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The Greatest Trade Ever
The Greatest Trade Ever Read online
Copyright © 2009, 2010 by Gregory Zuckerman
All rights reserved.
Published in the United States by Crown Business, an imprint of the Crown Publishing Group, a division of Random House, Inc., New York.
www.crownpublishing.com
CROWN BUSINESS is a trademark and CROWN and the Rising Sun colophon are registered trademarks of Random House, Inc.
Originally published in hardcover in slightly different form in the United States by Broadway Books, an imprint of the Crown Publishing Group, a division of Random House, Inc., New York, in 2009.
Library of Congress Cataloging-in-Publication Data
Zuckerman, Gregory.
The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history / Gregory Zuckerman. — 1st ed.
p. cm.
1. Paulson, John Alfred, 1955– 2. Hedge funds—United States. 3. Hedging (Finance) I. Title.
HG4930.Z83 2009
332.64′5092—dc22
[B] 2009033255
eISBN: 978-0-385-52993-8
Frontispiece: John Paulson (Mike McGregor / Contour by Getty Images)
v3.1
TO DAD AND TO MOM,
MY TEACHERS, MY FOUNDATION
TO MICHELLE, GABRIEL, AND ELIJAH,
MY JOY, MY INSPIRATION
Contents
Cover
Title Page
Copyright
Dedication
Introduction
Prologue
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Chapter 13
Chapter 14
Epilogue
Afterword
Acknowledgments
Notes
About the Author
introduction
The tip was intriguing. 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. But as I sat at my desk at The Wall Street Journal tallying the pain, a top hedge-fund manager called to rave about an investor named John Paulson who somehow was scoring huge profits. My contact, speaking with equal parts envy and respect, grabbed me with this: “Paulson’s not even a housing or mortgage guy.… And until this trade, he was run-of-the-mill, nothing special.”
There had been chatter that a few little-known investors had anticipated the housing troubles and purchased obscure investments that now were paying off. But few details had emerged and my sources were too busy keeping their firms afloat and their careers alive to offer very much. I began piecing together Paulson’s trade, a welcome respite from the gory details of the latest banking fiasco. Cracking Paulson’s moves seemed at least as instructive as the endless mistakes of the financial titans.
Riding the bus home one evening through the gritty New Jersey streets of Newark and East Orange, I did some quick math. Paulson hadn’t simply met with success—he had rung up the biggest financial coup in history, the greatest trade ever recorded. All from a rank outsider in the world of real estate investing—could it be?
The more I learned about Paulson and the obstacles he overcame, the more intrigued I became, especially when I discovered he wasn’t alone—a group of gutsy, colorful investors, all well outside Wall Street’s establishment, was close on his heels. These traders had become concerned about an era of loose money and financial chicanery, and had placed billions of dollars of investments to prepare for a meltdown they were certain was imminent.
Some made huge profits and won’t have to work another day of their lives. But others squandered an early lead on Paulson and stumbled at the finish line, a historic prize just out of reach.
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, South American nations with more than twelve million residents. Paulson’s personal cut was nearly $4 billion, or more than $10 million a day. That was more than the combined earnings of J. K. Rowling, Oprah Winfrey, and Tiger Woods. At one point in late 2007, a broker called to remind Paulson of a personal account worth $5 million, a sum now so insignificant it had slipped his mind. Just as impressive, Paulson managed to transform his trade in 2008 and early 2009 in dramatic form, scoring $5 billion more for his firm and clients, as well as $2 billion for himself. The moves put Paulson alongside Warren Buffett, George Soros, Bernard Baruch, and Jesse Livermore in Wall Street’s pantheon of traders. They also made him one of the richest people in the world, wealthier than Steven Spielberg, Mark Zuckerberg, and David Rockefeller Sr.
Even Paulson and the other bearish investors didn’t foresee the degree of pain that would result from the housing tsunami and its related global ripples. By early 2009, losses by global banks and other firms were nearing $3 trillion while stock-market investors had lost more than $30 trillion. A financial storm that began in risky home mortgages left the worst global economic crisis since the Great Depression in its wake. Over a stunning two-week period in September 2008, the U.S. government was forced to take over mortgage-lending giants Fannie Mae and Freddie Mac, along with huge insurer American International Group. Investors watched helplessly as onetime Wall Street power Lehman Brothers filed for bankruptcy, wounded brokerage giant Merrill Lynch rushed into the arms of Bank of America, and federal regulators seized Washington Mutual in the largest bank failure in the nation’s history. At one point in the crisis, panicked investors offered to buy U.S. Treasury bills without asking for any return on their investment, hoping to find somewhere safe to hide their money.
By the middle of 2009, a record one in ten Americans was delinquent or in foreclosure on their mortgages. During the teeth of the crisis, even celebrities such as Ed McMahon and Evander Holyfield fought to keep their homes. U.S. housing prices fell more than 30 percent from their 2006 peak. In cities such as Miami, Phoenix, and Las Vegas, real-estate values dropped more than 40 percent. Several million people lost their homes. And more than 30 percent of U.S. home owners held mortgages that were underwater, or greater than the value of their houses, the highest level in seventy-five years.
John Paulson and a small group of underdog investors were among the few who triumphed over the hubris and failures of Wall Street and the financial sector.
But how did a group of unsung investors predict a meltdown that blindsided the experts? Why was it John Paulson, a relative amateur in real estate, and not a celebrated mortgage, bond, or housing specialist like Bill Gross or Mike Vranos, who pulled off the greatest trade in history? How did Paulson anticipate Wall Street’s troubles, even as Hank Paulson, the former Goldman Sachs chief who ran the Treasury Department and shared his surname, missed them? Short sellers kicked themselves for dismissing signs of trouble. Even Warren Buffett overlooked the trade, and George Soros phoned Paulson for a tutorial.
Did the investment banks and financial pros truly believe that housing was in an inexorable climb, or were there other reasons they ignored or continued to inflate the bubble? And why did the very bankers who created the toxic mortgages that undermined the financial system get hurt most by them?
This book, based on more than two hundred hours of interviews with key participants in the daring trade, aims to answer some of these questions, and perhaps provide lessons and insights for future financial manias.
prologue
The window of Paulson’s corner office offered a dazzling view of Central Park and the Wollman skating rink. This morning, however, he had little interest in grand views. Paulson sat at his desk staring at an array of numbers flashing on computer screens before him, grimacing.
“This is crazy,” he said to Paolo Pellegrini, one of his analysts, as Pellegrini walked into his office.
It was late spring of 2005. The economy was on a roll, housing and financial markets were booming, and the hedge-fund era was in full swing. But Paulson couldn’t make much sense of the market. And he wasn’t making much money, at least compared with his rivals. He had been eclipsed by a group of much younger hedge-fund managers who had amassed huge fortunes over the last few years—and were spending their winnings in over-the-top ways.
Paulson knew he didn’t fit into that world. He was a solid investor, careful and decidedly unspectacular. But such a description was almost an insult in a world where investors chased the hottest hand, and traders could recall the investment returns of their competitors as easily as they could their children’s birthdays.
Even Paulson’s style of investing, featuring long hours devoted to intensive research, seemed outmoded. The biggest traders employed high-powered computer models to dictate their moves. These investors accounted for a majority of the activity on the New York Stock Exchange and a growing share of Wall Street’s wealth. Other gutsy hedge-fund managers borrowed large sums to make risky investments, or grabbed positions in the shares of public companies and bullied executives to take steps to send their stocks flying. Paulson’s tried-and-true methods were viewed as quaint.
It should have been Paulson atop Wall Street, his friends thought. Paulson had grown up in a firmly middle-class neighborhood in Queens, New York. He received early insight into the world of finance from his grandfather, a businessman who lost a fortune in the Great Depression. Paulson graduated atop his class at both New York University and Harvard Business School. He then learned at the knees of some of the market’s top investors and bankers, before launching his own hedge fund in 1994. Pensive and deeply intelligent, Paulson’s forte was investing in corporate mergers that he viewed as the most likely to be completed, among the safest forms of investing.
When the soft-spoken Paulson met with clients, they sometimes were surprised by his limp handshake and restrained manner, unusual in an industry full of bluster. His ability to explain complex trades in straightforward terms left some wondering if his strategies were routine, even simple. Younger hedge-fund traders went tieless and dressed casually, feeling confident in their abilities thanks to their soaring profits and growing stature. Paulson stuck with dark suits and muted ties.
Paulson’s lifestyle once had been much flashier. A bachelor well into his forties, Paulson, known as J.P. among friends, was a tireless womanizer who chased the glamour and beauty of young models, like so many others on Wall Street. But unlike his peers, Paulson employed an unusually modest strategy with women, much as he did with stocks. He was kind, charming, witty, and gentlemanly, and he met with frequent success.
In 2000, though, Paulson grew tired of the chase and, at the age of forty-four, married his assistant, a native of Romania. They had settled into a quiet domestic life. Paulson cut his ties with wilder friends and spent weekends doting on his two young daughters.
By 2005, Paulson had reached his twilight years in accelerated Wall Street–career time. He still was at it, though, still hungry for a big trade that might prove his mettle. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never had seen. Home owners felt flush, enjoying the soaring values of their homes, and buyers bid up prices to previously unheard-of levels. Real estate was the talk of every cocktail party, soccer match, and family barbecue. Financial behemoths such as Citigroup and AIG, New Century and Bear Stearns, were scoring big profits. The economy was roaring. Everyone seemed to be making money hand over fist. Everyone but John Paulson, that is.
To many, Paulson seemed badly out of touch. Months earlier, he had been ridiculed at a party in Southampton by a dashing German investor incredulous at Paulson’s meager returns and his resistance to housing’s allures. Paulson’s own friend, Jeffrey Greene, had amassed a collection of prime Los Angeles real estate properties valued at more than $500 million, along with a coterie of celebrity friends, including Mike Tyson, Oliver Stone, and Paris Hilton.
But beneath the market’s placid surface, the tectonic plates were quietly shifting. A financial earthquake was about to shake the world. Paulson thought he heard far-off rumblings—rumblings that the hedge-fund heroes and frenzied home buyers were ignoring.
Paulson dumped his fund’s riskier investments and began laying bets against auto suppliers, financial companies, anything likely to go down in bad times. He also bought investments that served as cheap insurance in case things went wrong. But the economy chugged ever higher, and Paulson & Co. endured one of the most difficult periods. Even bonds of Delphi, a bankrupt auto supplier that Paulson assumed would tumble, suddenly surged in price, rising 50 percent over several days.
“This [market] is like a casino,” he insisted to one trader at his firm, with unusual irritation.
He challenged Pellegrini and his other analysts: “Is there a bubble we can short?”
PAOLO PELLEGRINI felt his own mounting pressures. A year earlier, the tall, stylish analyst, a native of Italy, had called Paulson, looking for a job. Despite his amiable nature and razor-sharp intellect, Pellegrini had been a failure as an investment banker and flamed out at a series of other businesses. He’d been lucky to get a foot in the door at Paulson’s hedge fund—there had been an opening only because a junior analyst left for business school. Paulson, an old friend, agreed to take him on.
Now, Pellegrini, just a year younger than Paulson, was competing with a group of hungry twenty-year-olds—kids the same age as his own children. His early work for Paulson had been pedestrian, he realized, and Pellegrini felt his short leash at the firm growing tighter. Somehow, he had to find a way to keep his job and jump-start his career.
Analyzing reams of housing data into the night, hunched over a desk in his small cubicle, Pellegrini began to discover proof that the real estate market had reached untenable levels. He told Paulson that trouble was imminent.
Reading the evidence, Paulson was immediately convinced Pellegrini was right. The question was, how could they profit from the discovery? Daunting obstacles confronted them. Paulson was no housing expert, and he never had traded real estate investments. Even if he was right, Paulson knew, he could lose his entire investment if he was too early anticipating a bursting of what he saw as a real estate bubble, or if he didn’t implement the trade properly. Any number of legendary investors, from Jesse Livermore in the 1930s to Julian Robertson and George Soros in the 1990s, had failed to successfully navigate financial bubbles, costing them dearly.
Paulson’s challenges were even more imposing. It was impossible to directly bet against the price of a home. Just as important, a robust infrastructure had grown to support real estate, as a network of low-cost lenders, home appraisers, brokers, and bankers worked to keep the money spigot f
lowing. On a national basis, home prices never had fallen over an extended period. Some rivals already had been burned trying to anticipate an end of housing’s bull market.
Moreover, unbeknownst to Paulson, competitors were well ahead of him, threatening any potential windfall. In San Jose, California, three thousand miles away, Dr. Michael Burry, a doctor-turned-hedge-fund manager, was busy trying to place his own massive trades to profit from a real estate collapse. In New York, a brash trader named Greg Lippmann soon would begin to make bearish trades, while teaching hundreds of Paulson’s competitors how to wager against housing.
Experts redirected Paulson, pointing out that he had no background in housing or subprime mortgages. But Wall Street had underestimated him. Paulson was no singles hitter, afraid of risk. A part of him had been waiting for the perfect trade, one that could prove Paulson to be among the greatest investors of all. Anticipating a housing collapse—and all that it meant—was Paulson’s chance to hit the ball out of the park and win the acclaim he deserved. It might be his last chance. He just had to find a way to pull off the trade.
1.
And chase the frothy bubbles,
While the world is full of troubles.
—William Butler Yeats
A GLIMPSE OF WALL STREET’S TRADING FLOORS AND INVESTMENT offices in 2005 would reveal a group of revelers enjoying a raging, multiyear party. In one corner, making a whole lot of noise, were the hedge-fund managers, a particularly exuberant bunch, some with well-cut, tailored suits and designer shoes, but others a bit tipsy, with ugly lampshades on their heads.
Hedge funds gained public consciousness in the new millennium with an unusual mystique and outsized swagger. But hedge funds actually had been around since 1949, when Alfred Winslow Jones, an Australian-born writer for Fortune Magazine researching an article about innovative strategies, decided to take a stab at running his own partnership. Months before the magazine had a chance to publish his piece, Jones and four friends raised $100,000 and borrowed money on top of that to create a big investment pool.
The Greatest Trade Ever