How Charlie and Jamie turned $110k into $80M in The Big Short?

In The Big Short, the third group that was betting against the housing market was the Brownfield Capital Fund guys. In the movie, the name of their fund is Brownfield Capital. But the real name of their fund is Cornwall Capital. They had a unique strategy that most people would not even attempt.

Their Strategy

Michael Burry and Mark Baum had their own strategies and market specializations. Charlie and Jamie believed the best way to profit on Wall Street was to bet on the least expected outcomes. They were successful with this strategy before because Wall Street often underestimated the chances of big changes.

Charlie and Jamie didn’t have experience with mortgage bonds, real estate, or even the complex language of the bond market. They were also not sure if they could participate in this market. Because it was typically for big investors, and they were just a small group.

When they came to know about Jared Vennett’s presentation about shorting the housing market with credit default swaps. The first thing they thought was why more experienced and smarter investors than them were not already doing it.

However, after reading the presentation, they decided to try to short the market. They didn’t have a lot of money or a very convincing plan. But they had some ideas about how financial markets worked. Their one idea was to enter private stock markets. Where companies are bought and sold because they are better at pricing things than the public stock markets. In private deals, both sides usually have experts helping them, so the prices are more accurate.

Profiting from unique opportunities in the market

Public markets often have people making decisions based on short-term profits rather than the real value of a business. Also, the investors in the public market do not look at the bigger picture.

For example:- An investor in the US stock market only focuses on the US market. And a Japanese market investor focuses only on the Japanese market. Few people understood the mutual impact of the Japanese, European, and US markets.

When they started Cornwall Capital in 2003, they wanted to find opportunities where the market was not working efficiently. They planned to do this not just in one type of investment. But in various markets globally with stocks, bonds, currencies, and commodities.

Making money from Credit card company

They soon stumbled upon their first big opportunity a credit card company called Capital One Financial. Capital One was a credit card company that was good at lending money to people with poor credit scores. They were in the business of providing credit cards, not home loans. But they dealt with similar kinds of customers who would later have problems with their home loans. Capital One claimed, it could better determine if people with bad credit would repay their credit card bills. They thought they were better at predicting the risk of lending to such people. They had a good reputation in the market because they had survived a tough time when many other similar companies went out of business.

However, in 2002, their stock price took a big hit. The market worried that Capital One might not perform as well as it claimed and that it was hiding financial problems. Some even suspected them of fraud. Regulators were investigating the company, and their Chief Financial Officer resigned. This raised doubts in people’s minds.

Over the next six months, the company still made money, but its stock price stayed low, around $30 a share. There was a lot of uncertainty about the company’s true value. Charlie and Jamie researched the situation, talked to people, and even tried to meet with the company’s executives.

After researching the company, they concluded that either crooks ran it. Making it worthless, or it had strong fundamentals, and its stock was vastly undervalued by the market. They believed Capital One’s regulatory problems would resolve in a few months, causing its stock to either crash or rise significantly.

Profiting

As the company was going through troubles, its options were very cheap. So, Cornwall Capital bought 8,000 long-term options on Capital One’s stock. Their potential loss was limited to the amount they paid for these options, which was $26,000. If Capital One’s stock went up, their options would be worth a lot more. And that’s exactly what happened. Capital One was cleared by regulators, their stock price rose, and Cornwall Capital’s $26,000 investment turned into $526,000.

Event driven investing

This strategy of buying options on stocks poised for big changes became very profitable for them. It allowed them to make money when they sensed something dramatic was about to happen in the financial markets. They didn’t need to know everything about the specific market or asset. And used to hire experts to help them understand the details. They were good at spotting opportunities where the market had misplaced its confidence. And they were not afraid to make small bets with long odds that could result in significant gains.

After their success with Capital One, Cornwall Capital had more money to invest. They repeated their success by betting on a distressed European cable TV company called United Pan-European Cable (UPC). They bought call options worth $500,000 at a low price, and when UPC’s stock rallied, they made a quick profit of $5 million.

Next, they invested in a company that delivered oxygen tanks to sick people at home. Their $200,000 investment quickly turned into $3 million. After this, they named their approach “event-driven investing” because they were betting on events that could lead to significant price changes.

After making significant money, they decided to hire a certified hedge fund manager instead of handling it themselves. Whenever they interviewed a hedge fund manager and reviewed his portfolio performance, they felt disappointed and believed they traded better.

Dealing with Wall Street banks

As these guys were managing their own money, no big bank on Wall Street would want to deal with them. The big banks thought they were too small and just ignored them. But as shown in the movie, with the help of Ben Hockart, they got license to bet on bigger deals.

When they were first introduced to the Wall Street bond market, they had never traded bonds or mortgages before. So, they faced many difficulties understanding the various terms and acronyms Wall Street banks used to address various types of loans and instruments. But the very same thing turned out to be a blessing for them. As these guys were curious, they learned each and every term on their own and studied each aspect of mortgage-backed securities and CDOs.

It took them some time to learn, but eventually, they figured out that these MBS and CDOs were filled with worthless mortgages. They found more stuff about CDOs, such as that CDO “A” is a part of CDO “B” and CDO “B” has parts of CDO “C” and how messy it was. Then they did exactly the same thing that Michael Burry and Mark Baum did: they started to find which CDOs and MBS were filled with more worthless loans and were most likely to fail.

Doing things differently

One thing they did differently from Burry and Mark Baum was that they bet against AA rated CDOs. Which even Michael Burry and Mark Baum didn’t even think of doing. Their reason behind this was that, as all the mortgages were rated falsely by rating agencies, that means BBB rated bonds and AAA rated bonds are filled with exactly the same worthless loans. So if BBB rated bonds are failing, then AA and AAA rated bonds are also failing. The Wall Street traders thought these guys were dumb for betting on AA rated bonds, but in reality, these guys were geniuses.

Hiring other fund managers

Further down the line, these guys hired the services of a guy named Burt, who worked for a Blackrock fund that managed a trillion dollars. Burt’s job was to identify for BlackRock the bonds that were going to go bad before they went bad. When they showed him their bet against AA rated CDOs, Burt said to them, You people are the only ones who have bet against AA CDOs. When Burt analysed their CDOs carefully, he figured out that these guys had inadvertently invested in synthetic CDOs. The synthetic CDOs were most likely to fail because they had a swap contract that Michael Burry bought.

By January 2007, with their tiny $30 million fund, these guys were putting on bets that were multiples of the capital they had. Their biggest positive was that they accepted they knew nothing and were curious enough to learn about the investment they would make. They would go to any extent to learn about the potential investment by calling people, not giving up when they faced insults and got laughed at by Wall Street bankers. The thing that kept them going was that they figured out everything was wrong at the core of the financial system, and nobody was paying attention.

As the Big Short movie itself says, in the beginning, “A few outsiders could do what the big Wall Street traders couldn’t do because they just looked”. The Cornwall Capital guys did the same and just looked through the details of these MBS and CDOs. Their bet paid them around $80 million.

This is how these two guys played out their brilliant strategy in the big short and during the 2008 crisis. If you want to learn more about the 2008 crisis and the big short movie, then check out this playlist.

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