“The Greatest Trade Ever: The Behind-The Scenes Story of How John Paulson Defied Wall Street and Made Financial History” by Gregory Zuckerman
Gregory Zuckerman, an award-winning Wall Street Journal columnist, provides a wonderful, fast-paced summary of how John Paulson, a hedge fund manager, made billions of dollars. Ultimately, Paulson’s firm earned more than $15 billion. His compensation was close to $4 billion. Zuckerman devoted hours interviewing not only Paulson and his employees, but also other parties who had contributed to the housing bubble.
As a former professional bond trader for 35 years, I respect Paulson’s trading acumen. Paulson swam against the tide for more than a year. Most traders close out losing trades quickly because holding on to a losing trade can end one’s career because it magnifies the downside. By contrast, Paulson stuck to his positions regardless of the market swings.
To keep his composure, Paulson fixated on one simple chart: a plot of how much real estate prices had diverged from their historical norm. Housing prices had risen 1.4 percent after inflation from 1975 to 2000. After 2000, they had soared more than 7 percent annually. House prices rose 124 percent from 1997 to 2006. In sharp contrast, the Standard & Poor index fell by 8 percent during that same period.
Starting in 2006, Paulson risked enormous sums. He bet that housing prices had climbed to unsustainable levels because they outstripped personal earnings growth. Paulson deduced that U.S. housing prices would have to drop by 40 percent to return to their historic trend line relative to inflation and personal income. His company researched a myriad of choices on the optimal method of profiting from a decline in housing prices.
Paulson struggled with doubts, overcame obstacles and ultimately triumphed. But he didn’t seem equipped for that battle when he started. First of all, until 2006 Paulson was not a housing expert; his expertise was in mergers and acquisitions. Secondly, he did not initially select the optimal securities to bet against the housing market. Thirdly, Paulson made his bets too early, losing millions of dollars for his investors and himself.
Paulson ultimately figured out the right strategy — buying credit insurance. Credit insurance pays fully if the security defaults. Paulson made billions when people could not pay the mortgages that backed the securities.
Paulson realized bucking the establishment could backfire.
Bankers controlled trillions of dollars and could market their financially engineered products globally. The housing bubble appeared unstoppable.
The credit agencies gave unreasonably high ratings to subprime, mortgage-backed collateralized debt obligations, whetting the appetite of unsuspecting investors.
Central bankers ignored the danger of asset-price inflation. A global inverted pyramid of household debt was built on a narrow range of underlying assets — American house prices.
Regulators’ ardent belief that increasing home ownership was good. They exhorted Fannie Mae and Freddie Mac, the Federal Housing Administration and private institutions to provide liberal credit terms. By 2006, more than 33 percent of sub-prime loans exceeded 100 percent of the home value, and six times the annual earnings of the borrower.
Private mortgage lenders started making “Ninja” mortgages to borrowers with no income, no job and assets.
Paulson’s passion for profit raised moral dilemmas. He persuaded Wall Street firms to create securities backed by nasty mortgages, which he could then short. Nobody told the “sucker” investors that they were buying the most toxic mortgages so Paulson could profit when they defaulted.
Paulson also told Zuckerman about his latest unorthodox idea. Paulson is now betting on the decline of the U.S. dollar. As Paulson says, “It’s like Wimbledon. When you win one year, you don’t quit; you want to win again.”
Originally published in the Sarasota Herald-Tribune
