Friday, March 19, 2010

Michael Lewis on Michael Burry

Michael Lewis, whose writing I generally enjoy, has a new book out. It’s not about the financial crisis per se, but about a handful of traders who made huge amounts of money from the crisis. There’s an excerpt available on the Vanity Fair website, in which Lewis talks fairly admiringly about one such trader, Michael Burry.

I haven’t read Lewis’ book beyond this extract, nor do I know Burry personally (though I do know the trade he executed – it was a simple yet powerful idea, and full credit to him for conceiving it). But I do want to emphasize a couple of points that the VF article glosses over:

First, any story of this sort suffers from a huge amount of survivorship bias. For every Michael Burry or John Paulson who foresaw the crash and made money off it, I can name ten – nay, a hundred! – hedge fund managers who knew full well that there was a bubble in the housing market but could not get their timing right, and hence went bust1. (Either they bled to death on the negative carry, or their investors got impatient and pulled their money). Of course none of these other managers got their stories recounted in Vanity Fair, which is where the bias comes in. Lauding survivors for their investment acumen is meaningless without knowing the a priori probability of survival. Hindsight is always twenty-twenty.

And why are the odds of survival so very low? This brings me to my second point. The way the article describes it, Michael Burry was in the perfect position to do the subprime-CDS trade. Over previous years he had outperformed the S&P by huge margins, in good years as well as bad; by not looking to maximize his AUM he could pick and choose his investors; said investors loved him and hung on his every word; and his funds were structured with long lockup periods. If anyone had the wherewithal (deep pockets as well as credibility) to take a few quarters of losses while waiting for the big payout, it was Michael Burry.

But no. Quoting Lewis:
[Burry] assumed he’d earned the rope to hang himself. He assumed wrong ... He had told his investors that they might need to be patient ... They had not been patient ... Many of his investors mistrusted him, and he in turn felt betrayed by them ... To keep his bets against subprime-mortgage bonds, he’d been forced to fire half his small staff, and dump billions of dollars’ worth of bets...

If even a trader in Burry’s strong position was forced to the very brink by irrational investor behavior, what hope for lesser souls?

My point here is that traders do not operate in a vacuum. If your investors are myopic and greedy, that forces you to be myopic and greedy as well. If your colleagues are picking up nickels in front of a steamroller, then you have to go after those nickels as well. In Wall Street’s current “quarterly-earnings-are-everything” mindset, you simply cannot afford to sit back and be patient if you want to keep your job.

Of course the equilibrium is unhealthy: decisions that are rational at the micro level for individual traders, add up to an irrational macro market situation. In other words, a bubble. Quelle surprise!


# 1Conversely, I know plenty of hedge fund managers who either did not recognize, or chose not to recognize the bubble. For the most part these folks banked big bonuses pre-crash, and they haven’t had to return the money post-crash. Does this make them any dumber than Burry or Paulson, or any worse traders?


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    This should be no surprise. The defining characteristic of a bubble is positive feedback. Without positive feedback, incipient divergences from ‘fundamental value’ will always be counter-traded, causing reversion to the mean. And what is endogeneity (or circularity) but a positive feedback loop? The triggers may be various and even insignificant, but once a bubble gets under way, it’s very hard to pop. And despite the conventional wisdom, no rational trader would even try.

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