The Greatest Trade Ever

by Gregory Zuckerman

  Clients and colleagues seemed taken with his unique style. Well dressed and possessing boundless enthusiasm, Pellegrini was passionate about his deals, pushing hard to get buyers and sellers on the same page. Working on a floundering deal with David Nelson, a senior banker at Chase Manhattan Bank, Pellegrini pushed the various parties toward a compromise, impressing others at the negotiating table.

  “Paolo wasn’t your typical investment banker, he was full of life, almost flamboyant, with a tremendous amount of positive energy,” recalls Nelson, who helped arrange financing for some of Pellegrini’s insurance acquisitions. “Most guys were Anglo-Saxon, white-shoe bankers, but [Paolo] was this bigger-than-life, good-looking guy with Romanesque features and a distinctive accent driving the conversation.”

  But Pellegrini found it difficult to woo clients, blaming his unfamiliarity with American social norms. He once watched a playoff basketball game with the two top executives of a large insurance company and struggled the entire night to come up with topics of conversation or a single player he was familiar with.

  The best Pellegrini could muster to fill the awkward silence: “So you like basketball in Chicago?”

  Other times, the cutting, sarcastic humor he displayed that went over so well in his native land seemed to offend clients in the United States.

  Pellegrini failed to gain a promotion at Lazard, even as contemporaries vaulted past him. He became seen as a laggard and his work suffered. Pellegrini turned brusque with colleagues, convinced that his accent raised doubts among clients about whether he fully understood the nuances of the complicated transactions.

  “I was an outsider, it wasn’t my home turf, and my accent made clients worry that I’d miss the fine print. It tilted the balance away from me,” he recalls. “I was never the first call for companies; we had difficulty relating personal experiences.”

  Pellegrini was bursting with new ideas about how companies could raise money or undertake innovative merger structures, but the nitty-gritty of the banking job overwhelmed him. Pellegrini tried to focus on big-picture issues, ignoring details such as his appointment schedule. That led some to question his competence. Traveling to Rome with a group of senior Lazard bankers for a big meeting, Pellegrini had trouble guiding them to the meeting’s location and they arrived a half hour late, frustrating the group.

  “Everyone assumed I knew my way around because it was Rome but I didn’t; it was embarrassing,” he says.

  Pellegrini paid a coach to help him become an “active listener,” to better understand his clients and their needs, and he hired another coach to help eliminate his accent. He couldn’t shake it entirely, though. When Pellegrini became uncomfortable in public, he found it difficult to express himself, seeming stiff and awkward.

  A flurry of successful insurance deals improved Pellegrini’s stature at the firm, however, and by 1993 he was on his way to becoming a partner. Riches and prestige were sure to follow. That year, Lazard’s senior banker, Felix Rohatyn, set up a meeting for Pellegrini with the chief financial officer of Xerox Corp. to discuss a possible sale of the company’s flagging life-insurance subsidiary. Pellegrini was competing for the business with a fierce rival, Morgan Stanley’s star banker Gary Parr, even as rumors swirled that Lazard was quietly wooing Parr to join the firm, perhaps to lead Pellegrini’s insurance group. Pellegrini tried to get out of the assignment, but he couldn’t extract himself.

  As Pellegrini researched Xerox Life to prepare for the meeting, he concluded that it had deep problems. But he tried to strike an upbeat tone with the Xerox executives, encouraging them to pursue a sale because merger activity was so buoyant.

  “You can turn chicken shit into chicken salad in this market,” Pellegrini told them with enthusiasm, trying to drive home his point.

  Suddenly, the room went silent. The jaws of the Xerox team seemed to drop. They were shocked and insulted by Pellegrini’s coarse description of a unit that they didn’t consider to be operating so poorly. Pellegrini tried to backtrack, but it was too late; the damage had been done.

  Days later, his boss, Luis Rinaldini, a hard-driving Argentinean, called Pellegrini into his office—Xerox wanted him off the account. At that moment, Pellegrini was certain that his once-bright future was in jeopardy.

  “It was a lesson to me that people are always waiting at the pass to shoot at you,” Pellegrini recalls. “I knew my career was in trouble.”

  As his anxieties built, Pellegrini’s marriage to Goodman began to crumble. Word of their troubles, which soon led to a divorce, spread within Lazard. Pellegrini took comfort in a special bond he had developed with his two young sons. He frequently brought them to the office and boasted of their exploits to colleagues, showing a tender side that softened their view of him.

  But when Kendrick Wilson took over Lazard’s investment-banking group, the pressure grew. Wilson, a no-nonsense former Marine who had served as an officer in the Army Special Forces in Vietnam, had little patience for Pellegrini and his grand schemes. One day, Pellegrini brought Wilson an idea for an improved version of an employee stock-option plan that could be pitched to Lazard’s clients. Wilson was dismissive and sarcastic, telling Pellegrini to stick with mergers.

  “Just get it done, Paolo,” Wilson implored him, repeatedly.

  Pellegrini turned stubborn, unwilling to back down from his boss, colleagues, or rivals, even over minor points of disagreement. Some at Lazard buzzed about a screaming match between Pellegrini and another top banker, Chris Flowers. When Wilson heard a client complain about how rudely Pellegrini interacted with others at the firm, Wilson had had enough. He fired Pellegrini in 1995, after nine years at the firm, telling him that “a knife-and-fork role isn’t suited for you.”

  “He’s very, very smart, and his analytical skills are extraordinary,” Wilson recalls, “but he’s a classic hot-blooded Italian; he got into situations where everything was a zero-sum game.”

  Pellegrini says more bluntly, “He thought I was full of shit.”

  Pellegrini was thirty-eight years old, unemployed, and newly single. He threw a party at his apartment, trying to meet some new friends, but he was too uncomfortable to enjoy it very much, retreating to a corner of the room. His job prospects weren’t much better. Lazard was a topflight Wall Street firm, but nine years as a vice president without a promotion raised all kinds of questions in others’ minds.

  Pellegrini still had big ideas, however. He started an insurance company in Bermuda with Bill Michaelcheck, a former Bear Stearns colleague, to invest insurance premiums in hedge funds. He threw himself into developing complicated models. The idea was a success for Michaelcheck, who turned it into a separate business to invest in hedge funds, but it didn’t do much for Pellegrini, who left after a couple of years.

  He found more luck in love, marrying Beth Rudin DeWoody, the daughter of the late New York real estate mogul Lewis Rudin, in a 1996 wedding in Bermuda officiated by former New York Mayor David Dinkins. Pellegrini now was part of a wealthy, well-established family.

  Instead of relaxing, however, he began to worry about what would happen if DeWoody ever left him. Pellegrini was tapping into his 401(k) retirement savings to make hefty child-support payments for his two sons, who attended expensive New York private schools. The payments had been set when Pellegrini was working at Lazard and making much more money than he now was making from irregular consulting gigs in the insurance industry.

  Pellegrini and DeWoody lived an expensive lifestyle, and bills for art, evenings of entertainment, and a deluxe apartment added up quickly; Pellegrini favored expensive clothing, trying to keep up appearances and to fit into a privileged social scene. But he chafed at how little money was coming in and at the fact that the couple depended on DeWoody’s family to pay for their lavish lifestyle. His growing insecurities began to weigh on their marriage. Pellegrini tried to get his wife’s family to stake him some money to trade in the stock market, but they refused, asking to first see evidence that he could trade
profitably. As Pellegrini watched other men his age lose jobs and have difficulty making much of their lives, he worried that he would, too. He pushed DeWoody to adjust their prenuptial agreement to increase any payout to him, telling her that the terms gave her encouragement to leave him. But lawyers within the Rudin organization wouldn’t budge on the agreement.

  DeWoody tried to boost her husband’s confidence. “You just need the right situation, where someone believes in you and you don’t have to deal with clients,” she told him.

  Pellegrini never felt reassured, though. “A number of Beth’s friends had disposed of their husbands, and I felt that pressure,” he recalls. “I felt vulnerable and expendable.”

  In 2000, Pellegrini finally snapped, waking DeWoody in the middle of the night to demand sweetened terms from the prenup agreement and threatening to leave her. That’s it, DeWoody decided. She ignored his demands and Pellegrini walked out. A few days later, he tried to get his wife to take him back, but by then she was set on a divorce, no longer willing to deal with his insecurities.

  “I could have handled it better,” Pellegrini acknowledges.

  Pellegrini moved out of their Gracie Square home to an apartment in Westchester, receiving $300,000 from DeWoody in a divorce settlement, a pretax payout that he figured might have to last him through retirement. Being financially successful was at the top of Pellegrini’s life goals, right up there with having a happy family life. He had failed miserably at both.

  “I was forty-five and had zero net worth,” Pellegrini recalls. “And from my perspective, I had no prospects.”

  Pellegrini’s bright ideas kept coming, though. He developed a new method to use “statistical arbitrage” to trade stocks, though he couldn’t make much money with it. A stint at Tricadia Capital, a hedge fund founded by Michaelcheck’s Mariner Investment Group, Inc., gave Pellegrini an education in the world of securitized debt and credit-default swaps (CDS), which the firm was heavily involved in.

  But Pellegrini didn’t make many friends at Tricadia when he suggested that the firm find ways to short collateralized-debt obligations, even as others at the firm were buying and creating versions of these debts. After a derivative-focused company that Pellegrini hoped to set up for Tricadia failed to get off the ground, he began searching for a job once again. It was that development that led him to the interview that Paulson set up for him with two of Paulson’s executives, Andrew Hoine and Michael Waldorf.

  The meeting started with Hoine and Waldorf asking Pellegrini for his views on various European industries. Pellegrini had no clue—his most recent experience was with CDS trading. He hadn’t taken the time to brush up on other areas. Pellegrini tried to compensate by acting more cocky than he actually felt, but he could see Hoine and Waldorf becoming annoyed with him as the meeting progressed.

  Afterward, Pellegrini waited at home for days, hoping to hear back from Paulson. Pellegrini almost gave up. Ten days after the interview, he finally received a call. “Well, you managed to piss off my partners,” Paulson said. “If you hadn’t been such a jerk, you would have gotten a job earlier.”

  “If I came off as a jerk, I didn’t mean to,” Pellegrini responded, quietly.

  Paulson agreed to give Pellegrini a chance. His employees didn’t like him very much, but Paulson viewed Pellegrini as a smart gamble, a bright, well-educated analyst who might yet become an asset. He told Pellegrini it would take him a year or so to learn the merger-arbitrage business, and welcomed him aboard. Pellegrini was forty-seven, a year younger than his new boss and thrilled at the opportunity to show he wasn’t washed up.

  THE EARLY MONTHS at Paulson & Co. were tough on Pellegrini. Worried about being overwhelmed by the details of his job, as he had been at Lazard, Pellegrini arrived at the office before 6:30 a.m. each morning, among the first to arrive. He wanted to try to have a few recommendations ready when Paulson walked in. He had another motive: Pellegrini found early-bird $18 parking a fifteen-minute walk from their office at the corner of 57th Street and Madison Avenue. The price doubled if he arrived after 7 a.m. Pellegrini wasn’t sure how long he would have the job, so he needed to save his cash.

  Pellegrini took advantage of a full, catered lunch from a local upscale eatery that Paulson offered his employees. When Pellegrini returned home to his apartment in the Westchester suburb of Mamaroneck around 8 p.m., he usually made something light, like tomato salad, cheese, and bread.

  He had no television in his small one-bedroom rental. He chose to live close to a train station and his favorite golf course. For entertainment, Pellegrini began to catch up on classic American writers, such as Edith Wharton and Henry James, authors he never had a chance to enjoy in school. Pellegrini found a connection with their stories of outsiders struggling to break into high society, including New York’s upper-crust scene, something he had failed to do at Lazard Freres and through his marriage to DeWoody.

  “I could see the divide between people who are successful and optimistic and those at the other end, having trouble keeping up,” Pellegrini says. “There’s sadness about not realizing one’s hopes and expectations.”

  Pellegrini didn’t have many friends in the area, but his sons stayed over on weekends, sleeping on a pullout couch in the living room. Pellegrini felt the likelihood of turning his life around was dropping with each day, but he wasn’t ready to give up.

  “Somehow I needed to manage to stay in the United States and support myself; I didn’t want to be in another country and not be able to see my kids,” he says. “That kept me going.”

  Pellegrini put in long hours analyzing international mergers but couldn’t come up with many good ideas for the fund. It took him longer to get up to speed than he expected, and he was as disappointed in his work as Paulson was. When Paulson met his investors, he often brought along a few associates to introduce them and show off their education and backgrounds. Pellegrini usually was left back at the office, even though he was two decades older than most of the other analysts. He didn’t complain.

  “I didn’t have a great story to tell about myself and my experience,” Pellegrini says. “I produced usable work, but it was difficult for me to carry on conversations with clients. It was nice of John to give me the job and stick by me.”

  Pellegrini was so relieved to land the position that he missed fleeting signs that Paulson himself might be losing his touch.

  Some ridiculed Paulson’s focus on mergers, which seemed out of step with the instant wealth being created in housing. At a cocktail party in Southampton in late 2004, Paulson and a friend, Jeffrey Tarrant, stood in the corner of the room discussing how overheated the real estate market had become, when Stephan Keszler wandered over, a drink in his hand. Keszler, a dashing, six-foot-three, fair-skinned native of Munich, wearing tattered jeans and a blue blazer, was well-known in the Southampton scene as a real estate success story. He had spent twelve years purchasing and renovating upscale homes in the area.

  Inserting himself into the conversation, Keszler was dismissive of his friends’ caution.

  “What are you guys trying to do, a 10 percent to 12 percent return? How does that help anyone—you can’t do better than that?” he asked. “I’m doing more than 25 percent a year; I can double my money in a few years.”

  Paulson and Tarrant turned uncomfortable. In high school, mother jokes were the meanest put-down, but among the Southampton set, it didn’t get much lower than knocking someone’s investment prowess.

  “Good for you,” Paulson responded, “but I hope you know when to get off. Real estate has gone down in the past; why won’t it end badly this time, too?”

  Keszler chuckled and shook his head, before walking away.

  Part of the reason Paulson had grown concerned about real estate was that the Federal Reserve finally had begun to raise interest rates, which eventually would push borrowing rates higher, taking away the economy’s punch bowl.

  “Who’s the most vulnerable to higher rates?” Paulson asked a group of st
affers back at the office.

  Paulson became intrigued about whether consumers, many of whom already were struggling with debt, might have difficulties handling a rise in rates. Investment banks and financial firms also were heavy borrowers, Paulson told one of his traders. Some had more than $25 of assets for each $1 of equity they held. They might also be vulnerable as rates rose, Paulson said.

  He started to look into buying protection for his firm, in case all the borrowing in the economy led to deep troubles. He wasn’t the only one getting worried, however. Enough investors had purchased “put” contracts on the Standard & Poor’s 500—futures contracts that rise in value when stocks plunge—that the contracts had become too expensive to Paulson.

  Paulson had examined shorting shares of some financial-service companies, but some companies in that business recently had received takeover offers, sending the stocks racing higher, burning those who shorted them with deep losses. Was there any better insurance?

  One day in October 2004, Pellegrini, still nervous about his standing at the firm, got up the nerve to approach Paulson in the hallway to tell his boss that there might be a better way to protect the firm’s portfolio. Why not buy credit-default swaps?

  Paulson and his team weren’t very familiar with the world of credit-default swaps, beyond a vague understanding that these instruments provided insurance against losses from debt investments. Though trading of CDS contracts had soared in volume in recent years, it was a complicated, esoteric world. Paulson was one of many investors who shied away from using these “derivative” investments, described as such because their value derives from the change in some underlying asset.

  Pellegrini knew something about CDS trading from his previous job, he told his boss, and was glad to help. The beauty of CDS, Pellegrini explained, was that they are like insurance contracts—the annual premium you pay for the protection is the only downside, unlike a bet against a stock that can result in deep losses if the shares soar.