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we all know that during the 2008 crisis Michael bu bet money against the housing market and made huge profits but Michael bur did not bet the money directly on the housing market as everybody thought the housing market was always stable there was no method or instrument to bet against the housing markets any person who bet against the housing market would be considered crazy and looked down upon after studying the housing market Michael bur was sure that it was going to collapse and he wanted to short the housing market market so he went to those investment Banks and asked them to create credit default swaps the concept of credit default swaps is not something Michael bur invented these credit default swaps have existed since the 1990s the first CDs contract was created in 1994 by one of the bankers at JP Morgan it was used to manage the risk in A bank's loan portfolio so let's see exactly how these credit default swaps work credit default swaps are basically an insurance contracts providing protection to the buyer let's understand this with an example let's say there are three friends Kevin Mark and Daniel Mark wants to buy a car and he asks Kevin to lend him $30,000 Mark agrees to pay back Kevin with an annual interest rate of 5% Kevin lends Mark the money but he's also worried that if Mark faces financial difficulties then he might not pay him back so Kevin wants to secure his investment he goes to Daniel and convinces him to make a friendship default swap contract with him according to the contract terms Daniel will pay Kevin $330,000 if Mark fails to pay him back until then Kevin will pay Daniel a monthly premium of $300 for friendship default swaps as all three were friends Daniel knew Mark very well and he knew that Mark was a financially disciplined person so Daniel thought that Mark would never face any Financial difficulties and thought that whatever premium Kevin was offering to him was free money and he would never have to pay Kevin the $30,000 eventually Mark faces some Financial issues and he's unable to pay Kevin this triggers the Friendship default swaps contract between Kevin and Daniel and Daniel has to pay $30,000 to Kevin this contract was the same as credit default swaps this is what Michael bur did while buying credit default swaps he went to different investment Banks and bet the money on various mortgage-backed Securities the banks happily made these credit default swaps for Michael bur and collected premiums from him because they thought the housing market was always stable that's why they thought Michael bur was offering them free money and they would never have to pay him this is Wall Street Dr burry if you offer Us free money we are going to take it Michael bur specifically chose credit default swaps because they had very defined risks when you short or or bet against a stock or an asset directly your potential losses are theoretically unlimited if the price rises in contrast credit default swap contracts have a defined risk Michael bur knew that the most he could lose was the premium he paid for the CDs contracts which provided him with the level of risk management but if his guess was right then his bet can make him more money than what he paid for those premiums these credit default swaps allowed Michael Buri to amplify his bets using leverage he could make larger bets relative to the capital he had by using borrowed money potentially increasing his profits if his predictions proved accurate one more advantage of credit default swaps was that Michael bur could focus on specific risks about specific Financial products bur's primary focus was on the risk associated with subprime mortgage-backed Securities and collateralized debt obligations cdos that were heavily exposed to subprime mortgages by using CDs he could specifically Target this risk without being exposed to other factors that might affect the broader housing market Michael bery did not go with the traditional method of shorting the housing market because the housing market and its derivatives were highly complex and Michael Bry believed that traditional financial markets were not accurately pricing the risk credit default swap contracts provided a more direct and in his view efficient way to profit from what he saw a potential housing market collapse the swaps contract provided him with very little downside and huge profits if his guess was accurate this is the reason Michael bur used credit default swaps because of Michael bur many people bought these CDs contracts one such person was Mark Bal we recommend watching this video to learn about Mark bomb and why he bet against the housing market
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