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Wednesday, April 12, 2017

How to predict a financial crisis

I believe economists would benefit from reading The Big Short by Michael Lewis. The book describes the story of how hedge fund manager Michael Burry was able to predict the subprime mortgage financial crisis long before anyone else, while mainstream economists and institutions were largely blind to it. In 2013, Nobel prize recipient economist, Lars Peter Hansen said,


"I believe that the recent financial crisis exposed gaps in our knowledge... [Central banks] have a mandate to monitor systemic risk, but we don't have great trustworthy models to do precisely that." (Interview with Nobel Laureate Lars Hansen, 2013)


If economists are interested in identifying the next financial crisis, I believe they should take note of Burry's research style. I'm not saying this style is right for all economists, but I believe this type of research would be useful for predicting a financial crisis. The rest of this post is a collection of quotes from the book describing Burry's research style.


Analyzing subprime mortgage prospectuses


"In early 2004 another stock market investor, Michael Burry immersed himself for the first time in the bond market... He just sat alone in his office, in San Jose, California and read books and articles and financial filings. He wanted to know, especially how subprime mortgage bonds worked." (The Big Short, 2010)


"He read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them." (The Big Short, 2010)


"He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad." (The Big Short, 2010)


Michael Burry the analyst


"Burry had a gift for finding and analyzing information on the subjects that interested him intensely." (The Big Short, 2010)


"Burry said, 'I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.'" (The Big Short, 2010)


"Burry said, 'I was in a state of perpetual disbelief. I would have thought that someone would have recognized what was coming before June 2007. If it really took that June remit data to cause a sudden realization, well, it makes me wonder what a 'Wall Street analyst' really does all day.'" (The Big Short, 2010)