Burry's Prediction of the Collapse of the U.S. Housing Market

The purpose of this post is to research and discuss an infamous business prediction that proved to come true.  This discussion will include a summary of the prediction and two forces that impacted the prediction’s success.  I will discuss Dr. Michael Burry’s prediction of the 2007 housing market collapse for this discussion.

Predicting the Collapse of the U.S. Housing Market

Dr. Michael Burry, the founder of the hedge fund Scion Capital, is known not only for predicting the collapse of the U.S. housing market but also for driving profits for his fund and himself by $700 million and $100 million, respectively (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  This prediction and the story of how Dr. Burry’s prediction came to be was famously told through the 2015 movie, “The Big Short” (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  Using publicly available information submitted to the Securities Exchange Commission (SEC) and market intelligence of private markets, Dr. Burry accurately predicted the burst of the housing bubble, the collateral damage to consumer spending and jobs, and that this collapse would begin in 2007 (Van der Kolk, 2020).

The underlying mechanics of the housing market is highly complex and fraught with complicated financial instruments.  These highly-complex instruments included a series of investable mortgage-backed securities containing multiple layers of risk.  While the overall word count prevents a detailed summary of each, conceptually, the impacts of two market forces caused these instruments to successively fail and nearly bring down the U.S. economy (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  These two forces included the artificial rise in demand for new homes and the adjustable-rate subprime mortgage (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).

Force 1:  The Artificial Rise in Demand for New Homes

To understand the housing bubble, you must first understand the fundamental relationship between how supply and demand affect a product’s selling price.  If demand (the number of home buyers) exceeds the supply (the number of available homes), the selling price (home prices) increases.  This was precisely what happened during the housing bubble (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).

Incentivized to write more loans, banks significantly flooded the housing market with new buyers by offering loans to non-credit-worthy buyers (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  As more buyers entered the market, home prices rose dramatically (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  Because these mortgages were underwritten on homes, and “… who the hell doesn’t pay their mortgage,” banks felt secure with the underwriting as home prices escalated (McKay, 2015; Van der Kolk, 2020).  As Dr. Burry put it in his presentation at Vanderbilt University, once the banks ran out of new buyers willing to take on mortgages, “there was no chance of the housing market going sideways or stabilizing for any sustained amount of time” (Van der Kolk, 2020).

Force 2:  The Adjustable-Rate Subprime Mortgage   

The types of loans buyers agreed to are known as adjustable-rate subprime mortgages.  The highly-complex and sophisticated loans were offered at below-market interest rates, or teaser rates, that would later “adjust” to higher market-related interest rates at a pre-determined date within the loan agreement (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).  So long as market interest rates remained low or fell and the home prices continued to appreciate, home buyers were protected (McKay, 2015).  Dr. Burry performed significant analysis and accurately predicted that once the first set of mortgages reset to higher rates in 2007, homebuyers would be trapped in mortgages they could not afford, the loans would default and set off the chain of events that drove the U.S. economy to the brink of collapse (ANDERSON et al.; McKay, 2015; Van der Kolk, 2020).

If you like what you've read or you want to learn more, please provide a comment in the box or see the References below!

References

ANDERSON, C., BRIGGS, A., NGO, T., MAROLIA, V., PATEL, K., & TSOGTSAIKHAN, B. The Finance Major’s guide to The Big Short.

 

McKay, A. (2015, 2015). The Big Short, Paramount Pictures.

 

Van der Kolk, B. (2020). How did Michael Burry predict the 2008 housing bubble? (The Big Short Explained). In. YouTube.