The Greatest Trade Ever

by Gregory Zuckerman

  “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 f
latten 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, Paulso
n’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.