“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
—John Maynard Keynes
MOUNTAIN CLIMBERS CONFRONT THE MIGHTY K2 IN THE HIMALAYAS. Surfers brave Hawaii’s Pipeline Surf. In the investing world, there’s no more treacherous challenge than navigating a speculative mania; it can ruin amateurs and professionals alike.
History is littered with legendary investors who gave in to temptation and rode financial waves to their ruin, or attempted gutsy maneuvers to profit from what they viewed as inevitable crashes, only to suffer humiliating losses that sometimes haunted them for years.
In the early eighteenth century, Sir Isaac Newton, the man who discovered gravity as a fundamental force in nature and became the highest officer of Britain’s Royal Mint, decried the growing passion for shares of the South Sea Company, a British company that gained a monopoly on trade in South America. Newton sold his own stock holdings of the company, worth £7,000, for a 100 percent profit, sure the shares would fall with a thud. But as the buying grew more frenzied, even Newton couldn’t resist the pull; he bought more shares, only to lose £20,000 when the bubble finally burst.
“I can calculate the motions of the heavenly bodies, but not the madness of people,” he later remarked.1
Benjamin Graham, considered the greatest modern-day investor, was so caught up in the roaring market of the 1920s that he embraced the fast-trading lifestyle of his day, taking up residence in the luxury Beresford Apartments on Central Park, hiring a manservant, and borrowing money to expand his investment portfolio. Graham failed to see a crash coming, and his investments lost roughtly two-thirds of their value between 1929 and 1931.2
Renowned trader Jesse Livermore fared somewhat better. He anticipated 1929’s historic sell-off and scored $100 million of profits by shorting shares. The gains prompted threats on his life, and Livermore hired armed guards to protect him and his family. The stock market remained volatile, however, and by 1934 Livermore was bankrupt and suspended as a member of the Chicago Board of Trade. Six years later, he ordered two stiff drinks in the lobby bar of the Sherry-Netherland hotel, walked to the nearby cloakroom, and shot himself dead with a .32 caliber Colt automatic revolver. On a scratch pad attached to his wallet, he left a rambling note to his wife saying that he was “tired of fighting … my life has been a failure.”3
Hedge-fund manager Michael Steinhardt, who rang up huge profits wagering against overpriced stocks in the 1960s, also bucked the market in the early 1990s, buying bonds as investors fled the market. Many of Steinhardt’s own clients deserted him, doubtful his strategy would pay off. Bonds eventually rallied, however, leaving his fund $600 million richer.
“Betting against a bubble is dangerous, but it’s one of the most rewarding things, it’s truly a pleasure,” Steinhardt says. “In your mind you’re going to be right ultimately; there’s a certain virtue in being alone.”
Succumbing to hubris just a year later, however, Steinhardt lost 30 percent of his fund’s assets.
In more recent years, those standing in front of Wall Street’s rumbling herd were just as likely to be mauled. In the mid-1990s, when Jeffrey Vinik ran Fidelity Investment’s Magellan Fund, the world’s largest mutual fund, he increased the fund’s bond holdings after becoming worried about the stock market. Many of his clients became upset about missing out on a soaring stock market, however, and directed their ire at Vinik, ignoring his enviable track record. In 1996, he finally quit his job to invest largely for himself. A senior colleague at Fidelity, George Vanderheiden, who managed $36 billion, came under intense fire just a few years later, this time for resisting overpriced technology stocks. He ended up retiring at the age of fifty-four, watching from the sidelines as those same shares finally tumbled, just as he predicted.
Julian Robertson was in a better position to buck the madness for tech stocks in the late 1990s. After all, Robertson, who ran his own hedge fund—the largest on record at the time—was among the celebrated names on Wall Street.
But Robertson stubbornly clung to airline shares and other value stocks instead of shifting into Internet companies, and his performance suffered. The tech craze went on years longer than he expected. In 2000 Robertson threw in the towel and closed his firm. Just weeks later, technology stocks finally crumbled, but he had been unable to hold on long enough to claim vindication.
The bursting of the Internet bubble even cost George Soros, considered a Midas of the markets. In the months leading up to 2000, Soros badgered his top lieutenant, Stanley Druckenmiller, to reduce risk and dump the technology stocks that he had become enamored with.
Druckenmiller, an accomplished investor in his own right, shared many of Soros’s concerns. “I don’t like this market,” he told a colleague at the time. “I think we should probably lighten up. I don’t want to go out like Steinhardt.”
Despite these worries, Druckenmiller figured he was safe because the frenzy likely would go on a little longer.
He was wrong. By early 2000, technology stocks were in a sudden tailspin, shocking the Soros team. During the worst of this period, it happened that their offices were consumed by a powerful burning smell as electrical work on the floor above repeatedly started small fires, setting off deafening alarms. The smoke, the racket, and the dizzy headaches they caused seemed “like a divine message,” one Soros executive said of the bizarre scene. “We almost wished it would burn down.”
Facing losses of more than 20 percent over a few short months, Soros severed his long, profitable partnership with Druckenmiller and announced that he would cease managing money for others and take a more conservative stance.
“Maybe I don’t understand the market,” a reflective Soros said at a subsequent news conference. “Maybe the music has stopped, but people are still dancing.”4
Fighting a runaway market can have more serious results. In 2008, German industrialist Adolf Merckle was among a group of sophisticated investors convinced that shares of Volkswagen were wildly overpriced. Merckle, who was estimated to be worth $9 billion at the time, sold Volkswagen shares short, but they kept soaring. It turned out that sports-car manufacturer Porsche was in the midst of a furtive effort to buy up Volkswagen shares, driving their prices higher. Losses of hundreds of millions of euros eventually became too much for the seventy-four-year-old Merckle. On a cold evening in January 2009, he lay down on railroad tracks near his villa in the southern German hamlet of Blaubeuren as an oncoming train took his life.
“The understanding of a bubble doesn’t help you as an investor,” says Soros. “Those that reach historic proportions go further than you would think.”
JOHN PAULSON wasn’t very concerned about the stumbles of previous investors. He was sure he had discovered proof of a housing bubble, and he was determined to profit from it. It was fortuitous that Paulson was a merger pro, and not a veteran of the mortgage, housing, or bond markets. He wasn’t deterred by the dismal track record of those who already had bet against housing, and wasn’t fully aware that his bearishness wasn’t especially unique.
Two years earlier, in 2004, Professor Robert Shiller of Yale University produced data showing that U.S. residential real estate prices rose by only 66 percent between 1890 and 2004, or by just 0.4 percent a year. He contrasted that meager gain with the heady rise of 52 percent, or 6.2 percent a year, between 1997 and 2004. Shiller presented a series of lectures on the topic and included the charts and figures in an updated version of his best-selling book, Irrational Exuberance, in February 2005, trying to demonstrate how overpriced real estate had become.
Skeptical research on housing had been published in other countries as well. A report in early 2004 by Smithers & Co., a British consulting firm, said prices in the United Kingdom would have to fall by almost 30 percent to return to historic levels.
In fact, warnings were widespread that housing had gone off the rails. Between 2000 and 2003, there were 1,387 mentions of the phrase “housing bubble” in articles in U.S. publications. Over the next three years, there were 5,535 mentions of the phrase, including prominent stories in most major newspapers, some which sparked nervousness among major real estate investors.5
“Never before have home owners been so leveraged; and never before has the residential market been so speculative,” said François Trahan, a Bear Stearns strategist, in May 2005.
Around the same time, a popular video made the rounds putting the housing market on a virtual roller-coaster ride that started at the beginning of the century and followed the ups and downs of actual historic prices as plotted on a track. The ride finished with a nerve-rattling ride to unprecedented heights, one that turned the stomach of even hardy viewers and hammered home the dangerous level the market had reached.
Even those betting on the housing market seemed to hedge themselves. By late 2005, Ralph Cioffi, who operated two big hedge funds at Bear Stearns and appeared to have an insatiable appetite for mortgage products, was steering clear of the riskiest subprime mortgage investments. Angelo Mozilo, CEO of Countrywide, sold more than $400 million of shares in Countrywide between 2004 and 2007, an unusual move for someone who professed to be unconcerned about a national housing bubble.
Still others expressed strong doubts privately. In an internal e-mail, a Standard & Poor’s executive told a fellow analyst that a mortgage deal the firm was rating was “ridiculous” and that they “should not be rating it.” His colleague replied that “we rate every deal,” adding that “it could be structured by cows and we would rate it.” A manager of the collateralized-debt obligation group said, “Let’s hope we are all wealthy and retired by the time his house of cards falters.”6
“Does your brother-in-law, the real estate broker, owe you money?” asked financial-publication Grant’s in a June 2005 issue. “Now is the time to collect.”
ALTHOUGH INVESTORS long had been worried about housing, most were unable to profit from their stance, some failing quite miserably. Others already had dismissed the use of CDS protection that Paulson was warming to.
In 2002, William Ackman, a hedge-fund manager, argued that MBIA, the bond insurer, was heading for serious trouble, two full years before Paulson bought CDS protection on the company. But Ackman, a sharp-elbowed investor who relished telling corporate executives how to do their jobs, was too early, and he lost serious cash from the trade until late 2007.
“You can be totally right on an investment but wrong on the timing and lose a lot,” Ackman says.
Another well-regarded investor, Palm Beach–based Otter Creek Partners, developed early concerns about mortgages and shorted financial companies, only to see the market race higher. It was a brutal lesson for others considering the same tack. Prominent hedge-fund managers with doubts about housing, such as Paul Singer of Elliott Management Corp. and Seth Klarman of Baupost Group, bought some CDS insurance contracts on risky mortgages but chose to buy small portions of it and not go overboard. No one wanted to be known for hurting clients by turning bearish too soon.
“Buying so much was a reputational risk,” Klarman says. “It wasn’t a no-brainer.”
Others just didn’t feel comfortable buying CDS contracts, some of the very kinds of “derivative” investments tainted by legendary investor Warren Buffett as “financial weapons of mass destruction” for their ability to inflict huge losses.
Bill Gross of Pacific Investment Management Co., the $800 billion gorilla of the bond business, took the pulse of the market from picturesque offices in Newport Beach, California. He became rattled in 2005 when two of his children, one of whom was a teacher, confessed to using aggressive mortgages to purchase homes they otherwise couldn’t have afforded based on their limited salaries. After doing some research on real estate, Gross called an emergency staff meeting and began sending “shoppers” to key markets to pose as home buyers and glean intelligence about all the excesses. In 2005, Gross’s own top mortgage trader, Scott Simon, advised clients about the huge upside possible from CDS insurance on mortgage bonds, putting him well ahead of the pack.
But Gross was uneasy with CDS contracts. Most of the money he oversaw was in dowdy mutual funds, and many of his clients couldn’t own the derivatives contracts. Instead, Gross reworked Pimco’s portfolio, buying things like safe, short-term Treasury bonds, dabbling just a bit in the CDS insurance. Even these small moves left Gross’s newly conservative portfolio trailing the rest of the pack in 2006. It made Gross so miserable that he had to take an unplanned nine-day vacation midway through the year; he spent most of his break sitting around the house, sulking to his wife.
“I couldn’t turn on business television, I couldn’t pick up the paper; it was just devastating,” Gross said at the time. “You can’t sleep at night.”7
When housing finally weakened, of course, Pimco’s returns topped those of most competitors, a welcome relief to Gross. But Gross says he’s not sure he would have aped Paulson’s moves even if his investors demanded it.
“I’m a thirty-five-year veteran, an old fart, and the hedge-fund mentality is not me,” Gross says. “We can’t buy [derivative contracts] in a way to make it a slam dunk; we did the trade in a conservative, fall-asleep way.”
Investment advisor Peter Schiff seemed in an ideal position to benefit from real estate troubles. For years, he had predicted that housing would stumble and that the financial system would implode. Schiff eventually was seen as something of a Cassandra of the markets, ridiculed unmercifully on business television networks. After one appearance in which Schiff issued his usual apocalyptic warnings, Neil Cavuto, an anchor on the Fox Business Network, asked Schiff if his next project would be an “exposé on Santa Claus.” Commentator Ben Stein piled on, telling Schiff, “You’re just wrong.”
Schiff moved clients’ money out of stocks and shorted risky mortgages, as did Paulson. But Schiff picked the wrong investments to shift into, choosing foreign currencies, commodities, and emerging markets, among other things, all big losers in 2008. Some clients lost half their money that year, underscoring the fact that an awareness of an investment bubble is only valuable when you know how to profit from it.
A key reason even experienced investors resisted buying mortgage protection: CDS contracts were a classic example of a “negative-carry” trade, a maneuver that investment pros detest almost as much as high taxes and coach-class seating. In a negative-carry trade, an investor commits to paying a certain cost for an investment with the hope of untold riches down the line. In the case of CDS contracts, purchasers usually agree to make an up-front payment, and to shell out annual insurance premiums, both of which bake in a sure cost.
If negative-carry trades don’t work quickly, the cost piles up. An investor paying 5 percent a year to place a trade will face 20 percent cumulative losses after just four years. These losses grant a running start to competitors, an ill-advised move in a world where trailing a rival by even half a percentage point can lead to a swift dismissal. Mortgage and bond specialists were especially fearful of the costs of negative-carry trades because these investors didn’t usually rack up big gains. Buying insurance at home is one thing; doing it at the office is something entirely different.
Bill Gross’s star mortgage trader, Scott Simon, experienced the loathing of negative carry first-hand. In 2006, Simon tried to start a fund for Pimco to buy CDS contracts, pitching the idea to clients exposed to real estate, such as endowments, pension plans, and others. The insurance seemed custom-made for the investors. But they proved so unwilling to shell out money at the start of a trade that Simon and his team gave up, unable to sell the fund, thereby losing a chance to undertake the same trades as Paulson.
Even the most successful investors shun negative carry; it is like garlic to vampires. In the 1980s, when junior traders suggested that junk-bond king Michael Milken short especially risky bonds, he scoffed at the notion of paying high interest on the debt while waiting for it to fall in price. Trades that lock in instant payments in the hopes of a payday someday in the future make even the likes of George Soros queasy.
“I don’t know if I would have done it myself, if I was in [Paulson’s] shoes,” Soros says. “I probably wouldn’t have bet the house.”
Instead, most traders prefer “positive” carry trades, or those where profits are immediate and clear. Banks, for example, borrow money at low interest rates and lend it out at higher rates. A borrower may go belly-up, of course, but on paper the move looks like a winner.
There didn’t seem to be a more surefire positive-carry trade than selling insurance on even risky mortgage debt. Insurance companies like American International Group, huge global banks, and countless investors locked in instant gains from the premiums that Paulson and other bears paid for their CDS insurance. These profits sometimes meant the difference between hitting a profit goal and missing out on a huge bonus.
“Positive carry is the mother’s milk for capitalism; it’s ingrained and embedded in the minds of investors,” says Gross.
JOHN PAULSON’S perspective was so vastly different from that of most others on Wall Street that it was as if he had landed from a different planet. For one thing, Paulson had periodically shorted bonds all along, and didn’t see what the fuss was about. If an investment looked like a loser, he itched to bet against it, whether or not it might cost him a bit and allow a competitor to briefly pull ahead. To Paulson, CDS contracts on risky mortgage bonds were an investment with minimal downside and almost unlimited potential, a dream trade with a likely “asymmetrical outcome.”
Paulson also had good fortune on his side: By the time he determined that the housing market was in a bubble in the spring of 2006, prices had begun to flatten out, making it the perfect time to bet against the market. Others who had come to a similar determination much earlier were licking their wounds because they had placed wagers against real estate too early and suffered as it climbed further.
Paulson flashed back to a book he had read years earlier: Soros on Soros, detailing George Soros’s various insights. In the book, Soros urged investors to “go for the jugular” if they spotted a trade with huge potential.8
“That expression stood out for me,” Paulson recalls. “As I became more convinced that there had been a massive mispricing of risk, we said, why just sit here with one billion of protection? Why not go for the jugular?”
Some at Paulson’s firm noted that investors would have to be educated if these CDS trades were going to be the centerpiece of a dedicated new “credit” fund. A few clients already had indicated they were uncomfortable that the merger hedge fund purchased so much mortgage protection.
But Paulson was upbeat, predicting just a 10 percent chance of failure for his subprime trade. If housing cracked and it became difficult to refinance mortgage loans, borrowers surely would run into problems, crippling the collateral backing all those mortgage-backed bonds and rendering the BBB slices worthless. Even if real estate just leveled off, risky borrowers signing up for adjustable-rate mortgages in 2006 would be unable to refinance them in two years when the rates shot up, Paulson reasoned, because they would have little equity in their homes.
And if Paulson was wrong and housing somehow kept climbing? Most subprime borrowers probably would refinance their loans well before they had a chance to reset at higher rates, to avoid the increased monthly costs. Once the loans were refinanced, the protection Paulson purchased would expire, ending the trade with minimal losses—just the cost of the CDS insurance. Either way, Paulson was sure he would know by 2008 whether his trade would work.
“We found the El Dorado of investments,” he said at one point to a colleague. “Are we going to just dip our toes in?”
Darker scenarios were possible, of course, but Paulson didn’t focus on them. If the frenzy for risky investments grew and the BBB-rated bonds that he was skeptical of became even more popular, Paulson would certainly see losses.
But these bonds already traded at paltry interest rates close to those of the safest debt. Even investors with rose-tinted glasses were unlikely to accept yields on toxic mortgages unless they were greater than those of debt from the U.S. Treasury and other supersafe investments. To Paulson, it limited how much more expensive the mortgage bonds could become, reducing the dangers of wagering against them.
Sure, if the Fed slashed interest rates again, risky borrowers might be off the hook, as rates on their adjustable loans dropped, crippling the value of Paulson’s insurance. But the Fed had been raising rates, pushing the key federal funds rate up to 5.25 percent from 3.25 percent a year earlier. The Fed was unlikely to start cutting them again unless the economy dramatically weakened. By then it would be too late to save home owners.
“There’s never been an opportunity like this,” Paulson gushed to Jeffrey Tarrant after an afternoon of tennis at Tarrant’s Southampton home. Losses on pools of risky mortgages were running at almost 1 percent at the time. If they hit just 7 percent, the BBB slices “would be wiped out,” Paulson said, excitedly.
So Paulson decided to go for the jugular. He figured that even his biggest fans wouldn’t stomach losses of more than 25 percent over three years, or 8 percent or so a year. But if they could be capped at that level, Paulson might be able to raise a lot of money. He just had to figure out how to do it.
Paulson asked Rosenberg, his trader, for a quote. Rosenberg quickly came back with good news from the firm’s Bear Stearns broker: There still was so much demand for bonds backed by subprime mortgages, and so little appetite for CDS insurance to protect them, that the cost of insuring the BBB pieces was still just 1 percent of the value of the bonds. If Paulson wanted to insure another $1 billion of BBB-rated slices, it would cost just $10 million annually.
At those prices, Paulson argued, his firm really should back up the truck to buy insurance on billions of risky bonds. If he could convince enough investors to back a new fund with $1 billion or so, it could purchase CDS insurance contracts on, say, $12 billion of bonds at a cost of just $120 million a year.
A 12 percent annual cost likely would seem too steep for many investors in any new fund. But because premiums on CDS contracts, like those on any other insurance product, are paid out over time, the new fund could keep most of its money in the bank until the CDS bills came due, and thereby earn about 5 percent a year. That would cut the annual cost to the fund to a more reasonable 7 percent. Since Paulson would charge 1 percent a year as a management fee, the most an investor could lose would be 8 percent a year, the exact figure he was shooting for.
“We looked at ten-to-one, twenty-to-one, even higher, but twelve-to-one seemed right to us, and we thought it would be right for investors,” Paulson says.
And the upside? If Paulson purchased CDS contracts that fully protected $12 billion of subprime mortgage bonds and the bonds somehow became worthless, Paulson & Co. would make a cool $12 billion. Paulson and his team became more enthusiastic as they prepared to get in touch with prospective investors.
Paulson figured he could use some help running the fund, though, especially if it became as large as he hoped. He interviewed senior research executives at various Wall Street firms, dangling a top job at the fund. Some of the candidates had been recommended by Pellegrini, who scoured the industry for capable mortgage experts sharing a bearish bent.
But Pellegrini had mixed feelings about the assignment. He was thrilled that Paulson trusted him enough to help with the job search, and he was just as convinced as Paulson that the subprime trade would work. But Pellegrini had helped create the idea. He wanted Paulson to offer him a senior role at the fund; he was convinced he was up to the task. Instead, Pellegrini would have to work for the new hire, dropping down a notch on the hedge fund’s totem pole.
“It was tricky for me,” Pellegrini says. “If I resisted, it wouldn’t have worked out. If I got credit for a great hire, that would be better than nothing, I figured.”
For weeks, the response from the candidates Paulson approached was tepid, at best. Some analysts weren’t nearly negative enough on housing. Others felt leaving well-paid jobs to help run a bearish fund that might not succeed was too risky. Moreover, abandoning a cushy Wall Street job for a hedge fund wagering against housing could brand the trader with a scarlet letter, a stain capable of preventing them from returning to an industry that generally made money when real estate rose, not fell.
“Everyone who might have been qualified said the strategy wouldn’t work,” Pellegrini recalls.
Privately, Pellegrini was elated by the response from Wall Street. He secretly hoped that it might improve his own chances for a senior role in the new fund. One day in the spring of 2006, after the latest disappointing interview, Paulson stopped Pellegrini in the hallway. Paulson was smiling warmly, filling Pellegrini with instant hope.
“I’ve thought about it,” Paulson told Pellegrini. “We aren’t going to hire anyone. We’ve decided you should be co-manager of the fund.”
For a moment, Pellegrini was confused. He had no clue who the “we” was that Paulson was referring to and worried there might be someone else at the firm he had to impress. But when it dawned on him that he finally was getting the senior position he yearned for, Pellegrini turned ecstatic.
For the first time at the hedge fund, the terms of his compensation were put in writing. Pellegrini even moved into an office, in a corridor across from the firm’s accounting bullpen. He proudly put his new title, “Co-manager of the Paulson Credit Opportunity Fund,” under his name in his e-mails.
A few days later, however, Andrew Hoine approached Pellegrini. “You need to remove that new title from your e-mails,” he said. “It might confuse investors.” Later that day, Jim Wong, Paulson’s investor-relations chief, relayed the same message. Clients might think Paulson wasn’t running the fund, Wong said. Pellegrini turned ashen with embarrassment and agreed to drop the title from his e-mails. For all his valuable research and long hours, he hadn’t yet achieved a position of security at the firm.
ALTHOUGH PAOLO PELLEGRINI understood the trade as well as anyone at the firm, his touch with potential clients was a little rough. At a Red Cross fund-raising event in Connecticut, hedge-fund investor Martin Tornberg stood with an executive of a university endowment during the cocktail hour. Pellegrini walked over, holding a glass of red wine, to join the conversation.
They quickly began discussing Paulson’s new fund. The investors were intrigued. But as Pellegrini went on, they couldn’t understand how he picked securities to short or how the firm was placing its trades.
“It was too hard to follow him,” Tornberg recalls. “It was like torture.”
Paulson’s delivery was much smoother, and he proved expert at explaining his thesis and trade in simple terms. But some investors proved difficult to convince. Hoping to claim his alma mater, Harvard University, as a client for the new fund, an imprimatur that might encourage other investors, Paulson traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard’s endowment. Taborsky already had met with Paulson and Pellegrini in their New York office and had come away impressed.
But the fund cost of 8 percent a year concerned Taborsky. He also thought Paulson might be excessively gloomy about the housing market. Moreover, Paulson’s trade idea wasn’t especially new, Taborsky felt.
“Look, guys internally are doing this already,” Taborsky told Paulson, as he turned him down.
Afterward, Paulson shared his frustration with Howard Gurvitch. “They ought to be in,” Paulson told him. “They should get it.” (Harvard eventually purchased some mortgage protection, but focused on more inexpensive versions that didn’t have a big payoff.)
Paulson reached out to his existing investors. Pellegrini’s chart suggested that housing prices could plunge 40 percent, but Paulson and his team rarely expressed that view to investors. Even they didn’t fully trust the chart. As a result, Paulson decided not to short the slices of the bond deals rated A or AA, the safest ratings, but instead to bet against the riskiest BBB-rated pieces, bonds with risks that Paulson and Pellegrini were convinced investors would recognize.
Some were skeptical, nonetheless. Richard Leibovitch, who invested in hedge funds for a Boston firm called Gottex Fund Management, grilled Paulson in a meeting, repeatedly telling him it would be a difficult trade to pull off. Leibovitch said he had spoken with Mike Vranos of Ellington Management, the preeminent mortgage trader, and he wasn’t nearly as alarmed about housing.
“John, why do you think you know more than Vranos?”
“Look, you don’t have to be a mortgage guy to read the tea leaves. I don’t care if he’s a mortgage genius,” Paulson said. “Listen to the logic of my argument.”
In the end, Leibovitch turned down the fund, though he stayed a client of Paulson’s other funds. Before the meeting ended, he urged Paulson to meet with Vranos, but Paulson passed on the offer.
“Paulson was a merger-arb guy and suddenly he has strong views on housing and subprime,” Leibovitch recalls. “The largest mortgage guys, including Vranos at Ellington, one of the gods of the market, were far more positive on subprime.”
Paulson, Wong, and other members of the team described their investment thesis to Nolan Randolph, another client, who was an executive of a Texas firm called Crestline Investors. But Randolph kept shaking his head over and over again, unnerving the group. Randolph turned them down, arguing that the downside seemed too big if the trade didn’t pay off.
“We don’t think your fund will add alpha,” Randolph said, using the industry lingo for value.
Even some investors who agreed with Paulson’s bearish view doubted he would make much money because there was relatively little trading in the investments he was buying. They felt he might have a hard time selling them without sending prices tumbling, shrinking any profits.
“How are you going to get out?” asked one London-based investor.
Paulson patiently explained how the trade likely would play out, even predicting the dates at which nervous investors and banks would suffer housing-related losses and line up to purchase his mortgage protection. That would enable Paulson to sell it profitably, he argued. The investor wished him well, but passed on Paulson’s new venture.
“It looked like a dangerous game, taking one single bet that might be difficult to unwind,” says Jack Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said no to Paulson’s fund.
Still others grumbled that the new fund wouldn’t let investors withdraw money until the end of 2008, a “lockup” that Paulson insisted on to ensure he wouldn’t have to exit the trade due to client withdrawals before it began to work.
“Investors said, ‘If you’re so smart, why isn’t everyone doing it, and why are firms in the mortgage business making a different argument?’ ” Paulson recalls. “I said, my job isn’t to convince you.”
Paulson’s growing fixation on housing began to impact his business; some clients worried he was focusing on mortgages because opportunities were drying up in the merger area. Others thought he was becoming distracted. One longtime client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Paulson was “straying” from his longtime focus, and that it should pull its money from his firm, fast. The bank stuck with Paulson, but turned down his new fund.
Paulson even received flak from old friends.
“What could they do to mess with the trade?” Peter Soros grilled Paulson on regular phone calls and in meetings; he noted that politicians might feel compelled to aid mortgage holders. In the run-up to the election year, would Congress let two to three million home owners get thrown out of their homes? Soros asked.
Soros didn’t give Paulson an investment.
Paulson wanted his fund to be big, so he could purchase the most mortgage protection possible. But he also felt pressure to raise the money quickly. Competitors might figure out the trade for themselves and buy the same insurance, driving up the cost. That made Paulson reluctant to provide many details of his trade. It was a stance that made it more difficult to raise money.
“It doesn’t take much for hedge-fund managers to catch on, and it was such a glaring mispricing, I was afraid too much attention would cause it to disappear,” Paulson says. “I didn’t tell some potential investors the whole story, with all the details, because the more I discussed it, the more likely it would go away.”
James Altucher, a writer who also invests money in hedge funds for clients, met the Paulson team and was shaken by their arguments. Coming out of the midtown New York offices, Altucher turned to a colleague and said, “We’re screwed. The whole country is screwed.”
Back at the office, though, Altucher called pros for their opinions. They said the insurance likely would drop in value before it began to rise, and that pension funds and other believers in the BBB slices wouldn’t easily sell, limiting how much the bonds could fall in price. The advice dissuaded Altucher from investing in Paulson’s fund.
“Only a little bit of asking was enough to put the gas on neutral,” Altucher wrote in a column in The Financial Times. “It all made a lot of sense but I didn’t invest … Who knew how long the irrational behaviour would last?”
Paolo Pellegrini honed his pitch and became smoother in presenting the trade to investors. But at one point, he couldn’t bear all the dissing the firm received. In a meeting at the Ford Foundation, a Ford executive, Larry Siegel, said his organization wouldn’t invest in the Paulson fund because it was wagering against home owners, something that Siegel said was “inconsistent with our social mission.” To Pellegrini, the comment smacked of false piety; a colleague at Paulson & Co. had relayed an earlier conversation in which Siegel said he found a better trade to take advantage of housing weakness. After the meeting broke up, Pellegrini quickly approached Siegel outside the conference room, grabbing his attention.
“I heard you have a better trade … why is it better than what we’re doing?”
Siegel said he didn’t want to get into it, just that his was a more sophisticated approach than Paulson’s. (Siegel now says he was just trying to get out of the meeting, and that his bosses never would have approved an investment in a fund that wagered against mortgages.)
Paulson wasn’t getting much more respect from Wall Street’s establishment. Rosenberg invited two Morgan Stanley traders, John Pearce and Joseph Naggar, to visit the office, hoping to learn more about the market and include Morgan Stanley as one of its brokers on the trade.
Pearce and Naggar showed up in khaki pants and polo shirts, saying they didn’t have much time to talk because they were late for a golf outing with other clients.
“Let’s try to make this as brief as we can,” Naggar said.
Pellegrini and Rosenberg, in suits and ties, handed the Morgan Stanley traders a list of subprime mortgage–backed bonds that the firm was hoping to bet against.
“Here are the names we’d like to put more shorts on,” Pellegrini said.
Pearce and Naggar didn’t seem to have much interest in trading with Paulson’s team, though, or in spending much time on their questions.
“It sounds like a good trade; maybe we’ll do it,” Pearce said, with a laugh. Pearce was just humoring them, Rosenberg thought.
As they ended the meeting, Pearce said, “Well, if we get more capacity, we’ll put it on for you.”
Pearce and Naggar already had placed a few bearish subprime trades for their own firm, though they didn’t want to let that on in the meeting. To the Paulson team, it was another exasperating experience.
“That was a waste of time,” a glum Pellegrini said to Rosenberg as they walked out of the room.
By June, Paulson hadn’t raised much money. Jeffrey Tarrant wanted to invest for his firm, Protégé Partners, but he faced complaints from clients.
“One of our investors said, why would you agree to a trade with negative carry?” Tarrant recalls. “People on trading desks warned, ‘He doesn’t have expertise in the area,’ or ‘He doesn’t know what he’s doing.’ ”
Every day, Paulson walked into the office of Jim Wong showing unusual urgency, as if a clock was ticking on his trade.
“Lemme see the latest list” of investors, Paulson said to Wong insistently. After looking it over, Paulson asked in frustration, “Where are we with these people?”
On another occasion, passing Philip Levy in the hedge fund’s hallway, Paulson stopped the marketing executive, asking for an update of the level of interest in the new fund. After Levy delivered the latest disappointing news, Paulson complained, “I don’t know why they don’t get it … this is the trade of a lifetime,” before walking away, abruptly.
Paulson was thrilled to hear from Jeffrey Greene when he called in the spring of 2006. Greene, an owner of millions of dollars of real estate properties, was eager for a way to protect them from the downturn he was sure was coming. And he and Paulson were longtime friends. Greene was an obvious candidate for the new fund, someone who could write a big check and help get it off the ground.
Greene was one investor that Paulson would come to regret hearing from, however.