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Scion Capital's 2006 Letter to Shareholders

Michael Burry's letter outlined thesis for shorting subprime mortgages

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Cody Eustice
Dec 30, 2015
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Dr. Michael Burry founded Scion Capital with an $80,000 loan from his family and in less than a decade racked up a 400% return. He has become a legend in value investing circles thanks to his massive short of subprime mortgage and found new fame thanks to the biopic "The Big Short" based on Michael Lewis' 2010 book.

Every investor should read the book and see the movie. Burry was one hell of a value investor who was up double digits in 2000 and 2001 after the dot.com bubble burst.

In his 2006 letter to shareholders Burry discussed his thesis for shorting the subprime mortgages. Every value investor should read Burry's letter and posts on his old blog.

Scion Capital 2006 Letter:

Subprime mortgages, typically defined as those issued to borrowers with low credit scores, make up roughly the riskiest one-third of all mortgages. The vast majority of these mortgages fall well within the loan size limits set by Fannie Mae (

FNMA, Financial) and Freddie Mac (FMCC, Financial) but are not deemed eligible for purchase by these two mortgage giants for other reasons. That is, they are nonconforming. For these nonconforming subprime mortgages, the originator can certainly choose to hold on to the mortgage and retain credit risk in exchange for the interest payments. Alternatively, the originator can sell subprime mortgages into the secondary market for mortgages. This secondary market is vast and deep, thanks to the invention of mortgage-backed securitizations back in the 1970s.

In a securitization, a finance company buys up mortgages from the original lenders and aggregates these mortgages into large pools, which are then dumped into a trust structure. Each trust is divided into a set of tranches, and each tranche is defined and rated by the degree of subordination protecting the tranche’s principal from loss. The tranches are then sold in the cash market to fixed income investors by a placement agent – typically a well-known securities dealer. The lower-rated tranches may not be offered to investors but may be retained by the finance company. Too, the dealer placing the securities with investors may choose to purchase some of these securities for its own account, either as an investment decision or to help ensure a full sale of the deal. At the time of the creation of the trust, a servicer, also rated by the agencies, is hired to administer the mortgages within the trust. The trustee will manage the trust and all relations with investors, including monthly reports. The month’s end is typically the 25th.

For instance, we can take a look at PPSI 2005-WLL1, an early 2005 mortgage deal.

Here, it happens that Argent Mortgage Company and Olympus Mortgage Company separately originated a set of subprime mortgages, and each sold these mortgages to Ameriquest Mortgage Company. Ameriquest, which will be the seller in this deal, deposited these mortgages with a wholly owned subsidiary, Park Place Securities 1 Incorporated – PPSI. Park Place is therefore the depositor. Park Place refashioned this pool of mortgages into a trust, with Wells Fargo Bank being the trustee and Litton Loan Servicing being the servicer as set out in the Pooling and Servicing Agreement, or PSA. The seller hired Merrill Lynch as the placement agent to sell the deal to investors. Those tranches designated “NO” were not offered to investors but rather retained by Ameriquest for other purposes. An investor buying a tranche will receive LIBOR plus a fixed spread that correlates with the tranche’s rating and perceived safety.

Note the senior tranches, designated A-1A and A-1B, make up 79% of this particular subprime pool. That is, these senior tranches can count on credit support amounting to 21% of the pool as well as any additional credit support that builds up during the life of these tranches. If the pool experiences write-downs in excess of the credit support for the senior tranches, then the senior tranches will suffer erosion of their principal. This is deemed extremely unlikely by the ratings agencies, and these senior tranches therefore garner the AAA rating.

The mezzanine tranches in this pool include all those tranches that are rated but not rated AAA. For the lowest rated tranche – M11 in this particular pool – credit support is just 2.3% at origination. Baa3, or equivalently BBB-, is considered the lowest “investment grade” rating, and the lowest investment grade tranche in this PPSI deal is M9, which had 4.05% in credit support at origination. Note the M9 tranche is just under $6 million in size, less than 1% of the original deal size – these are tiny slices of a large risk pool. Still, the ratings agencies say each tranche is worthy of a difference in the rating due to the historically very low rate at which residential mortgages actually default and produce losses. Because home prices have been rising so steadily for so long, troubled homeowners have been able to refinance, take cash out and often reduce the monthly mortgage payment simultaneously. This has had the effect of reducing the rate of foreclosures. Also because of rising home prices, foreclosures have not resulted in enough losses to counteract the credit support underlying mortgage-backed securities. To be perfectly clear, write-downs occur when realized losses on mortgages within the pool overwhelm the credit support for a given tranche.

Credit support is therefore a key feature worthy of more attention. A tranche will not experience losses if any credit support for the tranche still exists. In addition to the structural subordination that contributes the bulk of credit support, finance companies build in overcollateralization – essentially, throwing more loans into the pool than necessary to meet the payment obligations of the pool – and the trust itself can engage in derivatives transactions to insure the pool against loss. An example might be an interest rate swap that produces excess cash for the pool as rates rise. Over the first couple of years, which are typically relatively problem-free for mortgages, one already normally sees an increase in credit support for all tranches. In an era of hysteria over a home price bubble, one would expect that the organizer of a new mortgage pool would include or extend use of these extra protections to help further bolster the credit support for the pool’s tranches. As 2005 came to a close, this is exactly what happened, and this is why I find many more recent deals much less attractive from a short’s perspective than mid-2005 deals.

As is always the case, timing is therefore important for an investor short-selling tranches of mortgage-backed securities. Catching a peak in home prices before it is generally recognized to be a peak would be critical to maximizing the chances for success.

Now, because the more subordinate tranches are so wafer thin, they are typically placed with either a single investor or very few investors. Securing a borrow on such tightly held subordinate tranches would be difficult, and as a result shorting these tranches directly is not terribly practical. A derivative method was needed – enter credit default swaps on asset-backed securities.

Credit default swap contracts on asset-backed securitizations have several features not common in other forms of swap contracts. One feature is cash settlement. Again, examining PPSI 2005-WLL1 M9 – the BBB- tranche – we see it has a size of $5,894,000. Because credit default swaps on mortgage-backed securities are cash-settle contracts, the size of the tranche does not limit the amount of credit default swaps that can be written on the tranche, nor does it impair ultimate settlement of the contract in the event of default. By cash-settle, I mean that the tranche itself need not be physically delivered to the counterparty in order to collect payment. An investor with a short view may therefore confidently buy more than $5,894,000 in credit default swap protection on this tranche.

As well, these credit default swap protection contracts are pay-as-you-go. This means the owner of protection on a given tranche need not hand over the contract before full payment is received, even across trustee reporting periods. For instance, if only 50% of the PPSI 2005-WLL1 M9 tranche is written down in the first month, the owner of $10,000,000 in protection would collect $5,000,000 and would not need to forfeit the contract to do so. If in the second month the remaining 50% is written down, the owner of protection would collect the remaining $5,000,000.

A mortgage-backed securitization is, of course, a dynamic entity, and a short investor must monitor many different factors in addition to the aforementioned credit support. For instance, as a mortgage pool matures, mortgages are refinanced and prepaid, and the principal value of mortgages in the pool declines. Prepayments reduce principal in the senior tranches first. Generally, the idea is that investors in subordinate tranches should not get capital returned until the senior tranches are paid off. There are some minor exceptions, but this is generally true. For instance, today, the current face value of the AAA tranches in PPSI 2005-WLL1, which was issued in March of 2005, is roughly $243,691,000 versus the original face value of $667,705,000 due to a high rate of refinancing. Those who can refinance will. Our focus is on those who cannot.

For those who cannot, some mortgages will go bad. Lenders tend to consider loans delinquent for roughly 90 days of missed payments, and then the foreclosure process looms. Typically within 90 days but occasionally up to 180 days after foreclosure, the real estate underlying the bad mortgage is sold. If the proceeds cannot pay off the mortgage, a loss is realized. If the cash being generated by the mortgage pool cannot cover the degree of losses, the mortgage pool takes a loss. This is applied to the most subordinate tranche first.

Most of these subprime mortgage pools will likely see maximum foreclosures a little over two years into the life of the pool. The reason is that most subprime mortgages included in these pools – typically 80% of the mortgages in the pools – are adjustable rate mortgages. As a result, the mortgage pool will experience its most significant stress when the initial teaser rate period ends on its set of adjustable rate mortgages. Generally, this period ends on average 20 to 24 months from the date of issuance of the mortgage pool.

Since the Funds-shorted mortgage pools mostly originated in spring through late summer 2005, I expect the pools shorted will see maximum stress during the latter half of 2007. No one shorting these tranches would expect to see a payoff during the first year of holding the short and likely not even during the second year. In fact, the apparent credit support under each rated tranche will grow during the first year or two. If the thesis plays out as originally contemplated, the reduction in credit support and ultimately the payouts on credit default swaps would come shortly after the mortgage pools face their peak stress, or roughly two to 2½ years after deal issuance.

In the interim, the value of these credit default swap contracts should fluctuate. In a worsening residential housing pricing environment, and with poor mortgage performance in the pools, one would expect that protection purchased on tranches closer to peak stress would garner higher prices, provided that home prices have not appreciated significantly during the interim. As well, credit protection purchased on tranches more likely to default should garner higher prices. I would note that during the summer of 2005, national residential home prices in the United States peaked along with the easiest credit provided to mortgage borrowers in the history of the nation. Recent year-over-year price declines have not been seen since the Great Depression.

read the rest here: http://valuestockquest.com/wp-content/uploads/2015/02/Scion-2006-4Q-RMBS-CDS-Primer-and-FAQ.pdf

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