How a few Individuals made billions by betting against the subprime Bubble (Long Read)

When I published the review of Michael Lewis’ Boomerang yesterday I was reminded of his slightly earlier book – The Big Short – Inside the Doomsday Machine – the story of a few people who profited from the market collapse. Before you praise them for their wisdom just remember where the money to prop up the insurance companies who had to pay out came from. AIG received US government support of $85 billion in 2008 to help pay off its CDS debts. There is also the case of Hedge fund manager John Paulson who just used some of the money he made to buy a piano company.


Dr. Michael Burry

One of the most compelling stories Lewis tells in The Big Short follows a doctor, Michael Burry, who decided to leave his neurology residency after his investment blog attracted attention from money managers across the country. Burry started a hedge fund named Scion Capital, which, Lewis writes, was “madly, almost comically successful” — even when the Standard & Poors index fell.

While investigating stocks to invest for his customers, Burry discovered that the bond market was absorbing subprime mortgage loans in incredible volumes. Soon he realized that the millions of dollars of credit swirling around the market were artificially inflated and almost worthless.

Burry figured that he could bet against pools of these subprime mortgage loans using an instrument called a “credit default swap,” essentially insurance on a corporate loan. Burry persuaded the investment banks to create credit default swaps for the subprime mortgage market.

“As the pools of loans that are underneath these bonds start to default,” Lewis says, the investment banks that gambled on the subprime mortgage loans were forced to send Burry money daily as the bonds went bad. “Wall Street firms, they were on the other side of the bets.”


Charles Ledley and Jaime Mai

Ledley and Mai were two guys in their early 30s who decided to start their own hedge fund with just over $100,000. They quickly made more than $15 million by betting on financial events that are extremely unlikely to occur — and therefore didn’t cost much to bet against.

“They thought that Wall Street underestimated the likelihood of really unlikely events,” Lewis says. “So they would buy options to buy stocks at prices far, far away from where the stocks were currently trading. They did this with currencies, they did it with commodities. They scoured the world, essentially looking to make bets on extreme things happening.”

Soon, Ledley and Mai stumbled into the subprime mortgage market and realized that they could bet against not only the loans but also the financial institutions themselves.

“They’re able to piece together a clear picture of what’s going on in a matter of months,” Lewis says. “They become less interested in the bet than the social implications of what they’re learning. They go to the SEC. They go to The Wall Street Journal. They’re screaming at the top of their lungs, ‘My God, there’s fraud in the system.’ ”

By betting against subprime mortgages, Ledley and Mai’s $15 million investment ballooned to $120 million. Soon, Ledley began to experience migraines and anxiety attacks.

“They were stressed about being right,” Lewis says. “I think they were so stressed that they realized that this wasn’t a bet against a company, this was a bet against an entire system. And it was a bet that arose from their insight that the system had become rigged — that, essentially, Wall Street had become a giant Ponzi scheme.”

Lewis says the two men — like Dr. Burry — were able to see the failures of the market before the rest of the world did because they viewed the world differently.

“This is the story of human perception as much as it is anything else. And their attitude toward the financial markets was peculiar,” Lewis says. “It was peculiar to be running around the world looking for unlikely things that might happen. … And it told you something about Wall Street and … the way the markets were functioning when they were dysfunctional. There weren’t enough people thinking this way. There weren’t enough people taking into account the real likelihood of extreme change in the world.”


The Greatest Trade Ever – How John Paulson Bet Against the Markets and Made $20 Billion by Gregory Zuckerman

The story of one man’s refusal to believe in the health of the housing boom tells us a great deal about the financial crisis, says Heather Stewart

The mania that gripped investors in the wild bubble years of the 00s is widely portrayed as a universal affliction, but in fact a few stubborn souls refused to succumb. This book tells the story of one such refusenik, hedge fund manager John Paulson, who was not only sceptical about the health of the over-inflated US housing market, but bet against it – and won.

The scale of Paulson’s big bet, “the greatest trade ever”, as Greg Zuckerman describes it, was extraordinary. By piling into complex “credit default swaps” against mortgages – in effect, insurance policies that would pay out if homeowners defaulted – his fund made an unthinkable $15bn (£9.8bn) in a year, $4bn of which he took home himself.

On a single morning in 2007, when gung ho sub-prime lender New Century announced it was in trouble, Paulson’s fund clocked up gains of $1.25bn – more than his idol George Soros made in his notorious gamble against sterling in 1992, when Britain was forced out of the European exchange rate mechanism.

TJ Quote

How A Few Made Millions Betting Against The Market

The Greatest Trade Ever: How John Paulson Bet Against the Markets and Made $20 Billion by Gregory Zuckerman

Never Trust the Money Men (Blog Post)

‘Predatory’ lending during the american subprime bubble affected Americas poor blacks far more than any other group – now read the case for reparations – and not just for this injustice...(Blog Post)

Boomerang by Michael Lewis – Travels in the new Third World  (Blog Post)

Steinway Piano Business to be bought by American Hedge Fund Manager  (Blog Post)

AIG (Wiki)

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