The Wall Street investor who shorted subprime – and made $15bn
Jan 28, 2008
John Paulson’s bets on the implosion of the US housing market will go into the “annals of Wall Street lore”, said Nat Worden on TheStreet.com. Last year two funds managed by his New York-based firm, Paulson & Co, were up $15bn or 600%, netting the unassuming Paulson an estimated $3bn-$4bn in fees.
Some have put his success down to luck, but luck had little to do with it – more a grasp of basic economics. In early 2006, there were some concerns about slack lending standards, but few people expected a crisis in the housing market. That’s why so many big Wall Street players are now nursing vast mortgage-market losses, says Gregory Zuckerman in The Wall Street Journal.
But Paulson spotted the warning signs as early as 2005, when optimism about housing was at its peak. He told a colleague: “We’ve got to take as much advantage of this as we can.” But how? He needed to find a way to bet against the property markets, given that “you can’t short houses”.
After extensive research, he and his team came up with complex debt trades that would pay off if mortgages lost value. During the boom, Wall Street specialised in repackaging mortgage securities into instruments called collateralised debt obligations (CDOs), which could be sliced into bundles with ostensibly varying degrees of risk. For buyers who wanted to insure against the debt going bad, Wall Street offered another instrument called credit-default swaps (CDSs).
Paulson suspected, as he told Christine Williamson in Pensions and Investments, that the “exuberance in the credit markets and the massive liquidity was severely mispricing these securities”. When the then-largest maker of subprime loans agreed to a $325m settlement for improper lending practices in January 2006, Paulson became convinced that aggressive lending was widespread. In mid-2006 he launched a hedge fund solely to bet against risky mortgages, buying CDSs that complacent investors seemed to be pricing too low, and shorting risky CDO slices.
Housing remained strong and the fund lost money, but Paulson added to his bet, saying, “it’s just a matter of waiting”. The bet was in keeping with a maxim learnt from his former boss, Marty Gruss, who told him to “watch the downside, the upside will take care of itself”. Paulson told Zuckerman, “I’ve never been involved in a trade that had such unlimited upside with a very limited downside”. By the end of 2006, Paulson’s Credit Opportunities Fund was up about 20% and he launched a second one. Both rose over 60% in February 2007 alone.
But entering the top half of the Forbes rich list is unlikely to change his life much. The industrious New Yorker was already worth $100m. Born in 1955, he was Valedictorian of his class at New York University and graduated from Harvard Business School as a Baker Scholar, a distinction conferred on the top 5% of the graduating MBA class. His career moved into high gear when he joined the mergers and acquisitions team at Bear Stearns in 1984. Four years later he moved to Gruss & Co as a mergers arbitrager, before launching his own business in 1994.
He has tried to keep a low profile, saying he is reluctant to celebrate while so many Americans face losing their homes. In October he gave $15m to the Center for Responsible Lending to fund legal aid for those facing foreclosure. Meanwhile investors are banging on his door. He advises that it’s still not too late to bet on economic woes.
A queue forms for a slice of Paulson wisdom
As Paulson’s funds racked up huge profits, everyone became eager to learn his strategy, including George Soros, who allegedly invited Paulson to lunch in an attempt to get him to divulge details of his trades, says The Wall Street Journal. Some of his clients began spreading news of his tactics and Paulson was so furious he started using software to prevent them from forwarding his emails.
One person, however, who did manage to profit from Paulson’s insights was an old friend, the flamboyant Californian property magnate, Jeff Greene. In the spring of 2006, when Paulson was recruiting investors for his new fund, he gave Greene a “peek at his plan”, says Jonathan Karp in The Wall Street Journal. Paulson outlined the sophisticated securities trade he was devising for his new fund, which needed the help of an investment bank, and Greene says that when he asked Paulson if he could do the trade himself, Paulson replied, “you’ll never get approved”.
At first the banks did turn Greene down, but after producing enough paperwork, Merrill Lynch & Co and JP Morgan Chase & Co agreed, making Greene – according to insiders – the first individual to have been approved for this type of trade. To date Greene has locked in $72m profits and at the beginning of the month his positions at Merrill Lynch and JP Morgan were up about $466m. Greene also tried to invest in Paulson’s funds, but was turned away. “When I mentioned to him that I had already done some of this on my own… he seemed to be upset,” said a bemused Greene.
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