John Paulson and the “Gutsiest” Trade Ever

January 20, 2010 at 11:30 pm 8 comments

Although the pain and suffering of the 2008-09 financial crisis has been well documented and new books are continually coming out in droves, less covered are the winners who made a bonanza by predicting the collapse of the real estate and credit markets. Prizewinning Wall Street Journal reporter Gregory Zuckerman decided to record the fortunes made by hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).

Paulson’s Cartoonish Cut

Zuckerman puts Paulson’s massive gains into perspective:

“Paulson’s winnings were so enormous they seemed unreal, even cartoonish. His firm, Paulson & Co., made $15 billion in 2007, a figure that topped the gross domestic products of Bolivia, Honduras, and  Paraguay…Paulson’s personal cut was nearly $4 billion…more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together.”

 

As impressive as those gains were, Paulson added another $5 billion into his firm’s coffers and $2 billion into his personal wallet over 2008 and early 2009. 

There are many ways to skin a cat, and there are countless strategies used by the thousands of hedge fund managers looking to hit the jackpot like Paulson. John Paulson primarily made his multi-billion fortune thanks to his CDS positions (Credit Default Swaps), the same product that led to massive multi-billion bailouts and government support for various financial institutions.

Bigger Gamble than Perception

One surprising aspect I discovered from reading the book was the uncertainty surrounding Paulson’s negative real estate trade. Here’s how Zuckerman described the conviction level of John Paulson and Paolo Pelligrini (colleague) as it related to their CDS positions on subprime CDO (Collateralized Debt Obligation) debt:

“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”

 

Often the trades that cause you to sweat the most tend to be the most profitable, and in this case, apparently the same principle held.

Disingenuous Dramatic License

Before Paulson made his billions, Zuckerman uses a little dramatic license in the book to characterize Paulson as a small fry manager, “Paulson now managed $1.5 billion, a figure that sounded like a lot to friends outside the business. But the firm was dwarfed by its many rivals.” Zuckerman goes on to call Paulson’s hedge fund “small potatoes.” I don’t have the industry statistics at my fingertips, but I’ll go out on a limb and make an educated guess that a $1.5 billion hedge fund has significantly more assets than the vast majority of hedge fund peers. Under the 2 and 20 model, I’m guessing the management fee alone of $30 million could cover Paulson’s food and shelter expenses. Before he struck the payload, the book also references the $100 million of his personal wealth he invested with the firm. I think John Paulson was doing just fine before he executed the “greatest trade.”

What Drove the Greatest Trade

Hind sight is always 20/20, but looking back, there was ample evidence of the real estate bubble forming. Fortunately for Paulson, he got the timing generally right too. Here are some of the factors leading to the great trade:

  • CDO Leverage in Subprime: By the end of 2006, the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). But thanks to the introduction of CDOs, there were more than $5 trillion of risky investments created from all the risky subprime loans.
  • Liars & Ninjas: “Liar Loans” loans based on stated income (using the honor system) and “ninja loans” (no income, no job, no assets) gained popularity and prevalence, which just led to more defaults and foreclosures in the mid-2000s.
  • No Down Payments: What’s more, by 2005, 24% of all mortgages were completed with no down payment, up from approximately 3% in 2001. The percentage of first-time home buyers with no down payment was even higher at 43%.

Overall, I give kudos to Gregory Zuckerman, who spent more than 50 hours with John Paulson, for bringing something so abstract and homogenous (a skeptical real estate trade) to life. Zuckerman does a superb job of adding spice to the Paulson story by introducing other narratives and characters, even if the story lines don’t blend together perfectly. After reading The Greatest Trade Ever I came away with a new found respect for Paulson’s multi-billion dollar gutsy trade. Now, Paulson has reloaded his gun and is targeting the U.S. dollar. If Paulson’s short dollar and long gold position works out, I’ll keep an eye out for his next book…The Greatest Trad-er Ever.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VNQ), but at time of publishing had no direct positions in companies mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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8 Comments Add your own

  • 1. Mariano  |  January 21, 2010 at 7:25 am

    “the pain and suffering of the 2008-09 financial crisis has been well documented.” Well maybe yes, maybe no. I know about the pain of Main Street but all I read about in the WSJ is the traders and managers who made a killing with their “gutsiest trade ever.” How about a story on the hedge fund manager who lost their shirt and is now waiting tables to pay the bills? The road to mediocrity is paved with “gutsy calls” gone wrong.

    Reply
    • 2. sidoxia  |  January 21, 2010 at 9:42 am

      Good point. The public becomes fixated with the big guys (and gals) that suffer horribly or make it big. The thousands of “small fry” hedge funds that have gone under just disappear into obscurity.

      ~WS

      Reply
  • [...] the center of financial institution collapses and the billions made by John Paulson (see also the Gutsiest Trade Ever). More recently, CDSs were cited as negative contributors to the Greek financial crisis. Lockyer [...]

    Reply
  • 4. Goldman Cheat? Really? « Investing Caffeine  |  April 19, 2010 at 4:35 pm

    [...] is being charged for defrauding investors for not disclosing the fact that John Paulson (see Gutsiest Trade), a now-famous hedge fund manager who made billions by betting against the subprime mortgage [...]

    Reply
  • [...] freely disclosing the involvement of now-famous, mortgage market short seller John Paulson (see the Gutsiest Trade) to the so-called sophisticated institutional investors, ACA Capital Holdings Inc. Was this lack of [...]

    Reply
  • [...] to Fail and Gregory Zuckerman’s The Greatest Trade Ever (see my reviews on Too Big to Fail  and The Greatest Trade Ever),  I still felt obligated to add Michael Lewis’s The Big Short to my bookshelf (OK…my e-reader [...]

    Reply
  • [...] book Too Big to Fail. The subprime market was a big driver for irresponsible CDO creation too. In The Greatest Trade Ever, Gregory Zuckerman highlights the ballooning nature of the $1.2 trillion subprime loan market [...]

    Reply
  • [...] being famous for 15 minutes is apropos. Paulson’s $15 billion subprime housing bet in 2007 (read The Greatest Trade Ever) paid off handsomely and now he is attempting to further his wealth position based on this [...]

    Reply

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