He picked an opportune time to ask. By late 2006, Wall Street firms were squeezing every last drop from the housing market. After hemming and hawing, his contacts at Lehman Brothers and Bear Stearns agreed to sell him CDS contracts, as long as the paperwork was approved by their superiors. But they insisted that their credit departments approve Lahde before each trade he made, much like a parent insisting on accompanying a new driver.
One day in November, just after 5:30 a.m., the phone rang in Lahde’s bedroom, startling him. His broker at Lehman Brothers called to say the paperwork was complete and Lahde could begin trading. Not only that, but the CDS insurance contracts he wanted were so unpopular that Lahde actually would be paid an up-front fee if he agreed to pay regular premiums on this insurance for risky mortgages. Lahde fumbled with the phone in the dark, trying to make out the implications of the quote.
Do you want the trade, the broker asked?
“Do it,” Lahde responded, before he rolled over and went back to sleep.
Over the next few weeks, Lahde accumulated more protection on slices of the ABX index, ranging from those rated BBB– all the way up to AA, focusing on mortgages handed out during the first half of 2006, when the market was at its most exuberant.
But Lahde’s stress level was building as the new year approached. He’d hired an associate for his firm, legal bills were due, and Lahde was down to $100,000 of savings. Even after raising another $1.5 million and buying more CDS contracts, he owned protection on just $17 million of risky mortgages, a figure so puny by Wall Street’s standards that it was embarrassing. The trade of a lifetime was slipping through his fingers. Unless Lahde could quickly raise some serious money, he would have to shutter the firm and look for a job.
A friend called to level with Lahde: The brochures with the summary of his investment thesis that he’d been sending out to prospective investors made him look like a rank amateur. Lahde had to concede the point.
A week before Christmas, Lahde sat down at his circular, glass desk, which doubled as his apartment’s dining-room table, to rework his marketing materials. He kept at it, writing and rewriting the presentation, again and again. He canceled Christmas plans. Pretend I’m in a submarine and out of touch, he told his mother. Lahde put in a series of all-nighters, including one on New Year’s Eve, finally finishing on January 7. The marketing materials now looked impressive. But he wasn’t sure he had enough time left to pull off his trade.
IN LATE 2006, Paulson stayed upbeat. He was waiting for his trade finally to begin to work. In November, he closed his fund, the Paulson Credit Opportunities Fund, to new investors. He had raised $700 million and spent it all on various mortgage protection. Paulson immediately launched a sister fund to make the same bets, even though his trade, though profitable, wasn’t clicking.
To let off stress, he spent hours swimming and sailing in Southampton, and playing tennis with his friend Tarrant, displaying a nasty serve. To keep his employees loose and upbeat, Paulson sometimes adopted a faux British accent, keeping the ruse going during an entire dinner with one client. Paulson started one meeting about the mortgage business with a spot-on imitation of a current television commercial:
“You just filed for bankruptcy? No job? No problem! No money down!”
For all his equanimity, however, his concern was growing. What if the subprime market really did collapse—who would be on the hook for the billions of insurance he was buying?
“We didn’t know who was selling it all to us,” recalls Rosenberg, who traded with investment banks, not directly with those who sold Paulson & Co. insurance. “But if the sellers got in trouble, it would hurt the investment banks.”
Concerns about the health of his brokers led Pellegrini to set up separate accounts for the firm at various banks, and to settle positions with his trading partners on a daily basis.
Paulson’s outlook for the financial system became downright glum as a new advisor gained his ear. Paulson came across a newsletter published by an obscure economist in suburban New Jersey named A. Gary Shilling that predicted dour things for the economy. Paulson was so taken with the forecast that he asked Rosenberg to call Shilling and invite him to come by, to discuss his views. Shilling had spent more than a decade publishing a newsletter and periodic articles, usually with a single theme: The bad times were around the bend—sell everything! Most dismissed Shilling’s warnings, sometimes with a laugh. The end was never as near as Shilling predicted.
Paulson was a merger guy—he didn’t know Shilling was Wall Street’s version of the Boy Who Cried Wolf. When Shilling met with Paulson and predicted a collapse of home prices and a sharp rise in mortgages foreclosures, Paulson took notice.
Shilling, a septuagenarian with bushy eyebrows and a balding pate, favored bright-red pocket handkerchiefs in his blue blazers. He emphasized to Paulson’s team that the subprime market wasn’t a fringe area, but rather a key underpinning to the entire real estate market. When it went, so would housing, bringing down much more.
“Boy, if you’re right, the financial system will fall apart,” Paulson said to Shilling, after one more dire forecast to a room of Paulson’s analysts.
“Yes, John, it will.”
Shilling, who vividly recalled the tears in his father’s eyes during the Great Depression, predicted that housing prices would fall 37 percent.
“Do you really think it’s going to get that bad?” Paulson asked, after another dire forecast.
“As sure as you can be.”
Paulson began to focus on the linkages, and how troubles for subprime borrowers could topple housing, which might in turn bring down the financial system and the global economy.
This could really get bad. We need to broaden the trade.
But even Paulson didn’t realize how quickly his prediction would come true.
11.
PAOLO PELLEGRINI RECEIVED AN URGENT PHONE CALL IN EARLY 2007 from a trader at a major bank eager to lend him a hand. The prices of some home-mortgage bonds had weakened a bit, helping Paulson & Co.’s positions. But the trader reminded Pellegrini that those same subprime investments had dropped in price in late 2005, before quickly snapping back. It could happen again, costing Paulson the small profits it had achieved from its trade, he warned.
“Why don’t you sell us back your positions so you can buy them back cheaper in March?” the trader advised Pellegrini.
Pellegrini was convinced his counterpart was trying to sow seeds of doubt. If Pellegrini followed his advice and exited positions, the trader might be able to get out of CDS insurance he had sold Paulson & Co. Or maybe he was trying to discourage Paulson from buying more protection, given the pressure it put on mortgage investments owned by the trader’s bank.
“I actually don’t know how much we have,” Pellegrini replied. “We may have sold already.”
Pellegrini was playing coy. He knew his boss was quietly raising the stakes of his bet, rather than cashing in his chips, putting to work money that was arriving daily from new investors. Paulson even had Rosenberg buy CDS insurance on mortgages with a high A rating—investments that others saw as relatively safe—not just BBB bonds.
To Paulson, it seemed obvious that housing was about to crack. Borrowers with spotty credit were running into trouble paying their loans. HSBC and others were dealing with problems, and subprime lenders, worried they were running out of borrowers, dropped already-low underwriting standards to hand mortgages to those with even weaker credit.
Despite those concerns, investment banks were fighting with one another to acquire subprime lenders, as if they were picking over the last jewels of a treasure chest. In January 2007, Stanley O’Neal and Merrill Lynch proudly unveiled an agreement to pay $1.3 billion to buy First Franklin Financial, one of the largest subprime lenders; Merrill now had more than $11 billion of such loans, even though the firm’s own economists predicted a decline in housing prices of up to 5 percent. Morgan Stanley and Deutsche Bank, with billions of their own loans to borrowers
with sketchy credit, also purchased subprime-lending companies.
Reading about it all on his Bloomberg computer terminal, Paulson shook his head, bewildered. He picked up the phone to speak with his old friend Howard Gurvitch.
“It just doesn’t make sense.… These are supposedly the smart people.”
But so far the prices of mortgage bonds hadn’t fallen very much and CDOs built on risky BBB-rated loans were barely moving, preventing Paulson from making much money.
When will the market catch on? he thought.
Paulson was particularly aggravated by New Century Financial. The nation’s second-largest lender to borrowers with iffy credit was smashing earnings records and enjoying a climb in its share price, even as other subprime lenders reported growing problems. Some home buyers weren’t even making their first payments. Yet New Century claimed its performance was getting better. New Century executives explained that its underwriting was more thorough than its competitors’, allowing it to grab business as the rivals faltered.
Paulson wasn’t buying it. He asked an analyst to track loans made by New Century; he found its mortgages were running into more problems than those of its rivals, not fewer, feeding Paulson’s suspicions.
“They’re lying through their teeth. It’s just not possible!” Paulson told Pellegrini, displaying unusual emotion after another aggravating day of watching New Century’s shares rise. “These guys are preying on poor people!”
In early January, when Paulson shorted the company’s shares, betting that they would go down, competitors snickered. New Century’s largest shareholder was David Einhorn, the frequently praised investor and poker-tournament champ who counted actor Michael J. Fox among his loyal clients.
A salesman called Rosenberg expressing caution.
“Do you realize that Einhorn is on the board of New Century?” he asked. “He does serious due diligence.”
The respect New Century commanded on Wall Street grated on Paulson. Every few hours, he got up to walk by Rosenberg’s desk and check on his trades or receive an update on market chatter. Sometimes Paulson pulled up a chair and put his feet on the desk, watching CNBC on a nearby monitor.
Paulson’s apparent calm reassured his staff. But in fact he was impatiently counting down to February 7, the day New Century was scheduled to release its 2006 results. You can lie about first-quarter, second-quarter, and third-quarter earnings, Paulson theorized, but year-end results are audited by an accounting firm, forcing a company to come clean.
Sitting at his desk late in the afternoon on February 7, a paper bag of red cherries nearby, Paulson looked up to see Andrew Hoine almost running toward him. Hoine placed a press release from New Century on Paulson’s desk and watched him digest the news: New Century had reported an unexpected loss for the fourth quarter of 2006.
“John, these guys are blowing up!” Hoine blurted excitedly.
Paulson, peering over his tortoiseshell bifocals, read on: So many of New Century’s borrowers were running into problems paying their loans that the company was forced to take back loans it had sold to various banks, reducing the company’s previously reported profits for almost a full year. It turned out that New Century was just like the other subprime lenders.
Paulson looked up at Hoine, a look of relief across his face.
“Finally.”
The news was a glass of cold water to the face of investors. The next day, New Century’s stock plunged 36 percent on huge trading volume, Paulson’s first big score.
As bond trading got under way in the morning, Rosenberg dialed a broker to get the latest quote on the ABX index. The response left him agape.
“Repeat that?! Did you say it’s down five points?!”
Paulson held insurance on $25 billion of subprime mortgages. So a 1 percent move in the ABX index—or each single point drop—meant a 1 percent profit for the firm. That worked out to about $250 million. The 5-point move meant Paulson & Co. had just pocketed $1.25 billion—$250 million more than George Soros scored with his legendary bet against the British pound. All in a single morning!
Watching the ABX on the screen in his office, Paulson was transfixed by the figures flashing by.
“This is unbelievable,” he muttered.
As the ABX plunged further over the next few weeks, Paulson kept his emotions under wraps. Employees sometimes caught glimpses of his building excitement, though. Leaving at the end of the day, he often had a big smile on his face. Instead of snapping at the small mistakes of his staff, Paulson became patient with them.
One afternoon in February, after the close of trading, Paulson wandered into Hoine’s office and sat in a chair near him, crossing his legs and flashing a mischievous grin. Slowly, he raised then dropped his hands on the armrest, without saying a word, his grin turning into a broad smile. Hoine didn’t have to ask—it was another good day.
Paulson and a few staff members followed the ABX index on their computer screens. His other investments, such as those betting against select subprime mortgage bonds and various CDOs, were harder to track because they didn’t trade as frequently and weren’t tracked with an index.
To get a sense of how the entire portfolio was doing, the firm’s risk manager, Adam Katz, came around twice a day to deliver a printout of each position to Paulson. The mere sight of Katz rounding the bend, making his way to Paulson’s office, sent the hearts of Paulson’s team aflutter, just as the bells of an ice-cream truck get a child’s heart racing. They knew the better the firm did, the larger their bonuses would be. Some staff members squinted to try to see Paulson’s reaction to the printout, but he usually maintained his poker face.
Many of Paulson’s clients were unaware of the growing troubles for subprime mortgages, news that didn’t yet grab many headlines. A few weeks later, after they received a letter describing the fund’s results for February, Jim Wong, the head of investor relations, received a call from a major client who sounded bewildered.
“Is this a misprint?? It’s 6.6 percent, right, not 66 percent??”
But it wasn’t a mistake—Paulson’s credit fund had climbed 66 percent that month alone. Investors were incredulous. Paulson never before had gained anywhere near 66 percent, even in a full year. Some investors remained so dubious that Wong and his staff had to reiterate that the figure was indeed accurate.
“They wanted to hear it again, to make sure it was real,” Wong recalls. “They were shocked.”
Wong became uneasy delivering the results, sure investors wouldn’t believe him or would think the firm had done something incredibly risky to produce those kinds of profits.
“It was just so off-the-wall that I felt uncomfortable,” he recalls.
Panic soon swept the rest of the financial world. On Morgan Stanley’s huge trading floor in Midtown Manhattan, hedge funds made urgent calls to their brokers, desperation in their voices.
“We missed it!” one bellowed into the phone, frustrated that he hadn’t purchased any mortgage insurance. Some barely knew what a CDO or a CDS was, pleading for immediate tutorials. Calls also came from traders at big banks like Citigroup, Merrill Lynch, and UBS, who were frantic to get their hands on CDS insurance. The buying sent the price of the ABX still lower, adding to the angst.
Paulson’s trade finally was working. His two credit funds had spent about $1 billion to buy CDS protection on $11 billion of assorted subprime mortgage investments. His merger and other funds together spent another $1 billion or so for insurance on $14 billion more mortgages. Already he was sitting on extraordinary gains of about $2 billion.
Banks and others now owed Paulson an amount of money that rivaled any sum owed in a financial trade. Some of them balked at forking all that cash over to Paulson before the CDS contracts were ended. Pellegrini and his team insisted, though, citing terms of their agreements, and the money was handed over. One bank dared Paulson to cause a default but ultimately backed down and posted the required collateral, a huge reverse margin call. The amateurs were putting
the screws to the pros.
Paulson sold a bit of his CDS protection, to lock in some profits, but he clung to most of it, convinced that much worse was ahead for housing. The trade had become much riskier, however. When the cost of mortgage insurance was dirt cheap, Paulson was able to pay very little for protection, limiting his risk. But now that the ABX had tumbled from 100 to 60, Paulson had a lot more to lose—the index easily could snap back to 100. If the mortgage investments recovered in price, Paulson would be known as the investor who let the trade of the year slip through his fingers. For days, Pellegrini grew increasingly anxious about this prospect. Finally, he walked into Paulson’s office with a recommendation.
“We should probably do some selling here, John.”
Paulson looked Pellegrini straight in the face before giving him a curt reply: “No.”
Pellegrini knew he wasn’t going to get anywhere by protesting. He walked out, disappointed.
Pellegrini’s fears soon proved well placed as it became clear that the industry was rallying behind subprime mortgages. Those with the most at stake, such as Bear Stearns, seemed the most eager to race to the defense of the market. The firm was the fifth-largest underwriter of subprime mortgages and generated a big chunk of its profits trading this debt. Bear also operated two large hedge funds run by investor Ralph Cioffi that owned all this debt.
Gyan Sinha, Bear’s top mortgage analyst, convened an urgent conference call for clients to discuss the ABX index. Paulson and Pellegrini were among those who listened closely as Sinha addressed nine hundred investors. Most were hanging on his every word, eager for guidance in dealing with the crumbling market.
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