“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 the
y 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.
7.
JEFFREY GREENE CAME ACROSS AS SOMETHING OF A HOLLYWOOD CLICHÉ. A lifelong bachelor in Los Angeles, Greene dated would-be starlets and wannabe models. When he wasn’t hosting parties for friends like Mike Tyson, Heidi Fleiss, and Paris Hilton, Greene was relaxing at one of his spectacular homes, including an estate on five acres overlooking the Malibu shore, where he had enough space for his miniature horse, Winston, to run free. Gracious and down-to-earth, Greene stood out in the Hollywood scene with his easy laugh, Harvard education, and winning touch in business.
But by the spring of 2006, Greene’s laid-back image masked growing concerns. The six foot tall, youthful-looking fifty-two-year-old, sporting thick brown hair and arched eyebrows, had spent over a decade accumulating more than seven thousand apartments and a handful of office buildings in Southern California, as if they were properties on a Monopoly board. They were valued at more than $500 million, according to the overheated prices of the time.
But as he woke one morning in his Malibu home and opened the Los Angeles Times, Greene’s face tensed. Reading fresh details of the raging local housing market, Greene was reminded that another downturn could leave him broke. He was too old to go through that again. Somehow, he had to protect himself from a collapse.
Greene called everyone he knew, from stockbrokers to business associates, asking what to do. Sell some properties and wager against shares of home builders? That wasn’t nearly good enough. Finally, Greene reached out to his longtime friend John Paulson. Paulson told him he was working on an interesting idea, something to do with shorting mortgage bonds. He invited Greene to come to New York to discuss it.
Shortly afterward, Greene walked into Paulson’s offices, excited to see his old friend. They had first met back in 1990, introduced by a mutual acquaintance over dinner at a popular Southampton restaurant. When Greene asked Paulson to join him and some young women at a barbecue the next day, Paulson eagerly accepted the invitation, riding his bicycle thirty miles to the Amagansett home where Greene was staying. Over the years, they remained close; Greene served as an usher in Paulson’s wedding; John and Jenny stayed at Greene’s Malibu home during their honeymoon. The two were a contrast in styles—Greene relaxed and outgoing, Paulson more serious and reserved. But Greene was drawn to smart people and he got a kick out of Paulson’s dry humor and expert storytelling.
As Greene patiently waited for his friend in the main conference room at the hedge fund, he glanced around the office and was impressed. Greene always had been the wealthier and more successful of the pair. When Paulson came to the West Coast, Greene usually would ask his chef to prepare a gourmet meal; when Greene was in New York, Paulson lugged bags of groceries from an upscale market before making dinner. Paulson’s firm’s previous offices had been a simple, 2,000-square-foot space.
This time, though, Paulson had new, expansive digs. On one wall of the conference room was an abstract painting by Louisa Chase of disembodied hands and feet in a swirl of blue and white; in the corner were assorted drinks and a shiny ice chest. The glass paneling provided a view of young, well-dressed traders and analysts walking briskly through the halls. As Paulson walked in, Greene was about to compliment his friend on the look of his operation. But Paulson had an intense look on his face, and a colleague was a step behind him. Paulson closed the door firmly and extended a hand to Greene, who responded with a warm hug. Paulson seemed uncomfortable with the display of affection, surprising Greene.
Sitting across a long, polished wood conference-room table from Greene, Paulson launched into an overview of the housing market, a speech he had given endless times to prospective clients. Greene was dressed casually, in a jacket, an open-collar dress shirt, and slacks; Paulson wore a full suit and tie. Greene realized Paulson was making a business presentation, not greeting a good friend.
A few minutes into the pitch, Greene tried to offer a point of his own, but Paulson cut him off.
“Just listen,” Paulson said sharply, his voice rising.
Greene wasn’t sure what to make of Paulson’s bizarre behavior. He offered no smile, leavened his speech with no humor, and maintained a strange formality. Why weren’t they chatting in Paulson’s private office, as they usually did?
It’s as if he doesn’t know me, Greene thought.
Paulson spoke for twenty more minutes, leafing through an elaborate marketing document that featured Pellegrini’s housing data. He described how Paulson’s new “credit” fund would buy protection on subprime mortgages. Greene, shrugging off his friend’s odd behavior, tried to keep up with him.
Although Greene didn’t know it, Paulson was in a difficult position. An investment from Greene would help Paulson get his new fund off the ground. But once again Paulson felt torn; if he shared too many details of his moves with his friend, others might hear of the trade and ape him, reducing any gains.
“It doesn’t take much for investors to catch on, and I had just a fixed amount I could spend” on the insurance, Paulson says, explaining his behavior.
Greene was intrigued by the presentation but remained noncommittal about the fund. He was more than a bit confused about how it all would work. Moreover, he wasn’t sure why he needed to pay to invest in a special fund to short the market, rather than just doing the trades himself as he had with previous tips from Paulson.
“Can I just do it on my own?”
Paulson looked disappointed. “There’s no way you can get ISDAs,” he responded, referring to the formal documentation from the International Swaps and Derivative Association necessary to trade the sophisticated CDS contracts.
They met again Friday night for dinner. Paulson seemed friendlier this time and more himself, putting Greene at ease.
“Jeff, this trade could be huge,” Paulson confided in Greene. “This could take me to another level.”
Greene still didn’t quite follow Paulson’s idea, though.
“I didn’t know what the hell J.P. was talking about, tranches and credit-default swaps,” Greene recalls. “It was hard to understand. You’re not shorting, exactly; it’s a derivative that mimics the bond … I figured I needed a tutor o
r something.”
Greene asked an old friend, Jim Clark, to join them for lunch the next day. He hoped that Clark, a mathematician and Ph.D. in computer science who helped found pioneering Internet company Netscape Communications, among others, could give him some guidance. But after lunch at Nello’s, a popular Upper East Side restaurant owned by one of Paulson’s friends, Clark told Greene that he couldn’t quite follow Paulson’s idea either.
Back in Los Angeles, Greene couldn’t stop thinking about Paulson’s trade. Buying cheap insurance on other people’s risky mortgages sounded too good to be true. Paulson said Greene couldn’t do the trades by himself. But Greene had built a fortune on his own; maybe he could protect it with these mortgage investments.
GREENE HAD BEEN BORN in Worcester, Massachusetts, in a blue-collar community that seemed a galaxy removed from jet-set Los Angeles. Greene’s father, Marshall, worked in the textile-machinery business, much like his own father before him, reselling machinery parts. Jeffrey sometimes tagged along as his father visited mills around New England, selling knitting spools, parts, and other machinery.
The Greene family owned a three-bedroom, one-bathroom home in a close-knit, mostly Jewish neighborhood. His mother, Barbara, taught Hebrew school three days a week. He had a sister who was two and a half years older, and a younger brother, eight years his junior. The family couldn’t afford to send their three children to summer camp, but they rented a cozy two-bedroom house near Nantasket Beach on Massachusetts’s South Shore, two blocks from the ocean.
Jeff was close to his maternal grandfather, a peddler from Eastern Europe who sold needles, thread, and other household items. Spooked by crime in the area, he had closed his store and gone door to door, extending credit to his neighborhood customers for their purchases. He often took his grandson along on his rounds.
Studious and clean-cut, Greene was on the verge of nerdy. He didn’t touch drugs and he played the trumpet in his high-school band. He never had a serious girlfriend. Slow dancing to the Bee Gees in a friend’s wood-paneled basement was as wild as it got for Greene.
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