We all know during the 2008 crisis Michael Burry bet the money against the housing market and made huge profits. But Michael Burry did not bet the money directly on the housing market. As everybody thought the housing market was always stable there was no method or instrument to bet against the housing market. He used a new method called credit default swaps.
Any person who bet against the housing market would be considered crazy and looked down upon. After studying the housing market Michael Burry was sure that the housing market was going to collapse and he wanted to short the housing market.
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Credit Default Swaps
So he went to those investment banks and asked them to create Credit default swaps. The concept of credit default swaps was not something Michael Burry invented. These CDS existed since the 1990s. The first CDS contract was created in 1994 by one of the bankers at JP Morgan. It was used to manage the risk in a bank’s loan portfolio.
How credit default swaps work?
Credit default swaps are basically an insurance contract, providing protection to the buyer. Let’s understand this with an example.
Let’s say there are three friends Kevin, Mark, and Daniel. Mark wants to buy a car and he asks Kevin to lend him $30,000. Mark agrees to pay back Kevin with an annual interest of 5%.
Kevin lends Mark the money but he is also worried that if Mark faces financial difficulties then he might not pay him back. So Kevin wants to secure his investment. He goes to Daniel and convinces him to make a Friendship Default swaps contract with him.
According to the contract terms, Daniel will pay Kevin $30,000 if Mark fails to pay him back, till then Kevin will pay Daniel a monthly premium of $300 for Friendship default swaps. As all three were friends, Daniel knew Mark very well and he knew that Mark was a financially disciplined person. So Daniel thought that Mark would never face any financial difficulties and thought that whatever premium is Kevin offering him was free money and he would never have to pay Kevin the $30,000.
Eventually, Mark faces some financial issues and he is unable to pay Kevin. This triggers the FDS contract between Kevin and Daniel and Daniel pays $30,000 to Kevin. This contract was the same as credit default swaps.
Why banks sold credit default swaps to Burry?
This is what Michael Burry did while buying Credit Default swaps. He went to different investment banks and bet the money on various Mortgage-backed securities. The banks happily made these credit default swaps for Michael Burry and collected premiums from him, because they thought the housing market was always stable. That’s why they thought Michael Burry was offering them free money and they will never have to pay him.
Credit default swaps risk
Michael Buryy specifically chose credit default swaps because they had very defined Risk. When you short or bet against a stock or an asset directly, your potential losses are theoretically unlimited if the price rises. In contrast, CDS contracts have a defined risk. Michael Burry knew that the most he could lose was the premium he paid for the CDS contracts, which provided him with a level of risk management. But if his guess is right, then his bet can make him more money than what he paid for those premiums.
Benefits of credit default swaps
These Swaps allowed Michael Burry to amplify his bets using leverage. He could make larger bets relative to the capital he had by using borrowed money, potentially increasing his profits if his predictions proved accurate.
One more advantage of CDS was that Michael Burry could focus on Specific risks about specific financial products. Burry primarily focused on the risk associated with subprime mortgage-backed securities and collateralized debt obligations (CDOs) heavily exposed to subprime mortgages. Using CDS, he could specifically target this risk without exposure to other factors affecting the broader housing market.
Michael Burry did not go with the traditional method of shorting the housing market because the housing market and its derivatives were highly complex. And Michael Burry believed that traditional financial markets were not accurately pricing the risk. The Swaps contracts provided a more direct and, in his view, efficient way to profit from what he saw as a potential housing market collapse.
With the help of CDS, Michael Burry could bet primarily on very specific financial products in the market. The swaps contract provided him with very little downside and huge profits if his guess was accurate. This is the reason Michael Burry used credit default swaps.
Because of Michael Burry, many people bought these CDS contracts. One such person was Mark Baum. We recommend watching this video to learn about Mark Baum and why did he bet against the housing market.
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