Scion Capital: A Market Prediction
In 2005, hedge fund manager Michael Burry, known for his unorthodox investment strategies, identified a flaw in the U.S. housing market. His analysis revealed that subprime loans were unstable, and he predicted their collapse by mid-2007. To capitalize on this impending downturn, he devised a plan to create a credit default swap market, enabling him to bet against mortgage-backed securities.
Major investment and commercial banks agreed to his proposal, allowing him to short the housing market with over $1 billion in positions. However, substantial monthly premiums were required to maintain the strategy, leading to frustration among his investors. Lawrence Fields, his primary client, accused him of squandering funds. As panic spread, many demanded the reversal of his trades. Faced with mounting pressure, Burry restricted withdrawals, a move that angered investors further. Fields ultimately filed a lawsuit against him.
Despite the controversy, Burry’s prediction proved correct. As the market collapsed, his fund’s value surged by 489%, generating an overall profit of $2.69 billion. Fields alone received a payout of $489 million.
FrontPoint Partners: Exposing the System
Jared Vennett, a Deutsche Bank executive specializing in asset-backed securities, was among the first to recognize the significance of Burry’s findings. After verifying the data with his quant team, he decided to invest in credit default swaps himself. However, the high cost of maintaining these positions prompted him to offload some of the risk.
An accidental phone call connected him to Mark Baum, a hedge fund manager at FrontPoint Partners. Skeptical of the banking system, Baum became intrigued by Vennett’s argument. He learned that subprime loans were being bundled into AAA-rated collateralized debt obligations (CDOs), which would inevitably fail. This revelation convinced Baum’s team to purchase swaps from Vennett.
A field investigation in South Florida revealed deeper issues. Mortgage brokers admitted to profiting from risky loans, which were then repackaged and sold to banks. The system encouraged fraud, fueling a housing bubble destined to burst. Armed with this knowledge, FrontPoint increased its short positions.
In early 2007, as defaults began rising, CDO prices inexplicably remained stable. Credit rating agencies refused to downgrade them, raising suspicions of corruption. During a conference in Las Vegas, Baum confronted a CDO manager, who confirmed that synthetic CDOs—bets on failing mortgage bonds—exceeded the actual mortgage market in scale. This realization led Baum to understand the global financial system was on the brink of collapse.
As the crisis deepened, Baum discovered that Morgan Stanley, under which FrontPoint operated, had offset its short positions by betting on higher-rated mortgage derivatives. These were now crumbling, placing Morgan Stanley in financial jeopardy. Baum, under immense pressure, chose to hold his positions until the last possible moment, securing over $1 billion in profits. Despite his success, he remained disillusioned, predicting that the government and banks would shift the blame onto immigrants and low-income individuals rather than acknowledging systemic fraud.
Brownfield Fund: Small Players, Big Gains
Charlie Geller and Jamie Shipley, young investors running the Brownfield Fund, stumbled upon an investment prospect through a marketing presentation left at a JPMorgan Chase lobby. Excited by its potential, they researched Vennett’s strategy and decided to follow suit, recognizing the opportunity in credit default swaps.
Lacking the capital required to enter high-level trades, they sought assistance from Ben Rickert, a retired trader. With his connections, they secured a position in the market. Initially confident, they were unsettled when CDO values rose despite increasing mortgage defaults. Geller suspected banks of manipulating prices to protect their interests.
At the American Securitization Forum, they uncovered the truth—regulators had failed to oversee the mortgage-backed securities market. Realizing the depth of corruption, they adjusted their strategy, targeting higher-rated AA mortgage securities. These were considered safe, yet they carried significantly higher payout ratios when shorted.
As defaults escalated, the anticipated crash remained artificially delayed. Banks and ratings agencies secretly maintained CDO prices while discreetly selling their own positions. Outraged, Geller and Shipley attempted to expose the fraud. However, their efforts to alert the media were unsuccessful, as journalists feared alienating their banking sources.
Ultimately, the collapse arrived, and Rickert, while vacationing in England, sold their swaps. Their $30 million investment yielded $80 million. Yet, instead of celebrating, they reflected on the devastating consequences for ordinary citizens. Rickert, disgusted by the system, reaffirmed his decision to retire permanently.
Epilogue: Aftermath and Consequences
Jared Vennett received a $47 million bonus for his firm’s profits. Mark Baum, despite his success, remained troubled by the broader implications of the financial collapse. His team continued operations, but his outlook on the industry had changed.
Charlie Geller and Jamie Shipley parted ways. Jamie continued managing the fund, while Charlie relocated to Charlotte to start a family. Their attempt to sue credit rating agencies was unsuccessful.
Ben Rickert withdrew entirely from finance, preferring a quiet life. Michael Burry, after enduring multiple IRS audits and public backlash, closed his hedge fund. He shifted his focus to investing solely in water securities.
No significant legal consequences befell the major banking institutions responsible for the crisis. Only one trader, Kareem Serageldin, was prosecuted. By 2015, banks had rebranded CDOs under a new name: “Bespoke Tranche Opportunities,” continuing the cycle of risky financial practices.