Dr. Michael Burry saw the mortgage crisis coming from miles away. He was featured in Michael Lewis’ “The Big Short”, along with others who also saw the debacle coming. This year, Dr. Burry was keynote speaker at the 2012 UCLA Dept of Economics Commencement. It’s a speech well worth listening to. Dr. Burry is quite pessimistic about the future of U.S. as the debt-to-GDP ratio rises to levels higher than that of Greece. And the problems are no longer in the future, he says, but they have already begun to manifest themselves throughout society.

Perhaps most shocking to some (unless you’ve already gotten used to the TSA groping children)… he describes what happened to him after he wrote a New York Times op-ed criticizing the actions of the government and the Federal Reserve ( I Saw the Crisis Coming. Why Didn’t the Fed? – NY Times ). Within weeks all 6 of his funds were audited, he was compelled to provide Congress with every email he wrote since 2003, and the FBI showed up at his door. He wasted thousands of hours and over $1 million in legal/audit fees defending himself against a frivolous witch hunt against someone with clout who dared stand up and say “I saw it, why didn’t you?”

While not one bankster has ended up in jail, banks have collectively been given $$ TRILLIONS more of our money. And instead of consulting with truly smart and insightful people like Burry (instead of the crooked bankers themselves) as to how such events can be avoided in the future, our government offensively attacks those who predicted the crisis well in advance.  Instead of seeing people like Burry as able to offer true wisdom and insight, they treat him as if he had somehow played a part in masterminding all the pervasive and massively over-leveraged mortgage fraud that went on.

Another great quote from his speech: “As it turns out, information is not perfect, volatility does not define risk, markets are not efficient, the individual is adaptable.”

As a final note, here’s another great bit of Burry’s insights I’ve kept on hand since reading “The Big Short“:

‘ In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. “Generally you don’t raise any money unless you have a good meeting with people,” he said, “and generally I don’t want to be around people. And people who are with me generally figure that out.” He went to a conference thrown by Bank of America to introduce new fund managers to wealthy investors, and those who attended figured that out. He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. “By and large,” he later put it, “the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.” He was greeted by silence and ate lunch alone. He sat at one of the big round tables just watching the people at the other tables happily jabber away. ‘

(GlobeInvestor) “ETNs expose investors to the risk of losing all or most of their principal. That’s because ETNs are set up as unsecured, long-term debt obligations of the issuer, Ms. Pelant explains. ETF investors don’t face the same default risk because ETFs own a pro rata stake in a basket of stocks, bonds, or derivatives held by a custodian in trust and legally separate from the issuer, she says.”

“When Morgan Stanley’s viability came under question in September , its family of Market Vectors ETNs sold off dramatically. ‘The Market Vectors Remnimbi/USD ETN (CNY) plunged more than 25 per cent versus a 1-per-cent drop in a comparable ETF,’ observes Greg Newton, a veteran financial journalist who writes the NakedShorts blog.”

However, if the ETFs don’t actually hold the securities that make up the fund, and instead use synthetics or swaps rather than physicals, investors may also be exposed to much more credit and counter-party risk than they realize. And as Jeffrey Gundlach discussed at the recent DoubleLine Luncheon at the New York Yacht Club, “Never, ever take counterparty risk. It is the one risk you are almost never rewarded for taking. Unless you are running $800 billion dollars, there is no need to use swaps, synthetics or baskets – trade cash markets and avoid any trades that require a counterparty.”

(HistorySquared) “In light of the counter party risks inherent in ETFs, especially those that use synthetic swaps rather than the physicals, there might be an inexpensive way to express a bearish view on some of the European banks.

For example, in 2008 Lehman Brothers had several failed ETNs. ‘The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment.’ ”

These are some clever lower-risk trading ideas for expressing a bearish view on the future solvency of a particular counterparty:

“Perhaps there are some far OTM options on some of the Socgen ETFs that are worth a look . Or a less risky trade could be long an ETF with physicals underlying the ETF that is issued by a more secure bank, and short the highly correlated Socgen ETFs. A potentially catastrophic event could be triggered by Deutsche Banks popular x-trackers.”

Full Story: ETFs as Tail Risk Trades (HistorySquared)

(Bloomberg) “ETFs that use swaps to clone stock, bond or currency returns have been criticized by regulators and firms including Fidelity Investors, which say clients risk losing money should the banks writing the derivatives become insolvent. Outflows from Lyxor are another blow to Societe Generale, France’s second-largest bank, whose shares have tumbled this year as the escalating sovereign-debt crisis squeezes lenders’ funding.

‘It’s an issue of counterparty risk related to the financial health of the backing bank,’ said Jose Garcia Zarate, an ETF analyst at Morningstar Inc. in London. ‘Fears over synthetic replication have been building up, and at the same time, fears of banks’ peripheral-debt exposure have grown. Put those two together: bingo!’ ” — Swap ETFs, Lyxor Have Record Outflows (Bloomberg)

(TheHippo) “The reality of the matter and one that I have believed in is that during crisis there is NO SAFE HAVEN! It is a figment of your imagination and the collective mind of the market. As a friend of the family who was a trader said, ‘when markets drop the correlation becomes 1′. What he was saying is that when a crisis occurs there is no safe haven and there is no place to hide.”

“So then the question becomes what does one do? Outside of the obvious, which is short the market. Go back and look at the charts and look at what happened EACH AND EVERY TIME. The market went back up. This should not be a surprise to you, and should be rather obvious. Yet nobody during those times says, ‘buy equities, bonds, though they did say buy gold’. All you hear are about Safe Haven plays (which don’t work) and how you need to step back and wait.”

“I am a numbers guy. I focus on the statistics and let it define my plays. So when you see these charts a dropped market is a screaming buy! It does not matter what, but everything is a screaming buy. So why don’t people buy? .. Easy answer it’s about the psychology. Buying in times of market turmoil is very very difficult. I have read this Contrarian book that said people would rather be wrong with the crowd than be right in the individual.”

Full Story: Understanding Safe Haven Plays and Market Turmoil $AGG, $PCY, $GLD, $BTI (Haah-TheHippo)

In times of turmoil, your only real safe haven is holding straight CASH in your home currency. Your greatest defense against future crisis and turmoil is proper position sizing (keep your positions small and manageable), stay clear of leverage (especially overnight), and always keep a chunk of cash on hand to take advantage of any great opportunities that may arise. From the article, $PCY (PowerShares Emerging Mkts Sovereign Debt ETF) looked mighty interesting around those October 2008 lows. Historically speaking, many great fortunes have been some of the greatest fortunes made have been in times of crisis. Find opportunity when others panic, and keep your position size small and manageable so that you can always consider adding a bit more if the opportunity becomes even juicier.

(Mish) “We will not get to see the precise wording of Prime Minister George Papandreou’s referendum because enough cowards in the Greek parliament in conjunction with blackmail by Merkel and Sarkozy have put an end to Papandreou’s regime. Thus, the on-off on-off Greek referendum is once again set to ‘off’ this time permanently.”

(NYTimes) “Europe’s leaders should have paid more attention to the distress of ordinary Greeks and less to the distress of well-heeled European bankers. Rather than trying to punish the ‘profligate,’ they should have thought about the consequences of condemning Greece to years of negative growth, soaring unemployment and rising taxes with nothing promised in return except that maybe, a decade from now, its ratio of debt to gross domestic product might get back down to the problematic levels of 2008-9.

Greece needs to make serious, painful reforms, including doing away with antiquated labor rules, streamlining a bloated public sector and selling off poorly managed state assets. Mr. Papandreou was already making real progress. But it was becoming impossible to keep laying off thousands of state workers while austerity choked off any realistic possibility of their finding private sector jobs or to keep slashing social benefits and services while the numbers of poor and unemployed surged.

It is late but, we hope, not too late to avert a full meltdown. Europe’s leaders need to renegotiate the pending Greek bailout deal to emphasize reform and growth over unremitting austerity and offer other bailout applicants the same approach. If they want any of the money lent to Greece paid back, Athens needs room to grow and earn.” — Greece on the Brink (NYTimes)

(Mish) “Democracy Dies to Protect Banks – Indeed, resolution of this mess has been 100% about how to bail out banks at taxpayer expense even though banks brought this mess onto themselves by treating sovereign debt as if it had zero risk. Worse yet, banks plowed into sovereign debt trades with massive leverage.”

Notice the tight convergence of all Eurozone country sovereign debt interest rates before 2009. European banks and other investors placed foolish bets anticipating little or no additional risk. They priced in virtually no risk premium holding Greek bonds over German bonds.

(Mish) “Merkozy and the EMU ought to be spending time on developing a full blown Euro exit strategy for nations because there has never been a currency union in history that has survived without a fiscal union in place at the same time.”

Full Story: Eurozone’s Waterloo; Papandreou Forced to Cancel Referendum; Democracy Dies to Protect Banks; Germany’s Dilemma: The Eurocratic Nanny Zone Vote (Mish)

(MartinArmstrong) “The most important aspect is the economy. Screw that up and you get war, depression, and starvation. We then elect a whole bunch of people to posts and automatically assume these people have the (1) real intelligence ABOVE average to comprehend such complex subjects, and (2) they understand the right thing to do. Where did we ever get these ideas? Most of the staff members employed by politicians are smarter than the people they work for. But unless they believe an economic crisis is possible, they will not even look at the issue.” — Martin Armstrong, Happy Days Are Here Again

(Interloper) “Outside of the entertainment factor, the primary differences between the two archetypes is that the first has risen to their position by attracting new money while the latter holds their position by effectively managing money. Type One*, with a travel schedule encompassing 150 days annually is dependent of their model for performance because they have much less time for specific analysis – hence the preponderance of more black box, momentum strategies. They are also much more dependent on their analysts and traders back at the office who must make the majority of the day-to-day decisions. Type Two* on the other hand, only really cares about the analysis. They are pissed when the marketing department drags them put of their cave before they’ve finished investigating a fishy footnote in the last quarterly statement. (Don’t think I’m exaggerating with that, btw. I personally know PMs that will spend weeks on a single footnote).”

“Here’s the important part: the industry loves them some Type One PMs. Momentum managers trade a lot more than value managers and this keeps the trading desk commission train rolling. The accommodating Type One manager is, unbelievably, available for evening functions where Financial Advisors can bring their top clients who, inevitably will be running around with blank checks by slide eight. Everybody makes money.”

“If you’ve read this far you have probably guessed where my preference lies. For my own money, I would much rather have the plodding, boring manager who obsesses about every aspect of a potential or existing holding, rarely straying from a concentrated portfolio of companies they are completely comfortable with. Like Buffett, they do not feel compelled to make changes (and thus rarely get referrals from capital markets) and will literally wait years for a stock to drop to valuation levels they find attractive. Type Twos will also avoid hot sectors and thereby escape the attention of the individual investor until the market craps out, and they don’t feel like putting more money into the market anyway. I pay Type Twos, in other words, to exhibit the discipline that I don’t have.”

” .. it remains important to understand the industry’s bias in this regard and that ‘best manager’ may mean something much different to the average investor than on the trading floor.”

* “Type One: Physically attractive, Ivy League (Harvard or Wharton, almost always), momentum-based investment strategy. .. They will be compelling, energetic, will pause and answer your question in a non-patronizing way. They will linger after the presentation until everyone has left, happily chatting about markets or whatever else the fellow-lingerers want to talk about. .. They are, in short, marketing machines.

Type Two will be older, having spent far more time as a senior analyst due to a dearth of personal charisma. They will likely not be Ivy League. Type Two will execute a more fundamentally-based investment process. Their longer performance track record has a better chance of being stronger, beating the index by a few percentage points per year by holding value during bad years. Type Two’s presentation will be so dull that you’ll want to gouge out your eyes after half an hour.”

Full Story: PORTFOLIO MANAGER SEARCH PRO TIP: FIND THE WORST PUBLIC SPEAKER POSSIBLE (Interloper)

And finally, this short passage from Michael Lewis’ book “The Big Short” seems to perfectly capture the essence of these points:

“In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. ‘Generally you don’t raise any money unless you have a good meeting with people,’ he said, ‘and generally I don’t want to be around people. And people who are with me generally figure that out.’ He went to a conference thrown by Bank of America to introduce new fund managers to wealthy investors, and those who attended figured that out. He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. ‘By and large,’ he later put it, ‘the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.’ He was greeted by silence and ate lunch alone. He sat at one of the big round tables just watching the people at the other tables happily jabber away. ”

How I wish I had been there that day to sit with him.

Was the May 6^th, 2010 intraday crash and recovery just another one of those once-in-a-lifetime rare anomalies -– a rare confluence of events coming together to form the “Perfect Storm”?  And if a “Perfect Storm” generally occurs so infrequently, why does it seem that we are presented with a newsworthy “Perfect Storm” in the markets on an almost regular basis?  With all the misinformation and outrageous reasons the media and its “pundits” offer, perhaps it’s time to revisit exactly how markets work, and what (or who) may be to blame.  It’s a lot easier to blame a “fat finger” or some naughty short-sellers for a huge market-selloff, than to accept that markets do not always have a buyer for every seller.  Very simply, when a large number of market participants decide they all must sell (or buy) at the exact same time, an “air pocket” of price action will form.  Anyone who has traded a market knows that this type of single-sided liquidity “crisis” occurs every day in the markets to various extents, especially after significant news events are released.  While these relatively smaller moves may not be nearly as significant as a 1000 point intraday drop and overall market selloff, the dynamics are more or less the same.  The setup develops with a large number of market participants all thinking the same way (ie. very strong bullish or bearish sentiment), generally due to a strong extended trend in a market.  When the market finally turns, the large group of participants on the wrong side of the trade all decide to reverse course at the same time, at similar stop levels, just to save their leveraged hides.  Does the trading term “slippage” ring a bell?

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Most traders and investors at one time or another have fallen into the “confidence” trap. Sometimes it’s a result of believing in the infallibility of their research. Other times it’s due to having a presumed “hot” hand — they’ve finally got the game figured out and can do no wrong. Maybe they’ve gotten caught up with some hot new money-minting trading system with a great historical track record. Or perhaps they’ve been drawn in by someone else’s hot streak, in a chat room for instance (novice traders, trying to skip a few steps, are notorious for succumbing to this). All the calls turn out great, and even the fundamental and technical research that’s shared always seems right on the money. However, up to that point they’ve just watched –- and they’re kicking themselves for missing out on yet another huge gain. Let’s take our fictional trader and call him Bernie.

Bernie decides he’s not going to miss out on the next opportunity that comes up. When the next “hot stock” is revealed, it happens to be a stock that he himself already had on his radar. The additional research backs up his conviction. Everything seems right, and the stock appears perfectly poised for a huge move. Bernie’s confidence level for the trade is higher than ever. Forget about what he can afford to lose, this is the trade that’ll make his year!

Bernie decides to accumulate a position much larger than normal — 3 times as large in fact, equating to about a quarter of his total account size. At first, all seems to be working out great and the trade has even moved a nice 5% in his favor. Two days later however, he wakes up to find the stock down 25%, blowing right through any stop levels he may have considered. The company out of the blue announced a dilutive secondary offering to “better take advantage of opportunities that may become available” or some other similar mumbo-jumbo.

Bernie feels caught, but he figures the big picture still hasn’t really changed, and that prices should find support around the offering price. In fact, he decides to double his position around the offering price if he can. The company’s valuation seems cheaper than ever, and the company will now have even more cash to materialize its goals.

However, as the price continues to drop, Bernie starts to wonder… More investors, increasingly disgusted by the management’s apparent lack of regard for their investing well-being, decide to throw in the towel. By the end of the week, the stock is down another 38% just from the offering price! The same stock that traders and investors all loved at $9 just a few days earlier, they now hate at $5. Even those investors who bought into the secondary are feeling completely betrayed.

Ironically, if the research and valuations are accurate, the stock should be more attractive than ever at these levels. Of course, it doesn’t matter anymore, as most traders (including our newbie trader Bernie) decided to throw in the towel as the stock sells off in a panic around $4/share leaving Bernie with a whopping 44% account loss (requiring a 125% increase in account value just to reach breakeven). Several days later, the stock is trading back around its offering price. How’s that for the perfect reaming. Bernie feels crushed, blames the guy in the chat room for putting out such a horrible call, and calls him a fraud despite the fact that all his other picks turned out pretty well.

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