Michael Burry on the financial crisis

Soon, though, my attention, my activities in Scion Capital, I thought of myself as a value investor. Soon, my attention was caught by this growing importance of the housing sector. The amount and type of leverage, the generations-old acceptance and assumption that prices always went up, and the very broad societal participation, greater than 60% owning homes. This all called out to me. This was not just a case where a few early adopters made a lot of money or a few venture capitalists acted badly. The entire economy depended on home price appreciation. The slope. Home price appreciation. Consumer spending, jobs, securities markets, all of it. Soon, I would see financial Armageddon with housing as its trigger point.

Now, in predicting when and how the collapse would occur, my focus was again on the actions of our government and the response of the private sector. This was much in keeping with my studies a decade earlier in Chicago. Let's consider that history. The idea of an American dream being related to homeownership has been around for nearly a century. Nearly every modern president promoted it in one way or another with a named program. The government helped returning GIs after World War II buy homes, and the government was the first to securitize mortgages in the early '70s. Private securitized mortgages followed shortly thereafter, thanks to Lou Ranieri. President Reagan would sign the Secondary Mortgage Market Enhancement Act,

which, among other things, allowed insurance companies and pensions to invest in these securitized mortgages. And a short time later, Reagan signed a law that made these types of products much more tax efficient. To be clear, securitization of mortgages means there is actually virtually no limit on the amount of mortgages that can be originated by an institution. They just get sold through to Wall Street to investors. But all this was considered harmless. It was a good thing for the American dream to almost all concerned for decades. 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 adjustable-rate 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. Specifically during the '90s, the Community Reinvestment Act of 1977 was reinterpreted several times by Robert Rubin, the Treasury Secretary at the time, and Bill Clinton, the President at the time.

The general point was to increase pressure on banks to make more loans to less creditworthy customers. And they did. Subprime issuance bloomed about five to six times during the 1990s. And there was a mini-crisis thereafter. Bill Clinton had a name for this drive, as all presidents did. His name was the National Homeownership Strategy. Then, in 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933 and officially removed the increasingly leaky separation between the activities of Wall Street banks and depository banks. This freed banks to experiment and to expand into new lines of business, none more fateful than the experiment with derivatives and subprime asset-backed securities.

The private market therefore gained the capability to mount a massive response to all the government's efforts to stimulate housing. We all remember 1999 very well, but in fact, our global village underestimated many, many risks throughout the 90s, as is typical of a generally good economic time. And we had to deal with stock market crash, Enron, 911, WorldCom, and eventually war. The Federal Reserve stepped in, cutting the discount rate it charges lenders from 6% to roughly 1% in order to stave off recession. Other key short-term interest rates followed. Not all coincidentally, from 2001 to 2003, we saw American home prices, which had largely moved in line with household income over the decades, suddenly accelerate up and away from the household income trend line.

Home prices had good reason for such a deviation. From 2001 through 2003, rapidly declining short-term rates to lows not seen since the aftermath of the Great Depression induced a boom in adjustable-rate mortgages. A homeowner's dollar went farther during that teaser rate period, and so home prices rose unnaturally. Risk would be low as long as home price appreciation was strong under this paradigm, thanks to refinancing options. 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 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. Mr. Greenspan went on to advise in 2004 that they were underutilizing the new types of adjustable-rate mortgages. In 2005, he allowed specifically the technologies used by subprime lenders to get subprime borrowers into homes. Tragically for all of us, the Federal Reserve actually had authority to block any lending activity it deemed deserving of such treatment, but it had absolutely no will to do so. In any event, by 2003, mortgage rates stabilized at 40-year lows. And importantly, plain-vanilla adjustable-rate mortgages had already come into widespread use.

This was a big problem for public lenders with a growth mandate. They needed to stimulate more loan volume despite stable mortgage rates and inadequate income growth. At this point, if home prices were to rise significantly, they would have to float almost entirely on the back of the type and quality of mortgage credit provided to the buyer. Critically, interest rates alone would no longer determine affordability. In my letter to investors at the time, I termed this "credit extension by instrument," and it took our housing market into a new paradigm. It was the private market's time to overreact. The instrument chosen for subprime borrowers by lenders in 2003 was a relic of the 1920s, the interest-only adjustable-rate mortgage.

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. The only question was, how far could they go? Ominously, fraud jumped. The point at which the provision of credit was most lax, in my mind, would mark the point of maximal price in the asset.

I imagine the top in the housing market would be marked by a mortgage in which home buyers of subprime quality were enticed to buy with teaser-rate monthly payments near zero. I was very aware lenders would take this to the nth degree. Thanks to securitization, any loans the banks did not want to keep, they could always sell through Wall Street to investors who were simply ravenous for yield. Importantly, because subprime mortgages were being turned into securities, there were mandatory regulatory filings. And this is how I educated myself on the sector. At times, I felt I was the only one reading these things. By summer of 2005, these documents revealed that interest-only mortgages had taken a substantial share in the subprime market just a year or so later after they were introduced to that market.

More than 40% of subprime originations that were passing through Wall Street on their way to investors—this was up from 10% a year earlier. Simultaneous second-lien mortgages ramped up significantly. This was not disclosed in every document I read. And stated income—a stated income option available to borrowers—inspired a new vernacular: the "liar loan." In some mortgage pools, 40% of subprime loans were for second or vacation homes, condos in Miami. Yet as late as 2005, Moody's and S&P, so crucial to the securitization process—Moody's and S&P being the ratings agencies everybody watched—they were not reacting at all. The top would soon be fast upon us. As the subprime interest-only adjustable-rate mortgage started to touch maximum sales channel penetration, we saw the introduction of yet another

more extreme teaser-rate mortgage called the pay-option ARM or cash-flow ARM. In this new type of mortgage, never before seen in a widely standardized format, the borrower could basically pay next to nothing each month. And the unpaid interest would simply negatively amortize into the growing mortgage balance. Rampant cash-out refinancing had already made the home a magical ATM for most Americans. And now housing had its credit card. This was what I had been waiting for: peak credit. Such a mortgage product would only exist as long as home-price appreciation was the central assumption. And home-price appreciation was not long for this world precisely because these mortgage products existed. Some of these sorts of mortgages started making their way into the subprime channels, too.

I knew this because by 2005, as early as 2005, I could see these mortgages being packed into Alt-A securitizations. I read those, too. Those are between subprime and prime. Not all of these, though, were sold. Not as many as you would think were actually coming through this way, though. Most of them were not being sold through the Street. I noticed something else. Incredibly, Washington Mutual and Countrywide, again, two very national giants in home loans, began to load their own balance sheets with these pay-option adjustable-rate mortgages. Facing yet another slowdown in loan volumes, these companies saw the negative amortization feature as a way to show loan growth in a slowing market. Yet these companies, in doing so, also expressed confidence in home-price stability in the event of a slowdown in loan origination.

Of course, this is what the ratings agencies, the Federal Reserve, Congress, the President, and all the President's men believed as well. I disagreed. 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 can 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, seeing the economy on the verge of collapse, I did the logical thing: I sought to profit from it. Specifically, I set out to buy credit default swaps on subordinated tranches of subprime residential mortgage-backed securities. And that's where I lost my investors, too. In fact, in doing so, I gained a new level of insight into how Wall Street really works. I called different Wall Street firms, banks with which I had prior relationships due to my trading of distressed debt. I tried to convince them to trade in this market with me. Initially, I found no takers.

This was March of 2005. The whole effort was complicated because it was important to me that this security, this instrument that I'd like to use to short the market, would be standardized such that if I bought a credit default swap from one dealer counterparty, I could easily trade that credit default swap to another dealer counterparty. Bespoke, one-off contracts were full of contract and counterparty risk that I would not tolerate. Nevertheless, by May of 2005, standardized contracts were on the cusp of becoming reality. In May of 2005, May 19th of 2005, we agreed to our first trades, shorting the subprime mortgage market with Deutsche Bank. We worked on these soon-to-be-standardized contracts a bit, and in the first days of June of 2005, the first trades officially went through.

We would ultimately use nine different Wall Street dealer counterparties. To be clear, well, first I'd say Lehman and Bear I avoided for obvious reasons, even back then. Goldman Sachs featured very prominently early on. They were a very anxious crew. To be clear, these credit default swaps that I'm buying would rise in value as mortgages are written off and the value of these tranches fell. Goldman Sachs in the spring of '07 appeared to us to want to make its trade bigger. They wanted a bigger piece of the Big Short. A lower price, therefore, would benefit Goldman Sachs, and that's how Wall Street works. In late June of 2007, credit spreads started marching higher. And then they just took off once, once Goldman was on the same side as my trade.

Then it was AIG's turn to complain about Goldman's marks. Incredibly, it would later be reported that more than $60 trillion, $60 trillion in credit derivatives were in effect at the peak. Now, hyperbole would say that is more than the gross product of the world. But it's roughly equal, and who really knows what the gross product of the world is? How could that be? How could it even get close to the gross product of the world? Credit derivatives on an underlying asset could be worth multiple orders of magnitude more than the asset itself is worth because all asset-backed securities, all asset-backed derivative securities settled in cash. Pay-as-you-go. That was the secret sauce of the Doomsday Machine.

And so the crisis unfolded, with the market providing a signal far too late. Even so, Fed Chairman Ben Bernanke, Treasury Secretary Hank Paulson continued to underestimate the situation. I was apoplectic. I was just like that—apoplectic. Secretary Paulson now claims that even if he knew what was going to happen, he couldn't have done anything about it. Maybe true. After all, he would say, "I just joined the Treasury in the summer of 2006." But he came from the top CEO job at Goldman Sachs. And once Treasury Secretary, he wasn't so impotent. He orchestrated the once unthinkable government takeovers of AIG, Fannie Mae, Freddie Mac. Absolutely unthinkable just a few years ago. The bailouts of Wall Street.

He was anything but an impotent tool. And he had a running start unlike any other. But if he truly felt that way, this is an absolutely devastating commentary on how our government works. In fact, as books and articles on the crisis proliferate, it becomes clear that at nearly every failed institution and every relevant department of government, there was someone whose insight was every bit as good as mine, and in many cases, better. However, none, zero, zero were in the top job. That our CEOs, our governors, our presidents, and our chairmen did not see this coming, did not adequately prepare their constituencies, is an indictment of the manner in which we choose and enable our leaders. But such would not be the conclusions in 2008.

Broadly speaking, it's the hedge funds' fault. By the second half of the year, with the government targeting commodity hedge fund managers with punitive subpoenas, the global attack on so-called speculators and evil hedge funds, the nationalizations of Fannie, Freddie, AIG, et cetera, and their liabilities—very importantly, their liabilities, which are now a special purpose vehicle of the government, TARP—I worried about the future of a nation that would refuse to acknowledge the true causes of the crisis. In my view, an historic opportunity was lost. America had instead chosen its poison as its cure, and the Second Greatest Generation would never be born. Today, I expect the US government to attempt to continue easy money policies into the next presidential term.

past the meat of the foreclosure crisis and past the corporate and public refinancing humps that are upcoming. With junk bonds—junk bonds incredibly are again at all-time highs—quantitative easing seems to be working for now. But this is an invalid validation of what America is doing. This is, in fact, a Pyrrhic gamble. As we continue to debase our currency, Bernanke says he is not printing money. Again, again, I disagree. As it stands, I get an email every single day from the Fed saying, 'We just bought another $7 to $8 billion of Treasuries,' monetizing the debt. I don't know. That's pretty clear to me. In fact, this program, QE2—not Queen Elizabeth, Quantitative Easing—QE2, its scope and breadth raises a severe question of the Treasury's needs.

The government's borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers, and consumers is a short-sighted, easy decision for a population that has not yet learned that short-sighted, easy strategies are the route to long-term ruin. We never quite achieve the catharsis necessary to stoke a deep reevaluation of our wants, needs, and fears. Importantly, the toxic twins, fiat currency and an activist Fed, remain firmly entrenched, even more so with the financial reforms last year. In fact, the Federal Reserve, having acquired new powers through regulation, has insisted specifically that nothing in the field of economics or finance was of any help in predicting the crisis.

Period. No more comment. It's a worthless conclusion. It guarantees we'll make the same mistake again and again. So I have a problem with leaders. I should note, yes, I've been very vocal about these mistakes they've made. We need better leaders. But very frankly, this isn't going to happen. A problem cannot be solved if it can never be acknowledged. And I don't see acknowledgement happening. Taxes need to be raised. Spending needs to be cut. Loopholes need to be shut if we are to have any hope of returning to a stable base. Certainly, homeownership should not be a policy of the US government. And the banking system needs substantial reform and even bank breakups. Glass-Steagall needs a second run in a strong form.

and those 22 and a half million public workers have no business unionizing against the taxpayer. The list of things that won't happen but should happen goes on and on. As citizens of these United States, we should carefully consider what one trillion means. All personal income taxes collected in the US in a year do not add up to one trillion dollars. By 2020, interest expense on our national debt could very well exceed $1 trillion. When you consider our $1.7 trillion deficit, consider we really only take in a little of the Treasury's inlays are only a little over $2 trillion. It's quite a loss margin. $2 trillion also happens to be a little less than the amount of bank and government debt now held at our overly bloated Fed.

Two trillion seconds is 64,000 years. And what's minimum wage again? Our country's math is scary big, but even more scary is that it simply does not work. Speaking of math not working, how many of you checked that math? Pretty sure 64,000 years. So arguments on looming economic recovery must be considered alongside the fact that all this debt and all the money being printed is very much a real bill, a real tax on our future. It's debtor's prison for our children. It has not yet come due today except for savers and those on a fixed income. As such, I recommend sober analysis on the part of the individual. This is paramount. We must remember that entire societies can and do follow the wrong path for a very long time.

They do run aground. And there is nothing wrong with breaking from the social norm to ensure good outcomes. Legacies are a terrible and sometimes fatal burden in a rapidly changing world, and common sense must rule when it comes to career paths and life choices. Though the situation seems to call for it, it is not a time for a responsible individual to tolerate any level of blind faith directed toward any man or woman. It is absolutely not a time to follow. So all that said, I might recommend opening a bank account in Canada. So happy to take questions. I see a wave in the back. Well, I think the point at which the degree to which we can tax our population is basically eclipsed by the amount of our interest on our debt basically makes us a Ponzi scheme of some sort.

And I think that's the point. I think it's very hard to pick that spot. There's a long, long history. This is one of those things I wish, I think our leaders, our government are kind of in this teenage state right now. There's this long history we can rely on for a more mature view of how things work. And I think there's a long history of governments lasting a whole lot longer than they should. And a lot that we'd rather not have happen, certainly all the dictators seem to get it done. So I think it's difficult to time that very precisely. I think we'll have a warning, though. I think a smart analyst, or I shouldn't say that, because I don't even think I'm so smart. I was definitely 50th percentile here at Vanderbilt University, no higher.

I think if you just pay attention, you'll get a warning sign. Heck, when I figured out the subprime thing, I had to do it off human behavior and various sources of witchcraft, wizardry in 2005. By early 2006, it was apparent in the actual filings that were being made every month. And you just had to look at that, and it was really easy. And so I think you'll see that. If you're thinking, oh, one day a Treasury auction will fail, and then I'll have, you know, I don't see that happening, because I think we have enough domestic consumers of debt, including the Fed, but including military pensions, whatever, Social Security, et cetera, that it's too easy for the government to hide that. And I don't know that you can wait for that.