Pellegrini sat upright, staring at his trend line, amazed at how simple and clear it finally was. When he placed the data on a chart, the visual effect was even more dramatic. The next morning, he raced in to show Paulson.
“This is unbelievable!” Paulson said, unable to take his eyes off the chart. A mischievous smile formed on his face, as if Pellegrini had shared a secret no one else was privy to. Paulson sat back in his chair and turned to Pellegrini. “This is our bubble! This is proof. Now we can prove it!” Paulson said.
Pellegrini grinned, unable to mask his pride.
The chart was Paulson’s Rosetta stone, the key to making sense of the entire housing market. Years later, he would keep it atop a pile of papers on his desk, showing it off to his clients and updating it each month with new data, like a car collector gently waxing and caressing a prized antique auto. Pellegrini’s masterpiece was a guiding light that told Paulson exactly how overpriced the housing market had become. He no longer needed to guess.
“I still look at it. I love that chart,” Paulson says. “It’s the first key piece of our research. Here was a picture of the bubble!”
To Paulson and Pellegrini, their discovery meant that housing prices were bound to fall, at least at some point, no matter what the moves in unemployment, interest rates, or the economy. And falling prices would put a quick end to all the mortgage refinancing by subprime borrowers, placing them in mortal danger.
Pellegrini’s next assignment was to figure out how to make money from their thesis. The firm had been burned shorting various housing-related companies, so it seemed to make more sense to focus on subprime mortgages themselves. Paulson and Pellegrini remained convinced that CDS contracts provided the best risk-reward proposition for the fund, since they were insurance contracts that required Paulson & Co. to make set, annual payments, limiting any losses.
Looking for help, Pellegrini found Sihan Shu, a young analyst in Lehman Brothers’s mortgage department, who claimed to be just as skeptical about real estate as the Paulson team and was eager to quit his firm to pursue the thesis.
Paulson, wary that Shu wasn’t a true believer in the bear case and was just angling for a lucrative hedge-fund job, tested him in an interview.
“We think these securities are all junk,” Paulson told Shu, referring to bonds backed by subprime mortgages, awaiting his reaction to what was then a radical stance. “They’re going to go to zero.”
Shu passed Paulson’s test with flying colors, sharing overlooked research that Lehman had done showing that even flat home prices would lead to huge losses for many slices of the mortgage bonds. Shu was hired.
Pellegrini and Shu purchased enormous databases tracking the historic performance of more than six million mortgages in various parts of the country, hiring a firm named 1010data to make sense of it all. They crunched the numbers, tinkered with logarithms and logistic functions, and ran different scenarios, trying to figure out what would happen if housing prices stopped rising. Their findings seemed surprising: Even if prices just flatlined, home owners would feel so much financial pressure that it would result in losses of 7 percent of the value of a typical pool of subprime mortgages. And if home prices fell 5 percent, it would lead to losses as high as 17 percent.
Pellegrini didn’t know how much home prices would fall, or when a tumble might begin. But if even flat home prices resulted in 7 percent losses to pools of subprime mortgages it seemed to make sense to short the slices that would be impacted by those kinds of losses, he argued to Paulson—the BBB tranches of the mortgage pools. They were the obvious targets because they would be crippled if losses of even 6 percent resulted.
“We knew that if home prices just didn’t go up, the BBBs would be extinguished and we’d be home free,” says Paulson.
He ran Pellegrini’s findings past analysts at a few banks. They tried to undercut the bearish thesis, noting that home prices already seemed to have plateaued, without the kinds of losses Pellegrini’s data predicted. Some of them, like Bear Stearns, Lehman Brothers, Merrill Lynch, and Morgan Stanley, were anxious to increase their exposure to subprime mortgages and didn’t seem to appreciate Paulson’s negativity.
“People said, ‘Your work doesn’t mean anything … you’re wrong,’ ” Paulson recalls.
But the analysts at the banks missed a subtle wrinkle in the Paulson thesis. Loans from 2005 or earlier periods were for homes that already had soared in value, so it was no surprise that big losses hadn’t yet resulted, even though home prices had stopped soaring. These were the mortgages that were easy to refinance. The losses Paulson was predicting were for more recent mortgages on homes that wouldn’t appreciate enough to be refinanced before resetting at much higher rates. Paulson didn’t have any interest in refuting the arguments of the investment firms or banks, though—he was hoping they’d sell him mortgage insurance cheaply.
Excited by this new information, Paulson stepped up his buying of mortgage protection, purchasing insurance on $100 million, $200 million, and even $500 million of subprime mortgages a day. By the spring of 2006, Paulson’s hedge funds had about as much protection on subprime mortgages as they could handle. He and his team told investors that the insurance was a perfect hedge to their existing portfolios, without getting into Pellegrini’s chart and its troubling message about the housing market.
“We always told investors that we did not anticipate a meltdown in home prices, even though the chart implied a potential decline of forty percent,” Pellegrini recalls. “We did not want to sound implausible at that stage.”
Paulson was becoming even more convinced that CDS contracts on subprime mortgages would be a winner. The cost of the insurance remained dirt cheap—just 1 percent annually of the amount being protected. Paulson couldn’t get over the potential upside—he was used to shorting a stock or bond and making 10 points if it went from 100 to 90; but if the subprime bonds backing the securitizations fell 10 percent, the lowest slices of the deals easily could become worthless, making Paulson a fortune.
“There’s never been an opportunity like this,” Paulson gushed to his research director, Andrew Hoine.
Pellegrini’s team tracked millions of loans, becoming familiar with dozens of lenders around the country. They began to suspect that rating agencies were far too generous in their ratings. Subprime mortgages now made up 14 percent of the mortgage market, up from 1 percent a decade or so earlier. Housing prices were still rising, but the pace was slowing compared with the recent surge, one more sign that real estate was close to peaking. It was the perfect time for Paulson to put on his trade.
Traders at various investment firms told Paulson and his team that most of those selling mortgage insurance weren’t investors who understood either the securities or the real estate market. Some weren’t even especially bullish on housing. Rather, firms like Merrill Lynch, Morgan Stanley, and Credit Suisse were selling insurance to Paulson because they were eager to use the flow of CDS insurance payments from Paulson and other bears to create new investments for their clients. To Paulson, it was another reason to step up his buying of the insurance.
“We’ve got to take as much advantage of this as we can; it’s just a matter of time,” before the mortgages run into problems, Paulson told Hoine. “We really have to short as many securities as we can.”
Paulson’s funds already had committed to paying $100 million annually to buy insurance on $10 billion of risky mortgages. But it was always something of a stretch for the merger fund, or even some of Paulson’s other funds, to turn to these mortgage derivative investments as a hedge, and Paulson knew he couldn’t justify adding much more to the funds.
Paulson was tempted to use some of his own money to buy some mortgage insurance for his personal account and leave it at that. But he knew this was his chance to swing for the fences. To make a really huge score, he needed to sell investors on a new fund specifically dedicated to betting against these subprime mortgages. Earlier, Michael Burry had failed to convince in
vestors to back a similar fund. Now Paulson would take his own shot.
History wasn’t on his side, however.
6.
“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.
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sp; 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
The Greatest Trade Ever Page 13
