Lebanese University

Faculty of economic science

And Business Administration
Section II

Michael Burry and Mark Baum,

financiers who had anticipated the
subprime crisis (2007) and the
banking and financial crisis (fall
2008), benefited from the effect of
these crises.

Prepared by Mario Nakhleh 01/10065

Master 2 Finance
Presented to Dr. Jihane bou Khazem

Table of Contents
Introduction: What Went Wrong?................................................................................2
Causes of the crisis..................................................................................................... 4
Historical approach..................................................................................................... 5
Macroeconomic approach........................................................................................... 7
Michael Burry and Steve Eisman two Genius..............................................................9
Bibliograpy............................................................................................................... 11

Introduction: What Went Wrong?

The global financial crisis of 20072008 was the most severe since the Great
Depression of the 1930s.The contagion, which began in 2007 when sky-high home
prices in the United States finally turned decisively downward, spread quickly, first
to the entire U.S. financial sector and then to financial markets overseas.
The public tends to search for the guilty without necessarily understanding the
complex causes of the disaster. Many believe that the culprits were the bankers,
their bonuses, their greed, fraud, corruption and speculation. Others hint at human
failures: contingent decisions like the refusal to bail out the investment bank
Lehman Brothers, which triggered an avalanche of failing financial institutions.
According to Alan Greenspan, it was hard to avoid this hundred year flood
(Greenspan, 2010). Much of this is neither right nor wrong. We have witnessed a
systemic crisis in which many factors interacted. How could such greed emerge that
did not exist before? How could a crisis in a small segment of the financial markets
(i.e. subprime mortgages) turn into a deep global recession, with losses of gross
domestic product (GDP) amounting to nearly 10 per cent of global output in
20082010,1 not to mention the loss in values of assets and the astronomical bills
to be paid later? Why do the shareholders of profit maximizing corporations tolerate
such high bonus payments? It seems that the search for scapegoats targets only the
tip of the iceberg. Is the gist of the matter still hidden?
The darnage was not limited to the financial sector, however, as companies that
normally rely on credit suffered heavily. The American auto industry, which pleaded
for a federal bailout, found itself at the edge of an abyss. Still more ominously,
banks, trusting no one to pay them back, simply stopped making the loans that
most businesses need to regulate their cash flows and without which they cannot do
business. Share prices plunged throughout the worldthe Dow Jones Industrial
Average in the U.S. lost 33.8% of its value in 2008and by the end of the year, a
deep recession had enveloped most of the globe. In December the National Bureau
of Economic Research, the private group recognized as the official arbiter of such
things, determined that a recession had begun in the United States in December
2007, which made this already the third longest recession in the U.S. since World
War II.
How did a crisis in the American housing market threaten to drag down the entire
global economy? It began with mortgage dealers who issued mortgages with terms
unfavourable to borrowers, who were often families that did not qualify for ordinary
home loans. Some of these so-called subprime mortgages carried low teaser
interest rates in the early years that ballooned to double-digit rates in later years.
Some included prepayment penalties that made it prohibitively expensive to
refinance. These features were easy to miss for first-time home buyers, many of
them unsophisticated in such matters, who were beguiled by the prospect that, no
matter what their income or their ability to make a down payment, they could own a
home.

The insurance industry got into the game by trading in credit default swapsin
effect, insurance policies stipulating that, in return for a fee, the insurers would
assume any losses caused by mortgage-holder defaults. What began as insurance,
however, turned quickly into speculation as financial institutions bought or sold
credit default swaps on assets that they did not own. As early as 2003, Warren
Buffett, the renowned American investor and CEO of Berkshire Hathaway, called
them financial weapons of mass destruction. About $900 billion in credit was
insured by these derivatives in 2001, but the total soared to an astounding $62
trillion by the beginning of 2008.
The financial crisis happened because banks were able to create too much money,
too quickly, and used it to push up house prices and speculate on financial markets.
Banks created to much money
Michael Burry and Steve Eisman (Mark Baum), Hedge Funds Managers predicted
Americas financial collapse, as well as the first to create trades to profit from it.
They forecast that the housing bubble would burst as early as 2007, and acted on
his conviction by betting against subprime mortgages, using credit default swaps.
These were the truly visionary who saw through the tripe -A ratings and the hype
around mortgage-backed securities and placed huge winning bets by shorting the
market. In fact, the only reason these hedge fund managers could not make even
more money was because, large and established Wall Street firms thought they
were too small and too inconsequential to be allowed to place larger short positions.
The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to
grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure
out what they had done.
How these two realized that the millions of dollars of credit swirling around the market were artificially
inflated and almost worthless? And the tools they used to detect the crisis in their analysis.

Causes of the crisis

How did a crisis in the American housing market threaten to drag down the entire global
economy? It began with mortgage dealers who issued mortgages with terms unfavourable to
borrowers, who were often families that did not qualify for ordinary home loans. Some of these
so-called subprime mortgages carried low teaser interest rates in the early years that ballooned
to double-digit rates in later years. Some included prepayment penalties that made it
prohibitively expensive to refinance. These features were easy to miss for first-time home
buyers, many of them unsophisticated in such matters, who were beguiled by the prospect that,
no matter what their income or their ability to make a down payment, they could own a home.
Mortgage lenders did not merely hold the loans, content to receive a monthly check from the
mortgage holder. Frequently they sold these loans to a bank or to Fannie Mae or Freddie Mac,
two government-chartered institutions created to buy up mortgages and provide mortgage
lenders with more money to lend. Fannie Mae and Freddie Mac might then sell the mortgages to
investment banks that would bundle them with hundreds or thousands of others into a
mortgage-backed security that would provide an income stream comprising the sum of all of
the monthly mortgage payments. Then the security would be sliced into perhaps 1,000 smaller
pieces that would be sold to investors, often misidentified as low-risk investments.
As long as housing prices kept rising, everyone profited. Mortgage holders with inadequate
sources of regular income could borrow against their rising home equity. The agencies that rank
securities according to their safety (which are paid by the issuers of those securities, not by the
buyers) generally rated mortgage-backed securities relatively safethey were not. When the
housing bubble burst, more and more mortgage holders defaulted on their loans. At the end of
September, about 3% of home loans were in the foreclosure process, an increase of 76% in just a
year. Another 7% of homeowners with a mortgage were at least one month past due on their
payments, up from 5.6% a year earlier. By 2008 the mild slump in housing prices that had begun
in 2006 had become a free fall in some places. What ensued was a crisis in confidence: a classic
case of what happens in a market economy when the playersfrom giant companies to
individual investorsdo not trust one another or the institutions that they have built.

Historical approach
The underlying cause of the financial crisis was a combination of debt and mortgage-backed
assets. Since the end of WW2, house prices in the United States have been steadily rising. There
have been a few fluctuations but the trend has been upward.

In the 1980s financial institutions and traders realized that US mortgages were a previously
untapped asset. Traders at Salomon Brothers and Drexel Burnham Lambert were looking to
expand the bond market and they discovered that the steady stream of payments from US
mortgages could be restructured into bonds and then sold off to investors. Prior to this, investors
had no access to the US mortgage market other than by buying real estate or investing in

construction companies, which was suboptimal and did not necessarily give the correct exposure
to house prices.
In the late 1990s and early 2000s, there was an explosion in the issuance of bonds backed by
mortgages, also known as mortgage-backed securities (MBSs). The reason for this was the use of
securitization. In brief, securitization is the pooling of debt and then issuing assets based upon
that debt.
Investment banks were buying mortgages from mortgage issuers, repackaging them and then
selling off specific tranches of the debt to investors. As time went on, there were less and less
new mortgages to securitize so the structured products groups at banks started repacking MBS's
(i.e. taking the unsellable tranches of lots of MBS's, repackaging them and then selling the new
product - called collateralized debt obligations or CDOs).
Theoretically, the pooling of different mortgages reduced risk and therefore these assets were
quite safe, but in reality the majority of the mortgages being securitized were of poor quality
(also called sub-prime). The ratings agencies who rated the MBSs and CDOs did not fully
appreciate the low quality mortgages backing the assets they were rating, or they overestimated
the benefits of diversification in the housing market and as a result, many of the MBSs and
CDOs were rated AAA (the very top rating).
The top senior tranche of the MBSs and CDOs were rated AAA and paid a low rate of interest
whilst the bottom tranches were often rated as junk but paid a very high rate of interest. Many
investors did not want the expensive senior tranches which gave a low return and in order to
keep the securitization and CDO machine rolling, many investment banks took to keeping these
tranches on their own balance sheet.

From the viewpoint of the banks it was a fantastic move. These assets were AAA rated (i.e. as
safe as US treasury bonds at the time), required little capital to borrow against and essentially
provided them with a free return. Even though the return on the senior tranches was low, the
interest rate in the money markets was even lower so the banks were making an easy spread
(borrowing short term in the money markets to buy long term AAA tranches of CDOs and
MBSs) as well as taking the fees for creating the CDOs.
The US and global banks went on a massive spending spree, borrowing vast amounts of money
at low rates in the short term to fund their investments. Investment banks had leverage ratios
(debt to equity ratio) of 30x or even higher. Some of the top investment banks such as Morgan
Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns were almost entirely funded by short
term borrowing.

Macroeconomic approach
Start with the folly of the financiers. The years before the crisis saw a flood of irresponsible
mortgage lending in America. Loans were doled out to subprime borrowers with poor credit
histories who struggled to repay them. These risky mortgages were passed on to financial
engineers at the big banks, who turned them into supposedly low-risk securities by putting large
numbers of them together in pools. Pooling works when the risks of each loan are uncorrelated.
The big banks argued that the property markets in different American cities would rise and fall
independently of one another. But this proved wrong. Starting in 2006, America suffered a
nationwide house-price slump.
The pooled mortgages were used to back securities known as collateralised debt obligations
(CDOs), which were sliced into tranches by degree of exposure to default. Investors bought the
safer tranches because they trusted the triple-A credit ratings assigned by agencies such as
Moodys and Standard & Poors. This was another mistake. The agencies were paid by, and so
beholden to, the banks that created the CDOs. They were far too generous in their assessments of
them.
Investors sought out these securitised products because they appeared to be relatively safe while
providing higher returns in a world of low interest rates. Economists still disagree over whether
these low rates were the result of central bankers mistakes or broader shifts in the world
economy. Some accuse the Fed of keeping short-term rates too low, pulling longer-term
mortgage rates down with them. The Feds defenders shift the blame to the savings glutthe
surfeit of saving over investment in emerging economies, especially China. That capital flooded
into safe American-government bonds, driving down interest rates.
Low interest rates created an incentive for banks, hedge funds and other investors to hunt for
riskier assets that offered higher returns. They also made it profitable for such outfits to borrow
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and use the extra cash to amplify their investments, on the assumption that the returns would
exceed the cost of borrowing. The low volatility of the Great Moderation increased the
temptation to leverage in this way. If short-term interest rates are low but unstable, investors
will hesitate before leveraging their bets. But if rates appear stable, investors will take the risk of
borrowing in the money markets to buy longer-dated, higher-yielding securities. That is indeed
what happened.

The financial crisis of 2007-08 has taught us that the confidence of the financial market, once
shattered, can't be quickly restored. In an interconnected world, a seeming liquidity crisis can
very quickly turn into a solvency crisis for financial institutions, a balance of payment crisis for
sovereign countries and a full-blown crisis of confidence for the entire world. But the silver
lining is that, after every crisis in the past, markets have come out strong to forge new
beginnings.
With half a decades hindsight, it is clear the crisis had multiple causes. The most obvious is the
financiers themselvesespecially the irrationally exuberant Anglo-Saxon sort, who claimed to
have found a way to banish risk when in fact they had simply lost track of it. Central bankers and
other regulators also bear blame, for it was they who tolerated this folly. The macroeconomic
backdrop was important, too. The Great Moderationyears of low inflation and stable growth
fostered complacency and risk-taking. A savings glut in Asia pushed down global interest
rates. Some research also implicates European banks, which borrowed greedily in American
money markets before the crisis and used the funds to buy dodgy securities. All these factors
came together to foster a surge of debt in what seemed to have become a less risky world.
From houses to money markets
When Americas housing market turned, a chain reaction exposed fragilities in the financial
system. Pooling and other clever financial engineering did not provide investors with the
promised protection. Mortgage-backed securities slumped in value, if they could be valued at all.
Supposedly safe CDOs turned out to be worthless, despite the ratings agencies seal of approval.
It became difficult to sell suspect assets at almost any price, or to use them as collateral for the
short-term funding that so many banks relied on. Fire-sale prices, in turn, instantly dented banks
capital thanks to mark-to-market accounting rules, which required them to revalue their assets
at current prices and thus acknowledge losses on paper that might never actually be incurred.
Trust, the ultimate glue of all financial systems, began to dissolve in 2007a year before
Lehmans bankruptcyas banks started questioning the viability of their counterparties. They
and other sources of wholesale funding began to withhold short-term credit, causing those most

reliant on it to founder. Northern Rock, a British mortgage lender, was an early casualty in the
autumn of 2007.
THE collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought
down the worlds financial system. It took huge taxpayer-financed bail-outs to shore up the
industry. Even so, the ensuing credit crunch turned what was already a nasty downturn into the
worst recession in 80 years. Massive monetary and fiscal stimulus prevented a buddy-can-youspare-a-dime depression, but the recovery remains feeble compared with previous post-war
upturns. GDP is still below its pre-crisis peak in many rich countries, especially in Europe, where
the financial crisis has evolved into the euro crisis. The effects of the crash are still rippling
through the world economy: witness the wobbles in financial markets as Americas Federal
Reserve prepares to scale back its effort to pep up growth by buying bonds.

Two Genius
Nearly the whole financial system bought into subprime mortgages and the
securities that were backed by them and amounted to bundles of bad debt.
Michael Burry. He's a young hedge fund manager based in San Jose, Calif., who
has Asperger's syndrome. He started a hedge fund named Scion Capital, which, 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 began to realize that the futures of several companies he was investing in turned on a
weird lending market, the subprime mortgage bond market. So he started reading the
prospectuses of subprime mortgage bond offerings. In the structure of the loans, Burry could see
the future disaster. So he figured out how to use this knowledge to his advantage, and he became
the first investor off Wall Street to make the big bet against them. Burry went in so early that his
investors thought he was crazy. Because he didn't have much connection with people, everything
Burry did was via e-mail.

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," 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." His prediction against the
mortgage loan market in 2007 got him a personal profit of $100 million while the remaining
$700 million was disbursed to his clients.The day the bubble explodedand burst it didhe and
his clients made huge profits.

Steve Eisman grown up in New York City, gone to yeshiva schools, graduated from
the University of Pennsylvania magna cum laude, and then with honors from
Harvard Law School. In 1991 he was a thirty-year-old corporate lawyer wondering
why he ever thought he'd enjoy being a lawyer. "I hated it," he says. "I hated being
a lawyer. My parents worked as brokers at Oppenheimer securities. They managed
to finagle me a job. It's not pretty but that's what happened.
Steve Eisman said that fundamental causes of the crisis started in the 1990s with
two big events:
1) the shift to measuring leverage on a risk-weighted basis,
2) the creation of the shadow banking system.
The financial systems current method of measuring leverage amounted to some
kind of gobbledygook, and created a system in which leverage in Europe triples,
and goes up by two times in the US, but on a risk-weighted basis, risk is flat so no
one thinks there is too much risk.

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Shadow banking system is a way, really, to get things off balance sheets, to hide
risk, to keep risk away from regulators. Anything not on a bank balance sheet is
shadow banking. The subprime story starts when Chairman Greenspan lowers
interest rates to one. This creates an insatiable demand for yield . he ratings
agencies are the subject of the next part of the subprime story.
The ratings were problematic because, they were wrong, and they awarded higher
ratings to riskier loans. the ratings agencies awarded more triple-A credit the more
adjustable-rate mortgages comprised a pool of loans. The problem was, the whole
system worked fine as long as everyone could refinance. The minute refinancing
stopped, losses would explode. But rating agency models contained inaccurate
assumptions about pre-payment rates, and inadequate loss projections for
borrowers who did not refinance when their interest rates reset. The data the prepayment speeds were much, much higher, and losses remaining on those who
didnt re-fi were much, much higher, risky loans obtained higher credit ratings
because the models said the cash flow was bigger and the more cash flow, the
more triple-A.
Steve Eisman tried to tell the rating agencies that their model is wrong, the financial
analysts services didnt undestanad. This was all a fixed income game. Eisman
knew subprime lenders could be scumbags. What he underestimated was the total
unabashed complicity of the upper class of American capitalism. For instance, he
knew that the big Wall Street investment banks took huge piles of loans that in and
of themselves might be rated BBB, threw them into a trust, carved the trust into
tranches, and wound up with 60 percent of the new total being rated AAA.
In retrospect, pretty much all of the riskiest subprime-backed bonds were worth
betting against; they would all one day be worth zero. But at the time Eisman began
to do it, in the fall of 2006, that wasnt clear. He and his team set out to find the
smelliest pile of loans they could so that they could make side bets against them
with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was
the analysis of subprime lending that should have been done before the loans were
made: Which poor Americans were likely to jump which way with their finances?
How much did home prices need to fall for these loans to blow up? Eisman waited
the total collapse to come.
His bet against Wall Street saw the assets he managed at FrontPoint reach $1.5
billion.

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Bibliograpy

Havemen Joel, Global Financial Crisis, Feb 02 2009

The financial and economic crisis of 2008-2009 and developing
countries, United Nations New York and Geneva, December 2010
Michael A. Santoro, Ronald J. Strauss, Wall Street Values: Business
Ethics and the Global Financial Crisis, 2013
Michael Lewis, The big Short: Inside the Doomsday Machine 2010
Interview with Steve Eisman of FrontPoint, LLC VW staff March 14,
2016 in Value Investing
Nick Mathiason, The Guardian, 28 december 2008
Manoj Singh, The 2007-08 Financial Crisis Investopedia.
Andrew Beattie,Market Crashes: Housing Bubble and Credit Crisis investopedia
The Economist, The origins of the The Financial crisis: Crash Course
Alessandro Bruno, U.S. economic collapse: Michael Burry predicts
Financial crisis January 04 2016 New York Magazine.

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