Michael Burry's Subprime Speech at Vanderbilt: Inside the Doomsday Machine

We wanted to post up a recent speech by subprime short-selling legend Michael Burry. His now defunct Scion Capital saw outsized returns as the value investor turned subprime expert saw the housing crisis coming and profited handsomely. His story is chronicled in Michael Lewis' bestselling book, The Big Short.

His speech is entitled, "Missteps to Mayhem: Inside the Doomsday Machine with the Outsider who Predicted and Profited from America's Financial Armageddon."

While the investor walks us through his past line of thinking, he is curiously hesitant to answer questions about his current investment portfolio. In late 2010, we learned that Burry bought farmland and gold.

Embedded below is Michael Burry's speech (email readers come to the site to view it):




For more on Burry's amazing trade, definitely read Michael Lewis' chronicle in The Big Short. Additionally, we'd recommend reading Burry's primer on credit default swaps & the subprime mortgage short which he originally penned back in 2006.

Paulson & Co Clears the Air With Latest Letter to Investors

Hat tip to Barry Ritholtz for posting this up. Below is John Paulson and hedge fund Paulson & Co's letter to investors where they seek to clarify a few things as accusations regarding the Goldman Sachs fraud case start to fly. In addition to the letter below, if you want to be taken through the inside account of Paulson's subprime trade, we highly recommend Gregory Zuckerman's book that focuses on Paulson: The Greatest Trade Ever.


Embedded below is Paulson & Co's most recent letter to investors:



You can directly download a .pdf here.

So, hopefully that helps clear the air regarding their involvement. Also, given the topic of Paulson's letter, we thought it fit to also post up a presentation from one of the CDO investments back in 2007 that Paulson was betting against. If you haven't seen it already, below you will find Goldman Sachs and ACA's flipbook on Abacus 2007-AC1, a $2 billion synthetic CDO referencing a static RMBS portfolio. Here is the document:



You can download it via .pdf here as well.

Paulson sets things straight as to how they went about their investments at the time and it's intriguing to look back on the Abacus presentation and think about how all of this was going on just a few short years ago. For more on the ongoing CDO/CDS/subprime debate swirling around, we also detailed hedge fund Magnetar Capital's recent letter to investors regarding the investments they profited from during the housing bubble as well.

For more on hedge fund Paulson & Co, keep in mind that we've been tracking their equity portfolio and recently detailed their brand new stake in American Capital (ACAS). Additionally, we've covered Paulson & Co's recent performance numbers for those interested.

Hedge Fund Magnetar Capital's Letter to Investors Re: CDOs

John Gapper from GapperBlog at the Financial Times has just posted up hedge fund Magnetar Capital's latest letter to investors. If you peruse our 'What We're Reading' links that we post up each week, you'll recall that recently we linked to a ProPublica piece on Magnetar Capital and how they profited from the subprime trade. Needless to say, Magnetar wasn't too pleased with that and has fired back a retort, deeming the story misleading.

To follow the timeline accordingly, we of course recommend reading ProPublica's piece on the hedge fund first. Then, once you've finished, head down the page to read hedge fund Magnetar Capital's penned assault on ProPublica's story.

Embedded below is Magnetar's letter to investors, courtesy of John Gapper at the FT:



You can directly download a .pdf here.

It's obvious that Magnetar is rightly concerned with how they are being portrayed at a time when Goldman Sachs has come under siege for actions relating to their collateralized debt obligations (CDOs). Magnetar profited off of subprime's downfall much like John Paulson's hedge fund Paulson & Co did. This is certainly the time to 'set the record straight' to avoid any confrontations with the SEC now that the regulatory body seems to be on a CDO-related witch hunt.

In any event, an interesting read from Magnetar in their latest letter to investors. We haven't covered much of the Goldman Sachs fraud case as the SEC examines deals done with John Paulson's hedge fund. We figured we'd let the mainstream media cover that as the information flow has been non-stop. But if you want to learn more about Paulson's subprime trade, we highly recommend Gregory Zuckerman's The Greatest Trade Ever, which has intriguingly been a source of information regarding the recent CDO witch hunt.

Michael Burry & Scion Capital's Primer on Credit Default Swaps & the Subprime Mortgage Short

A big hat tip to Greenbackd for originally bringing this to our attention. Below you will find a very interesting primer on credit default swaps and the subprime mortgage short from Scion Capital's hedge fund manager Michael Burry. Burry of course was recently featured in Michael Lewis' latest book, The Big Short (which we highly recommend reading) for his notable early short position in subprime mortgages.

Michael Burry penned his primer back on November 7th, 2006 and it's almost comical now to think about how he was running a value fund focused on equities and then all of a sudden has to explain his short subprime trade and complex derivatives to his certainly surprised and confused investors.

Embedded below is Michael Burry's primer on subprime mortgages and you can directly download the .pdf here. It is a truly fascinating read now looking back and here's the document embedded via two formats to make sure everyone can read it at work, etc:




And then here is the second iteration of the exact same streamed document so hopefully one of the two is visible for you on the site:




Needless to say, what better way to learn about subprime mortgages than from the man who was one of the first (if not THE first) to short them. To read Michael Burry & Scion Capital's fully story, definitely pick up Michael Lewis' new book, The Big Short. Additionally, you can see Burry & Lewis from their appearance on 60 Minutes. Lastly, if you're looking to learn from Burry's origins and evolution as an investor, StreetCapitalist has an excellent post up here.

The Greatest Trade Ever By Gregory Zuckerman: Book Review

John Paulson is perceived as, for lack of a better term, a financial rock star. Young traders, analysts, and fund managers alike dream of the day they can emulate him, pocket billions, exclaim "F*ck you!" to the markets and then bask in the fame of those worshiping their every move. Many investors idolize him. Mainstream America now relishes his genius in predicting the crisis. This is the public perception. Gregory Zuckerman's new book, The Greatest Trade Ever, somewhat changes that.

In addition to detailing what the book's title deems, 'The Behind-The-Scenes Story Of How John Paulson Defied Wall Street And Made Financial History,' Zuckerman manages to humanize Paulson through his insider look. While this might imply that Paulson possesses some sort of villainous trait, one could argue the book showcases him as neither a financial deity nor a villain. Instead, he is portrayed as a diffident and practical human being that relentlessly pursued an idea and gained notoriety through success.

Let's first get to the facts: This is an intriguing book. So intriguing, in fact, that we read the entire thing in one sitting cover-to-cover. While we acknowledge that this could be in part due to the fact that we are enamored with tracking hedge funds at Market Folly, it is still a good read regardless.

The Greatest Trade Ever chronicles how hedge fund manager Paulson (and others) bet against subprime and reaped billions. The work of senior Wall Street Journal writer Zuckerman falls right into our niche and gives us an unprecedented look with exclusive access to Paulson through more than fifty hours of interview. It specifies how the thesis was formulated, how the idea was pursued, and most notably, how exactly the trade was put on. This book is the definition of insider access.

The remarkable thing about this story is the fact that Paulson's idea can be summed up by one simple chart: a plot of how much real estate prices had diverged from their historical norm. That chart, crafted by then Paulson & Co analyst Paolo Pellegrini, would serve as the glistening prize in their collective trophy case. What this book shows you though is just how complex of a journey it was to arrive at that simple piece of paper. While Zuckerman's work rightly showcases Paulson as the protagonist, it also details the journeys of other individuals pursuing the same historic trade. It details the investment timelines of Jeffrey Greene (an investor who knicked Paulson's idea and tried it on his own), Michael Burry (an investor who made the right call but was early to the play), and Andrew Lahde (the hedge fund manager who pursued his conviction in the play and later penned the infamous 'F*ck you' goodbye letter to Wall Street).

Zuckerman also rightly focuses on Paolo Pellegrini, the analyst who performed much of the legwork behind the idea. What's interesting about Pellegrini is his ruffled past. Before joining Paulson & Co, Paolo seemingly floundered in the investment industry and appeared to be on the brink. However, this match seemed destined to be, as the Paulson & Co team appeared a rather ragtag bunch sprinkled with 'grind-it-out' pasts. They weren't perfect and The Greatest Trade Ever highlights this, bringing this hedge fund deity (and envious readers) back down to earth. Just like you and me, the people behind this trade are human and struggled with tough times. Before his uprising, Paulson doubted himself and was essentially a run of the mill fund manager, nothing too out of the ordinary. Yet, all it took was an idea and a determined set of minds.

In short, The Greatest Trade Ever is a magnificent insider look at how Paulson and others profited off of subprime's demise, detailing both the formulation and implementation of such a trade. It chronicles the hedge fund's uprising and shows you how before this one idea, the ragtag bunch at Paulson & Co were far from deities. In the end, Zuckerman's work is both insightful and gripping. As for Paulson? He's back at it again. His latest bet? The demise of the US Dollar. As Paulson says, "It's like Wimbledon. When you win one year, you don't quit; you want to win again."


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The above is the latest addition to our growing list of book reviews. Make sure to check out our previous thoughts on these titles:

- The Murder of Lehman Brothers by Joseph Tibman
- Street Fighters: The Last 72 Hours of Bear Stearns by Kate Kelly
- The Ivy Portfolio: How To Invest Like the Top Endowments by Mebane Faber

And as always, you can head over to our recommended reading lists for other insightful books.

Paolo Pellegrini: Short Treasuries, Long Oil & Sees 'Anemic Real Returns' In Equities

While you may not be familiar with Paolo Pellegrini, you should be. The 52-year old used to work for John Paulson's hedge fund Paulson & Co and played an integral part in the research and investment ideas that led to Paulson's astonishing 570%+ return in 2007. As we covered on the blog before, Pellegrini has since left Paulson and started his own fund PSQR Management LLC with $100 million of his own money and will open to outsiders in 2010. PSQR's name has meaning for two reasons. Firstly, it is Paolo's initials squared (Paolo Pellegrini: P Squared). Secondly, it is an anagram for SPQR, or Senatus Populusque Romanus (Senate and the People of Rome). Pellegrini is a Rome native and this highlights the initials of the ancient Roman Republic as a tribute to his background.

In 2006 Pellegrini, a Harvard MBA, decided that the housing bubble was about to burst after he sifted through tons of housing data. In Spring of 2008, Pellegrini saw the severity of the situation and knew that massive government assistance would be needed which would send both stocks and the U.S. dollar down. Needless to say, he's been spot on both with his economic calls and his execution of a trading strategy that would profit from the crisis.

Strategy, Portfolio & Performance

Upon starting his fund, he shorted exchange traded funds (ETFs) that were loaded with financial stocks (most likely ticker XLF or some similar ETF), as well as S&P500 index ETFs (SPY, etc). In late 2008 he shifted his bets to the Treasuries market by shorting long-term treasuries. This is a trade we saw many hedge funds put on in the past and we recently detailed Julian Robertson's curve cap play that bets on rising long-term Treasury yields. And, Pellegrini expects the fall in Treasury prices (and rise in yield) to continue. He is taking a global macro approach by trading anything and everything he pleases, as long as it will help him make money off his theses. He has an uncanny ability to take an economic situation and turn it not only into a trade, but a profitable one.

Pellegrini is also bullish on commodities, especially those that are scarce or of daily necessity. In particular, he likes oil and has been buying oil futures. He likes commodities since he sees global competition for them elevating. Given this commodity thesis, he also likes the Australian Dollar as the country benefits from their natural resources. Pellegrini also has owned the Norwegian kroner which is interesting, as we saw Julian Robertson also recommended this currency. In a way, Pellegrini's theses here are also similar to that of legendary Quantum fund manager Jim Rogers. Rogers likes commodities and various currencies of commodity producing countries as we noted when we detailed Rogers' portfolio & positions.

Performance wise, Pellegrini has kept up the great numbers he helped generated at Paulson & Co. From April 2008 until December 2008, PSQR was up over 52%. Year-to-date through July for 2009, PSQR was up 80% largely on the heels of success in the Treasury market.

Thoughts on the Market

Given the sour economic situation he uncovered while at Paulson, Pellegrini still has a gloomy outlook for the economy. He sees the market essentially trading sideways and could even generate negative returns once you adjust it for inflation as he calls for "anemic real returns." The point is, he doesn't really see things going up by much as he cites budget deficits, household debt, and increased regulation amongst other things. As mentioned earlier, Pellegrini has been shorting long-term Treasuries and going long crude oil in a wager that was formulated on the basis of dollar devaluation. He cites massive stimulus programs, huge corresponding deficits, and the fact that the US is now a debtor nation as reasons for the currency's value dropping. While Pellegrini takes a long-term view in formulating his theses and putting on his trades, he does note that due to policy shifts and the market volatility, that his positions can (and will) change with the ebbs and flows of all the intertwined parts.

Pellegrini recently sat down for an interview on Bloomberg TV and we've embedded the video below. He discusses his strategies and his view on the economic trends we're seeing these days:




Obviously, Pellegrini paints a rosy picture... /sarcasm. He thinks fiscal stimulus and quantitative easing are not the solution and has been critical of the move the Federal Reserve has made. Pellegrini has been vocal in the past as he looks to solve the mortgage and housing crisis since it is at the root of much of America's problems. You can read some of Pellegrini's mortgage solutions here. He also sees a real decline in economic activity and some asset inflation as well.

John Paulson has called his former colleague "extremely smart and capable" as they previously met at Bear Stearns before moving on to Paulson & Co. Paulson has made a wager of his own when we saw that Paulson was buying financials. While this could have just been a trade, it is still interesting to see the difference of opinion. As you undoubtedly already know, hedge fund Paulson & Co also has a large gold position as they look to hedge their fund share class denominated in gold. But interestingly enough, they also have stakes in numerous gold miners. We'll continue to track the differences in thought and strategy between Paulson and PSQR as the economy meanders along.

Pellegrini parted ways with his former colleague because he always desired to run his own show and to run a true macro fund. Currently, PSQR is a smaller firm that recently hired Alex Patelis away from his position as Chief International Economist at Merrill Lynch in London. While he may run a smaller firm for now, you better believe that he has the credentials and the track record to succeed. The one question mark surrounding him is his ability to operate in futures markets, as he is relatively inexperienced there. We're sure he'd be quick to point to his winning Treasuries trades to refute that point though. But in the end, the majority of his experience lies in mortgage related markets and it will be interesting to see if he can continue to translate his economic theses into profitable macro trades. For more on Pellegrini, check out this in-depth profile of him from Bloomberg.

Washington Mutual's Failure

Very interesting piece on the rise and fall of Washington Mutual flagged to our attention by Barry Ritholtz. The Jacksonville Business Journal writes,

"But already by 2001 — long before the housing bubble stretched dangerously, before most Americans had heard the term “subprime loan” — Killinger (WaMu Chief Executive) had created the fractures that would cause Washington Mutual to collapse in the largest bank failure in U.S. history. The cracks, according to executives who were there at the time, would spread over the next 10 years, eventually rendering the 119-year-old bank that Killinger painstakingly built into the nation’s largest thrift too weak to withstand the greatest economic downturn of his career. “By the time you got to the last couple of years, pretty much the destiny of the company had been locked in,” said one former executive. Killinger declined repeated requests to be interviewed.

...

But, without exception, former and current executives interviewed for this article pointed to Killinger’s changes in the late 1990s as one of the chief causes of the company’s eventual downfall. One of the main reasons is that it gave much more power to the company’s mortgage division and the executives who ran it over the next 10 years, executives said. Under the new structure, the mortgage unit operated more on its own, and its independence grew when Killinger gave it its own IT and human resources departments, executives said. “The mortgage unit was responsible for its own bottom line,” said Lannoye. “The checks and balances were gone.” Ultimately, the changes paved the way for the mortgage unit to transform into a “culture of unmitigated greed,” according to a former executive team member, a view echoed by many former WaMu executives.

...

At the same time as he made the management shift in 1999, Killinger made an acquisition that seemed unremarkable. But Long Beach Financial was different. The California lender was a leader in a growing area of subprime mortgages, which were gaining popularity because banks could charge higher interest rates to those with poor credit, and reap more profit. Long Beach Financial was WaMu’s entry into the market. The highly profitable business made $752 million worth of loans in the first quarter of 1999 alone. Its 12,500 loan brokers were spread across all 50 states.

...

It marked the start of WaMu’s fateful foray into subprime loans, and its rapid, unchecked advance into risky mortgage lending — ultimately the chief cause of its collapse. Killinger had found a new growth strategy. After Long Beach, WaMu quickly snapped up three more mortgage banks. At the time, even many WaMu executives thought it was a good move. Home prices were rising, interest rates were low and banks earned sizable fees for originating loans. What’s more, the risk of default could be off-loaded by packaging the mortgages and reselling them to investors as securities.

...

Now the cracks at WaMu started to spread. The company began losing money on hedging — efforts to protect against movements in interest rates, a problem that was partially attributed to a failure to integrate a key mortgage system, according to executives who were present at the time. The bank also began losing money on home loans. Its profit, which had marched dramatically higher, plateaued at about $3.8 billion in 2003. Davis, who had led the home loan group since the late 1990s, left abruptly that year, executives said. The mortgage business, according to one executive, “became the Achilles’ heel of the bank.” The following year, the trouble deepened. Earnings tumbled by 25 percent, or more than $1 billion, the largest decline in annual earnings for at least a decade. More worrying, provisions for bad loans leapt fivefold, to $209 million. WaMu cut 13,450 jobs, closed 100 mortgage offices and closed 53 commercial banking operations.

...

In the desperate last months, Killinger was described as blindly optimistic and oblivious by those who worked with him. He had not in his career seen a market or a bubble like the one now engulfing Washington Mutual."

Read the entire piece.

Lots of Leverage and a Big Mess

A chart of how sub-prime became a recipe for disaster:

(click to enlarge)

Read more here.