The Big Short_ Inside the Doomsday Machine - Michael Lewis [27]
On May 19, 2005--a month before the terms were finalized--Mike Burry did his first subprime mortgage deals. He bought $60 million in credit default swaps from Deutsche Bank--$10 million each on six different bonds. "The reference securities," these were called. You didn't buy insurance on the entire subprime mortgage bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them. In doing so, he likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans--so that he could bet against them.
He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans. It surprised him that Deutsche Bank didn't seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by the rating agencies, Moody's and Standard & Poor's.* If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-rated tranches, 200 basis points--that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches--the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent--were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next--the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones, and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.
Once again they shocked and delighted him: Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. "This was shocking to me, actually," he says. "They were all priced according to the lowest rating from one of the big three ratings agencies." He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley