In 'The Greatest Trade Ever,' Gregory Zuckerman Details John Paulson's Big Win - WSJ.com
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OCTOBER 31, 2009
Profiting From the Crash
How John Paulson took home $10 million a day betting on a fall in home prices
By GREGORY ZUCKERMAN
It was the fall of 2007, financial markets were collapsing, and Wall Street firms were losing massive
amounts of money, as if they were trying to give back a decade's worth of profits in a few brutal months.
An investor named John Paulson somehow was scoring huge profits. His winnings were so enormous
they seemed unreal, even cartoonish. His firm, Paulson & Co., would make $15 billion in 2007.
Mr. Paulson's personal cut would amount to nearly $4 billion, or more than $10 million a day. That was
more than the 2007 earnings of J. K. Rowling, Oprah Winfrey and Tiger Woods put together. At one
point in late 2007, a broker called to remind Mr. Paulson of a personal account worth $5 million, an
account now so insignificant it had slipped his mind.
Mr. Paulson, known as J.P., bet that the housing market would collapse and risky mortgages would
tumble in value. The moves put the fund manager from Queens, N.Y., alongside Warren Buffett, George
Soros, and Bernard Baruch in Wall Street's pantheon of traders. And as one rival fund manager later
would say, with equal parts envy and respect, "Paulson's not even a housing or mortgage guy.... Until
this trade, he was run-of-the-mill, nothing special."
John Paulson launched his hedge fund in 1994. His forte was investing in corporate mergers that he
viewed as the most likely to be completed, among the safest forms of investing. When he met with
clients, they sometimes were surprised by his limp handshake and restrained manner, both unusual in
an industry full of bluster. Younger hedge-fund traders went tieless and dressed casually, feeling
confident in their abilities thanks to their soaring profits and growing stature. Mr. Paulson stuck with
dark suits and muted ties.
By early 2006 the 49-year-old Mr. Paulson had reached his twilight years in accelerated Wall Streetcareer time. He had been eclipsed by a group of investors who had amassed huge fortunes in a few
years. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never
had seen. Everyone seemed to be making money hand over fist. Everyone but John Paulson.
"This is crazy," Mr. Paulson said to Paolo Pellegrini, one of his analysts.
Mr. Pellegrini felt his own pressures. A year earlier, the stylish native of Italy had called Mr. Paulson
looking for a job after a career of disappointments. Paulson & Co. likely was his last stop on Wall Street.
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looking for a job after a career of disappointments. Paulson & Co. likely was his last stop on Wall Street.
Mr. Pellegrini spent hours in Mr. Paulson's office, debating how to deduce a turn in the housing market.
Mr. Paulson charged Mr. Pellegrini with figuring out whether homes were, in fact, overpriced. Late at
night, in his cubicle, Mr. Pellegrini tracked home prices across the country since 1975. Interest rates
seemed to have no bearing on real estate. Grasping for new ideas, Mr. Pellegrini added a "trend line"
that clearly illustrated how much prices had surged lately. He then performed a "regression analysis" to
smooth the ups and downs.
The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and
2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot:
U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had
prices climbed like never before, but Mr. Pellegrini's figures showed that each time housing had
dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be
brutal.
"This is unbelievable!" Mr. Paulson said the next morning. The chart was Mr. Paulson's Rosetta Stone
enabling him to make sense of the housing market. They had to figure out how to profit from it.
By the spring, Mr. Paulson was convinced he had discovered the perfect trade. Insurance on risky home
mortgages was trading at dirt-cheap prices. He would buy boatloads of credit-default swaps—or
investments that served as insurance on risky mortgage debt. When housing hit the skids and
homeowners defaulted on their mortgages, this insurance would rise in value—and Mr. Paulson would
make a killing. If he could convince enough investors to back him, he could start a fund dedicated to this
trade.
As Mr. Paulson and his team described their investment thesis to Nolan Randolph, an executive of a
Texas firm Crestline Investors and an existing Paulson & Co. client, Mr. Randolph kept shaking his
head. "We don't think your fund will add alpha," Mr. Randolph said, using the industry lingo for value.
The downside was too big if the trade didn't pay off, he said. He turned them down.
Hoping to claim his alma mater, Harvard University, as an early client for his fund, Mr. Paulson
traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard's endowment.
Mr. Taborsky was wary. Mr. Paulson's fund was willing to lose 8% a year to buy the mortgage insurance,
which seemed like a lot. Mr. Taborsky also thought Mr. Paulson might be excessively gloomy about the
housing market. Mr. Taborsky turned him down, too.
Even some investors who agreed with Mr. Paulson's view that housing prices would tumble doubted he
would make much money because there was relatively little trading in the investments he was buying.
He might have a hard time selling his investments without sending prices tumbling, shrinking any
profits, they said.
"It looked like a dangerous game, taking one single bet that might be difficult to unwind," said Jack
Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said
no to Mr. Paulson's fund.
Mr. Paulson's growing fixation on housing began to spark doubts about his business. One long-time
client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr.
Paulson was "straying" from his longtime focus, and that the bank should pull its money from Paulson &
Co., fast. The bank stuck with Mr. Paulson but turned down his new fund.
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Co., fast. The bank stuck with Mr. Paulson but turned down his new fund.
By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and
family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to
come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg,
Mr. Birnbaum got to the point.
Not only were Mr. Birnbaum's clients eager to buy some of the mortgages that Paulson & Co. was betting
against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as
securities, to hold their value. "We've done the work and we don't see them taking losses," Mr.
Birnbaum said.
After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson's office, a bit shaken. Mr. Paulson
seemed unmoved. "Keep buying, Brad," Mr. Paulson told Mr. Rosenberg.
Months into their new fund, Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against
risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon
found a creative and controversial way to enlarge their trade.
They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they
would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that
Paulson & Co. could wager against.
The investment banks would sell the CDOs to clients who believed the value of the mortgages would
hold up. Mr. Paulson would buy CDS insurance on the CDO mortgage investments—a bet that they
would fall in value. This way, Mr. Paulson could wager against $1 billion or so of mortgage debt in one
fell swoop.
Paulson & Co. wasn't doing anything new. A few other hedge funds also worked with banks to short
CDOs the banks were creating. Hundreds of other CDOs were being created at the time. Other bankers,
including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Mr. Paulson's
request and agreed to work with his team.
At Bear Stearns, however, Scott Eichel, a senior trader, and others met with Mr. Paulson and later
turned him down. Mr. Eichel said he felt it would look improper for his firm. "On the one hand, we'd be
selling the deals" to investors, without telling them that a bearish hedge fund was the impetus for the
transaction, Mr. Eichel told a colleague; on the other hand, Bear Stearns would be helping Mr. Paulson
wager against the deals.
Some investors later would argue that Mr. Paulson's actions indirectly led to the creation of additional
dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the
CDO slices.
At the time, though, Mr. Paulson still wasn't sure his trade would work. He simply was buying
protection, he said. "We didn't create any securities, we never sold the securities to investors," Mr.
Paulson said. "We always thought they were bad loans."
Paulson & Co. eventually bet against about $5 billion of CDOs. Months later, they had made more than
$4 billion of profits from these trades—including $500 million from a single transaction—according to
the hedge fund's investors and an employee of the firm.
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One of the biggest losers was the bank that worked with Mr. Paulson on many of the deals: Deutsche
Bank. The big bank had failed to sell all of the CDO deals it constructed and was stuck with chunks of
toxic mortgages, suffering about $500 million of losses from these customized transactions, according
to a senior executive of the German bank.
In late 2007, Mr. Pellegrini took his wife on vacation in Anguilla. Stopping at an automated-teller
machine in the hotel lobby to withdraw some cash, she checked the balance of their checking account.
On the screen before her was a figure she had never seen before, at least not on an ATM. It's not clear
how many others ever had, either: $45 million, newly deposited in their joint account. It was part of Mr.
Pellegrini's bonus that year.
"Wow," his wife said quietly, staring at the ATM.
They left, arm in arm, meeting a chartered boat to take them to nearby St. Barts.
Mr. Paulson's personal tally for 2007: nearly $4 billion. It was the largest one-year payout in the history
of the financial markets. The next year, he made another $5 billion for his firm by betting against
financial companies with exposure to housing.
By the middle of 2009, a record one in 10 Americans was delinquent or in foreclosure on their
mortgages. U.S. housing prices had fallen more than 30% from their 2006 peak. In cities such as Miami,
Phoenix, and Las Vegas, real-estate values dropped more than 40%. Several million people lost their
homes. And more than 30% of U.S. home owners held mortgages that were underwater, or greater than
the value of their houses, the highest level in 75 years.
As Mr. Paulson and others at his office discussed how much was being spent by the United States and
other nations to rescue areas of the economy crippled by the financial collapse, he discovered his next
targets, certain they were as doomed to collapse as subprime mortgages once had been: the U.S. dollar
and other major currencies.
Mr. Paulson made a calculation: The supply of dollars had expanded by 120% over several months. That
surely would lead to a drop in its value, and an eventual surge in inflation. "What's the only asset that
will hold value? It's got to be gold," Mr. Paulson argued.
Paulson & Co. had never dabbled in gold, and had no currency experts. He was also one of many
warming to gold investments, worrying some investors. Some investors withdrew money from the fund,
pushing his assets down to $28 billion or so.
Mr. Paulson acknowledged that his was a straightforward argument, but he paid the critics little heed.
"Three or four years from now, people will ask why they didn't buy gold earlier," Mr. Paulson said.
He purchased billions of dollars of gold investments. Betting against the dollar would be his new trade.
Printed in The Wall Street Journal, page W11
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