Why Michael Burry Sold his Credit Default Swaps?

In the movie The Big Short, all three groups of guys bought credit default swaps from various banks. The swap contracts were specifically made against the housing market, and once the housing market started to collapse, instead of collecting the value of the swap contracts, all three groups of guys sold their swaps to the banks.

Early Warning Signs

They could have held onto their positions and potentially received even more money if the financial crisis worsened. However, selling their swaps involved many factors beyond just maximizing immediate profits.

What happened was that Bear Stern’s hedge funds in the subprime housing market failed in mid-2007. When those hedge funds failed, all these banks realized that the subprime housing market was going to crash. And these banks wanted to make money off the falling market.

Valuation Issues with Banks

Michael Burry and other guys have been buying credit default swaps from these banks since 2005. And until 2007, these banks never valued Michael Burry’s CDS positions at all. When the housing market started to collapse, Michael Burry used to call these banks to check how much the value of his CDS had increased. The banks would either ignore his calls or those who picked up his calls would tell him that the CDS contract value was still the same.

Michael Burry experienced this with various banks when he used to call them for the valuation of his swap positions. The banks would give him an excuse for server failure, or the important person would fall ill, or some banks would tell him that they had a power outage.

Banks Betting Against the Market

In reality, these banks were making sure that their position was safe, so they started to betting against the housing market. These banks were buying swaps against the housing market before the market crashed completely. They deliberately undervalued the swaps until they had accumulated enough to profit. Till then, these banks tried their best not to value these swaps correctly. Once these banks had enough swaps, they started to value them correctly. That’s why in the movie you see Michael Burry getting angry and calling the banks out on their action.

The situation was so messed up that these banks sold mortgage-back securities to whoever was buying them, and then these banks would go to other banks and buy the credit default swaps against the same mortgage-back securities that they sold. Expecting them to fail. When Charlie and Jamie realized it, they went to the media, but the media refused to publish this bank scam.

Increased Demand for CDS

At this point, the situation was reversed on Wall Street. The people who were sure that the housing market would never collapse realized that the housing market was falling. So, to profit from the falling market, everyone on Wall Street wanted to buy credit default swaps to bet against the housing market.

Michael Burry’s position was about $1.9 billion. Just before the housing crisis began, people were offering him to buy his swaps for only 2% of the contract value, which is around $38 million. But when the housing market started to collapse, people were ready to buy his positions for 75% or 80% of their contract value.

Strategic Sale of Swaps

Liquidity and Counterparty Risk

Now all these guys sold their swaps because they wanted to profit from their investments. One more concern was liquidity. As the crisis intensified, the CDS market became illiquid, and finding buyers outside of the banks became challenging. Selling swaps to banks was the only practical way for them to cash out and take the profits.

The biggest concern these guys had was the counterparty risk. During the 2008 crisis, the whole financial system was on the brink of collapse. The risk of the banks themselves defaulting on their obligations grew as the financial crisis worsened.

These banks had bought lots of home loans from commercial banks, and all these home loans were losing value. As these loans were losing value, these banks faced major losses and were about to collapse.

That’s why, while buying credit default swaps from Goldman, Michael Burry says that he needs assurance of payment in case Goldman faces any insolvency issues. Insolvency means the bank has collapsed and is at a point of no recovery.

Selling their swaps minimized this risk and ensured they wouldn’t lose their profits due to an insolvent counterparty.

It is true that if they just held on to their swaps longer they could have made more money. But they realized that these banks were going to go broke. And if they went broke, then these banks would make excuses and would avoid paying these guys.

Of course, they could have sued the bank and gotten paid later. But again, that would have added to a huge legal battle over the years. So instead, they sold the swaps for lower profits instead of letting the swaps contract reach their peak value.

Actual Profits

Michael Burry sold his swaps for around $1.4 billion, which gave him a profit of $700 million.
The Cornwall guys sold their $200 million worth of swaps for $80 million, and Mark Baum sold his swaps for about $1 billion.

The banks could have just collapsed, and they could have avoided paying these guys altogether but the banks at the time had no idea that the government would step in and bail them out.

Had these banks had an idea that the government would step in and bail them out at the expense of taxpayers? These banks would not have bought their swaps and would have freely collapsed without any worries.

This is the reason all the groups of guys in the Big Short sold their swaps to the banks at the end. If you want to learn more about the Big Short and the 2008 financial crisis, then subscribe to our YouTube channel.

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