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Value investing lessons from the Big Short (film) – Part II

Big Short Takeaways for investors and traders – II

Part two of our three part series on The Big Short Case Study for value investors and fixed income traders. In our first post we reviewed the context of the book, characters and the Credit Default Swap (CDS) trade discussed in the film. The second post takes a look at investing lessons and takeaways for value investors and traders from the book for students registered in the portfolio management and optimization course at SP Jain and IBA.

Liquidity, “Over the Counter” (OTC) Trade and interim exits.

The original Mike Bury trade is based on a pool of reference securities issued in 2005. It is a trade between Scion Capital and counterparty banks Burry thinks are likely to survive the coming storm. Without a third party, exchange or regulator in between, these OTC trades are subject to liquidity and fair pricing challenges. More so if Mike decides to unwind or sell before maturity. If and when that happens he will be at the mercy of the banks pricing the trade.

In the movie Greg Lipmann says it perfectly to Vinny, Fore point’s head of trading:

“Yes, Swaps are a dark market and I get to set the price. When the times come to exit, I will rip your eyes out but you won’t mind because you would have made so much money… I get the sprinkles and the cherry but you get the Sundae, Vinny” 

While Mike is sharp enough to realize that banks may run into liquidity issues and pushes for collateral and pay as you go structures, its not enough.  Having the banks as a counter party creates issues for him when the market moves but the mark to market on his structures doesn’t. It is only when the banks have moved his positions from their books to other counter parties does Mike begins to see market based pricing on his positions.  This raises another interesting question – why did the banks retain the other side of the trade on their balance sheet? What was the motivation for the trade for them? What were they thinking?

We see references to this challenge with all three central characters.  Cornwall capital’s position is marked at US$ 600,000 by Bear Stearns the day before Ben Rickett sells it off for US$ 6 million in August 2008.  While the subprime mortgage market is clearly in a state of melt down the mark to market on Front point’s position in revised in favor of DB, the counter party, leading to a collateral call on the fund. Scion capital is down 19% year on year, faced with investor mutiny and premature exits before he finally gets a fair price that reflects ground reality.

It is not just the smaller counter parties who are penalized. Deutsche Bank (Greg Lippmann) and Morgan Stanley (Howie Hubler) go head to head debating how much collateral is owed by Morgan Stanley when the US$ 4 billion short Hubler CDS position is marked to market at 70 cents to a dollar by DB.

Luckily none of the trades needed to be held till maturity for the payoff to the traders to be booked. Mike Burry, Steve Eisman and Cornwall Capital are all able to off load their position to willing buyers once the market realizes the extent of the problem and their Credit Default Swaps begin to trade at 70 and 80 points compared to the original 1 – 3 points they were purchased at.

This basically means that a US$ 100 million notional position that was originally worth USD 1 – 3 million on the books of the fund and the investment banks is now worth US$ 70 – 80 million due to the impending and likely default on the underlying security.  Because the market has now revised the mark to market on the trades for the funds, it is now possible for them to sell their position to buyers who are need the protection the most. They don’t have to hold their positions to maturity, to wait for the actual default to happen. They can offload it through their brokers and traders much before maturity or actual default.

Stress Tests – Correlations goes to one.

The field of portfolio management and optimization is built on the diversification pay off. We pick securities to maximize returns and minimize portfolio standard deviation. We do this because security prices move based on a certain correlation as far as historical data is concerned. Energy, Power, Manufacturing, Housing, Transportation, Financial Services and Big Pharma – sectors of the economy that move in a specific fashion depending on what the future outlook is. We classify stocks between defensive and offensive based on their correlation with the economic cycle.

All this built on the foundation of somewhat stable correlations. But what happens when market panics push correlations all the way to one.

Taleb spends a great deal of time on the correlation challenge. On building portfolios that are robust. A recommended stress test is to test the correlation goes to one assumption – what happens when the diversification benefit disappears.

Cornwall capital indirectly play with this thesis when they correctly assess that when the subprime tranches rated B and below go under, they will take the AAA rated tranches down with them.  For them that thesis is driven more by the structure of the tranches and less by the actual correlation between them. More importantly for the CDO they are planning on shorting, even the AAA rated tranches are actually comprised of B rated tranches.

Howie Hubler at Morgan Stanely pays the penalty when his original thesis about limited correlations between the AAA rated tranches and the BBB rated tranches flies out of the window. Eisman correctly deduces that when the subprime market goes under, it will pull everyone down with it, CDO’s, bonds, and shares linked to the industry, historical correlations be damned.

It is the ultimate stress test. Correlations go to one. You should run it by your portfolio sometime. Think about it for a second – How would you test the correlations go to one stress test across asset classes; across positions within the same asset class?

Desired investor attributes – Curiosity.

In the film at the very beginning, Mike Burry asks a prospective candidate for an analyst position at his fund – How is it that as the tech bubble collapsed housing prices in San Jose actually went up? You would think that as the job market went under in the tech capital of the planet housing prices would come under pressure? Steve Eisman asks as he get into the Greg Lippmann trade, is there a housing bubble? Cornwall capital is quite keen to learn if shorting the AAA tranche is a bad idea? Are they missing something in the market because of their inexperience and their youth? Curiosity is the essence of a great portfolio manager. It is what drives discovery of the greatest trades.

For Mike Burry once his original thesis finds legs, the natural next step is for him to run through the prospectus for the subprime mortgage pools he wants to short. The book and the film both emphasize that other than the lawyers who wrote the prospectus, he is possibly the second person in the world to read through them.  His core question and answer is that for the 2005 pool of loans as teaser rates expire in 2008 will default rates rise?

Steve Eisman sanctions two trips to Florida to confirm that there is a bubble. This is followed by a trip to Vegas for the subprime industry annual convention to better understand the psyche of the people on the other side of the trade.  The film animates this perfectly with his engagement with the real estate agent, the mortgage brokers and the lap dancer with 5 condos, all financed with teaser rates mortgages.  For Eisman the right question is – is there a bubble?

For the Cornwall Capital team, the inspiration to short the AAA tranches occurs at the convention as they realize that while the market may have caught on to the BBB legs, it was still underestimating the failure probability for the AAA legs.  For them the key question is as the BBB legs fall, will the AAA tranches follow?

We have seen this “curiosity” mindset emphasized again and again by value investors – read, explore, discover and find out.  Learn about how businesses make money and how future is going to challenge or facilitate that model. Industry study characterize the greatest investors as voracious learners and readers.  The message is clear – if you see yourself as a value investor someday, learn to be curious, read and explore.  These are the tools that will lead you to ask the right questions.

Contrarian investing and group think

“So the Chairman of the Federal Reserve Alan Green Span is wrong and you are right?” “You want to bet against the housing market and you think Goldman Sachs will have difficulty paying you back?” “You want to keep paying premiums for the foreseeable future till an event happens that has never happened in the last thirty years?”

It wasn’t just that the market was wrong or off with its estimates. It was the fact that banks who created the market, who owned it, who modelled it, were off by billions of dollars in their estimates, the expected shortfall and the ultimate size of the hole in their balance sheets.   Burry and Cornwall capital were outsiders; Hubler and Eisman were not. Yet Hubler’s internal assessment and models were so off that rather than being the focus of the book as the first person who figured out the trade, he is an afterthought.

Contrarian investing is all about finding value and opportunity in spaces that the market has already discarded and rejected. But a bigger challenge after finding the opportunity is convincing yourself and the world that you are right.  Eisman and Cornwall capital struggle initially with the idea – how could this be even possible? Mike Burry struggles convincing his investors that his trade is in the right direction despite the market indicating otherwise.

Traditionally value investing focuses on finding securities selling at a discount that are likely to converge to their fair value once the market gets over its initial panic driven reaction. Where discount is generally evaluated in terms of ratios such as price to book, price to cash or price to sales.

The Big Short is unique education in terms of discount being applied to the probability of extreme events. Cornwall capital puts it right by buying deep out of money calls and puts on distressed or soon to be distressed securities. Their CDS bet on AAA tranches is an extension of the same strategy in a different market.

Opinions at Face value? Examine the incentives.

More important than the trade, the best example of group think and group-validation were the rating engines and the rating agencies.  Somehow the rating community agreed or accepted the assumptions that defaults would never cross the 4% threshold, that housing prices will continue to rise and never fall and that the diversification benefit assumption across different pools of mortgages was true and will hold.

It doesn’t matter where the opinion originates, if you take it at face value you will pay the final price. Don’t let the perception of success and competence deceive you. Look under the bonnet, take the car for a test drive, put it through the paces and examine the incentives of the counter parties involved with your trade. We have learnt to do the same thing with car salesman; its time the same rules apply to Wall Street.

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