remember "portfolio insurance"? Same problem.
Mortgage financing is so tied to public policy that predictions based on fundamentals are not possible. All we can do is to point out that huge stresses are accumulating in that sector. At some point, as interest rates increase, something will break in a big way. The result may look like the 1980s S&L debacle."
In 2006 I wrote:
"Interest-only loans as a percentage of new loans. (Graph) (Data from Loan performance)
People with these loans are not homeowners. They're renters, with an option to buy. One interest-rate spike and they're out on the street."
It took longer for this to crash than I expected. Mostly because the Fed pushed out cheap money to delay the crash. I was expecting an interest rate spike, but that didn't happen. I also didn't expect the thing to cascade so badly; I though the problem was going to be comparable to the 1980s S&L mess, not worse.
A key number to watch is the ratio of median house price to median income. Historically, that runs around 2.7. Above 3, trouble begins; people can't make their house payments. In the last bubble, it passed 4 for the US nationwide, and 10 for California. For that graph, see [1]. Click on "Price to Income". Look at the line for "United States". It's about 3.3 now; it hit about 4.1 before the last crash, then dropped to 3.0. Look at the graphs for California cities; they're much higher. But not as high as last time, yet. Keep watching those numbers; they're a leading indicator of a housing bubble/crash.
The problem with speculating on this is market timing. You can see the stresses building up, but it's hard to tell when the system will break. Those way-out-of-the-money option strategies hit this - you lose money every year as you wait for the big event. Burry almost ran out of time and money that way. Taleb, the "black swan" guy, doesn't release the results for his Empirica hedge fund for years other than the one year he hit the jackpot. His people got really upset when someone leaked them, they made it into Wikipedia, and he didn't look so good.
(On other fronts, I expected peak oil to be a bigger problem than it was; fracking fixed that, for now. And I thought Bitcoin would collapse long ago; instead, its use case for getting money out of China made it valuable.)
[1] http://www.economist.com/blogs/graphicdetail/2015/11/daily-c...