There were a handful of investors who made a boatload of money betting against the housing market in 2007 by shorting subprime mortgages through the use of credit default swaps and such.
John Paulson is the most notable, earning a $20 billion profit for his fund along with an estimated $4 billion for himself in 2007 alone.
This trade led to a bull market in the term asymmetric risk. The idea behind an asymmetric risk profile is you give yourself the opportunity for massive profits in return for a relatively minor expected loss.
For example, a small fund being run out of a garage called Cornwall Capital made around $80 million from a $1 million bet against subprime loans. The losses on that $1 million were defined and small but the potential gains were astronomical.
After these types of trades came to light following the blow-up of the housing market, this became the dream — for fund managers and investors alike.
Michael Lewis set the table for this dream in his book, The Big Short, by profiling a number of investors who pulled it off.
I’m sorry to be the bearer of bad news but you’re never going to find the next big short. Here’s why:
Even the best investors in the world wanted nothing to do with this trade. Michael Burry’s path to shorting the housing market was a story that was made for a Michael Lewis book.
Burry was a doctor who shared his investment ideas on Internet forums. His ideas were so good they attracted the attention of one of the most successful hedge fund investors of all-time, Joel Greenblatt.
Greenblatt’s Gotham Capital funded Burry’s investment fund when he decided to quit medicine and become a full-time investor. They even took an ownership stake that was rewarded handsomely when Burry’s value investments performed well right out of the gate.
But when Burry got interested in betting against the housing market in 2005-2006, Greenblatt, along with many other investors in the fund, balked.
Burry so believed in his bet against these terrible housing loans that he eventually put a gate on his fund. In hedge fund speak, this means he made it harder for his investors to withdraw capital.
Greenblatt and company threatened to sue and it almost forced Burry to give up on his trade of a lifetime:
“If there was one moment I might have caved, that was it,” said Burry. “Joel was like a godfather to me—a partner in my firm, the guy that ‘discovered’ me and backed me before anyone outside my family did. I respected him and looked up to him.”
Of course, Burry was proven right. By June 2008 his fund was up nearly 500% from its inception in 2000 versus a gain of just 2% in the S&P in that time.
He and his investors made out like bandits from his housing short. Greenblatt is a legend and he almost let one of the greatest trades ever made slip away because he didn’t understand it.
But can you blame him?
In 2006, the S&P 500 was up more than 15% while Burry lost close to 20% because the housing market had yet to roll over. Burry was a tried and true value investor so betting against the housing market was an enormous style drift on his part. And gating your fund after a horrendous year isn’t a great signal to investors.
If someone like Greenblatt nearly whiffed on the greatest trade of all-time, what chance would you have at seeing something like this through?1
It’s physically & emotionally exhausting. Even after realizing profits of more than $720 million, Burry wasn’t exactly basking in the glory of his genius trade. None of his investors bothered to say a word after he made them so much money.
He stated, “Even when it was clear it was a big year and I was proven right, there was no triumph in it. Making money was nothing like I thought it would be.”
Burry sent an email in the fall of 2008 to some of his friends that read:
“I’m selling off the positions tonight. I think I hit a breaking point. I haven’t eaten today, I’m not sleeping, I’m not talking with my kids, not talking with my wife, I’m broken.”
It’s hard enough to make money when the markets are in upheaval but Burry was basically betting against the entire system here. You get the sense from reading Lewis’s book that, although they made a ton of money, the people who pulled this off didn’t delight in the situation even after being proven right.
It exacted a toll on everyone involved.
This was the trade of a lifetime. Greg Lippmann from Deutsche Bank was telling every big-money investors who would listen about shorting the subprime loans.
The majority of them turned him down. The most common response was, sure you might be right but it’s not my job to short the subprime market.
Lippmann quickly realized the only reason this opportunity existed is because it was nobody’s job. Everyone else basically felt it was impossible for a catastrophe of that level to ever occur. These opportunities don’t come around often.
Hindsight Capital would have you believe the last big short was easy to see in real time but it absolutely wasn’t.
The next one won’t be either and constantly looking for this type of trade is much harder than it sounds.
Listen to Michael and I discuss this and more thoughts about The Big Short on our new podcast:
Re-Kindled: The Big Short
1One of the best exchanges in the entire book comes when Burry lets them know his true feelings after being vindicated on his trade:
To his founding investor, Gotham Capital, he shot off an unsolicited e-mail that said only, “You’re welcome.” He’d already decided to kick them out of the fund, and insist that they sell their stake in his business.
When they asked him to suggest a price, he replied, “How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?”
This was a mic drop moment if there ever was one.