One episode of Dirty Money where Fahmi short sells Valeant Pharmaceuticals, explains how short-sellers are natural contrarian thinkers. Howard Marks, the author of The most important thing illuminated which is one of my favorite books in investing, does a great job explaining the importance of being a contrarian.
I thought about how to learn more about great contrarian minds. Shortly The Big Short (the movie) came into my mind. Surely there must be a book I thought, so that’s how this book came on my reading list. It is a fascinating read and helped me a lot to improve my own investing style.
Here are my highlights from the book.
The other was that of the young man who set out to study the Talmud, not because he had the slightest interest in God but because he was curious about its internal contradictions. His mother had been appointed chairman of the Board of Jewish Education in New York City, and Eisman was combing the Talmud for inconsistencies. “Who else studies Talmud so that they can find the mistakes ?” asks his mother. Later, after Eisman became seriously rich and had to think about how to give money away, he landed on an organization called Footsteps, devoted to helping Hasidic Jews flee their religion. He couldn’t even give away his money without picking a fight.
In short order, the Salomon Brothers trading floor gave birth to small markets in bonds funded by all sorts of strange stuff: credit card receivables, aircraft leases, auto loans, health club dues.
“It was a fast-buck business,” says Jacobs. “Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people.
“Growing up in Queens, you very quickly figure out where the money is,” said Vinny. “It’s in Manhattan.” His first assignment in Manhattan, as a junior accountant, was to audit Salomon Brothers. He was instantly struck by the opacity of an investment bank’s books. None of his fellow accountants was able to explain why the traders were doing what they were doing.
He concluded that there was effectively no way for an accountant assigned to audit a giant Wall Street firm to figure out whether it was making money or losing money. They were giant black boxes, whose hidden gears were in constant motion.
“You can be positive and wrong on the sell side,” says Vinny. “But if you’re negative and wrong you get fired.”
Mobile home buyers were defaulting on their loans, their mobile homes were being repossessed, and the people who had lent them money were receiving fractions of the original loans.
How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.
All these subprime lending companies were growing so rapidly and using such goofy accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven, ones. They had the essential feature of a Ponzi scheme: To maintain the fiction that they were profitable enterprises, they needed more and more capital to create more and more subprime loans.
“If you are going to start a regulatory regime from scratch, you’d design it to
protect middle-and lower-middle-income people, because the opportunity for them to get ripped off was so high. Instead what we had was a regime where those were the people who were protected the least.”
“I now realized there was an entire industry, called consumer finance, that basically existed to rip people off.”
“Steve’s fun to take to any Wall Street meeting,” said Vinny. “Because he’ll say ‘explain that to me’ thirty different times. Or ‘could you explain that more, in English?’ Because once you do that, there’s a few things you learn. For a start, you figure out if they even know what they’re talking about. And a lot of times they don’t!”
“The very first day, we said, ‘There’s going to come a time when we’re going to make a fortune shorting this stuff. It’s going to blow up. We just don’t know how or when.'” By “this stuff,” Eisman meant the stocks of companies involved in subprime lending. Stock prices could do all sorts of crazy things: He didn’t want to short them until the loans started going bad.
Chapter 2 In the Land of the Blind
He now had a tactical investment problem. The various floors, or tranches, of subprime mortgage bonds all had one thing in common: The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them.
A couple of years earlier, he’d discovered credit default swaps. A credit default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $ 200,000 a year to buy a ten-year credit default swap on $ 100 million in General Electric bonds. The most you could lose was $ 2 million: $ 200,000 a year for ten years. The most you could make was $ 100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing.
It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. “Credit default swaps remedied the problem of open-ended risk for me,” said Burry. “If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it.”
Obsessiveness–that was another trait he came to think of as peculiar to himself. His mind had no temperate zone: He was either possessed by a subject or not interested in it at all.
The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules….
“The first thing I wondered was, When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He’s showing people his trades. And people are following it in real time. He’s doing value investing–in the middle of the dot-com bubble. He’s buying value stocks, which is what we’re doing. But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up fifty percent. It’s uncanny. He’s uncanny. And we’re not the only ones watching it.”
“The market found him,” says the Philadelphia mutual fund manager. “He was recognizing patterns no one else was seeing.”
“I found it fascinating and seemingly true,” he said, “that if I could run a portfolio well, then I could achieve success in life, and that it wouldn’t matter what kind of person I was perceived to be, even though I felt I was a good person deep down.”
As he scrambled to find office space, buy furniture, and open a brokerage account, he received a pair of surprising phone calls. The first came from a big investment fund in New York City , Gotham Capital. Gotham was founded by a value investment guru named Joel Greenblatt.
He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions.
Scion Capital charged investors only its actual expenses–which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors’ money grow.
“That was a classic Mike Burry trade,” says one of his investors. “It goes up by ten times but first it goes down by half.” This isn’t the sort of ride most investors enjoy, but it was, Burry thought, the essence of value investing. His job was to disagree loudly with popular sentiment. He couldn’t do this if he was at the mercy of very short-term market moves, and so he didn’t give his investors the ability to remove their money on short notice, as most hedge funds did.
“You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the [housing] market higher,”
“I hated discussing ideas with investors,” he said, “because I then become a Defender of the Idea, and that influences your thought process.” Once you became an idea’s defender you had a harder time changing your mind about it.
“People get hung up on the difference between + 5% and -5% for a couple of years,” Burry replied to one investor who had protested the new strategy. “When the real issue is: over 10 years who does 10% basis points better annually?
“If I describe it enough it sounds compelling, and people think they can do it for themselves,” he wrote to an e-mail confidant. “If I don’t describe it enough, it sounds scary and binary and I can’t raise the capital.”
Chapter 3 “How Can a Guy Who Can’t Speak English Lie?”
The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn’t know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.
The innocent observer might reasonably ask, What’s the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More prone to flooding–the first to take losses–they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building. The long answer was that there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their–soon to be everyone’s–nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren’t, as they might appear, all exactly the same things. They were another diversified portfolio of assets! This was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of debt triple-A.
Back in the 1980s, the original stated purpose of the mortgage-backed bond had been to redistribute the risk associated with home mortgage lending. Home mortgage loans could find their way to the bond market investors willing to pay the most for them. The interest rate paid by the homeowner would thus fall. The goal of the innovation, in short, was to make the financial markets more efficient. Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it. The market was paying Goldman Sachs bond traders to make the market less efficient.
Chapter 4 How to Harvest a Migrant Worker
They were constrained, however, by a boss with an imperfect understanding of the nuances of his own business, and whose judgment was clouded by his insecurity.
Here was a strange but true fact: The closer you were to the market, the harder it was to perceive its folly.
Chapter 5 Accidental Capitalists
Even as late as the summer of 2006, as home prices began to fall, it took a certain kind of person to see the ugly facts and react to them–to discern, in the profile of the beautiful young lady, the face of an old witch.
I think that parochialism is common to modern intellectual life. There is no attempt to integrate.” The financial markets paid a lot of people extremely well for narrow expertise and a few people, poorly, for the big, global views you needed to have if you were to allocate capital across markets.
“That has been a pattern of ours,” said Jamie Mai. “To rely on the work of smart people who know more than we do.”
“We were doing the sort of things that might cause your investors to yell at you,” said Jamie, “but we didn’t get yelled at by investors because we didn’t have any investors.”
The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn’t use it.
we realize that there’s a reason why it doesn’t quite make sense to us. It’s because it doesn’t quite make sense.” The subprime mortgage market had a special talent for obscuring what needed to be clarified.
“It took me a while to figure out that all of this stuff inside the bonds was pretty much exactly the same thing,” said Charlie. “The Wall Street firms just got the ratings agencies to accept different names for it so they could make it seem like a diversified pool of assets.”
Why pay 2 percent a year to bet directly against triple-B-rated bonds when they could pay 0.5 percent a year to make effectively the same bet against the double-A-rated slice of the CDO?
Chapter 6 Spider-Man at The Venetian
Their main argument, in defense of the underlying loans, was that, in their short history, they had never defaulted in meaningful amounts. Above the roulette tables, screens listed the results of the most recent twenty spins of the wheel. Gamblers would see that it had come up black the past eight spins, marvel at the improbability, and feel in their bones that the tiny silver ball was now more likely to land on red. That was the reason the casino bothered to list the wheel’s most recent spins: to help gamblers to delude themselves. To give people the false confidence they needed to lay their chips on a roulette table. The entire food chain of intermediaries in the subprime mortgage market was duping itself with the same trick, using the foreshortened, statistically meaningless past to predict the future.
On the one hand, it was exhilarating to hear a market insider say what he thought to be true; on the other, if the market became self-aware, its madness couldn’t last long.
There should be no greater thing you can do as an analyst than to be the Moody’s analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if Goldman likes General Electric paper.
Chapter 7 The Great Treasure Hunt
Digging deeper, he called S& P and asked what happened to default rates if real estate prices fell. The man at S& P couldn’t say: Their model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” says Eisman.
“I was sitting there listening to him. I had an epiphany. I said to myself, ‘Oh my God, he’s dumb!’ A lightbulb went off. The guy running one of the biggest banks in the world is dumb!” They shorted Bank of America, along with UBS, Citigroup, Lehman Brothers, and a few others.
“We have a simple thesis,” said Eisman. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.”
Gertner dug and dug and finally concluded that no matter how much digging he did he’d never be able to get to the bottom of what exactly was inside a CDO–which, to Jim Grant, meant that no investor possibly could either. In turn this suggested what Grant already knew, that far too many people were taking far too many financial statements on faith.
Chapter 8 The Long Quiet
All good news about the housing market, or the economy, was treated as an excuse to demand collateral from Scion Capital; all bad news was pooh-poohed as in some way irrelevant to the specific bets he had made. The firms always claimed that they had no position themselves–that they were running matched books–but their behavior told him otherwise
“I almost think the better the idea, and the more iconoclastic the investor, the more likely you will get screamed at by investors,” he said.
The definition of an intelligent manager in the hedge fund world is someone who has the right idea, and sees his investors abandon him just before the idea pays off.” When he was making them huge sums of money, he had barely heard from them; the moment he started actually to lose a little, they peppered him with their doubts and suspicions:
“I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.”
“That was the first time they moved our marks accurately,” he notes, “because they were getting in on the trade themselves.” The market was finally accepting the diagnosis of its own disorder.
Chapter 9 A Death of Interest
Asperger’s kids can apply tremendous focus and ramp up knowledge of a subject in which they have an interest very quickly, often well beyond the level of any peers.
Chapter 10 Two Men in a Boat
The demise of Bear Stearns had been so unthinkable in March of 2007 that Cornwall Capital had bought insurance against its collapse for less than three-tenths of 1 percent. They’d put down $ 300,000 to make $ 105 million.
Their clothes told you a lot, too. The guys who ran money dressed as if they were going to a Yankees game. Their financial performance was supposed to be all that mattered about them, and so it caused suspicion if they dressed too well. If you saw a buy-side guy in a suit, it usually meant that he was in trouble, or scheduled to meet with someone who had given him money, or both.