About an hour into the meeting, Rosenberg gently knocked on the door, interrupting the group. Entering the room, he leaned into Paulson’s ear, whispering something. Paulson immediately rose, apologized, and stepped out, leaving his guests staring at an array of Snapple iced teas.
Ten minutes later, Paulson returned, appearing much more upbeat, almost jovial. A wide, Cheshire grin streaked his face. Something had happened in those few minutes away from the room; the more they watched Paulson, the more it seemed he was holding a secret that he was dying to share.
Finally, one of Paulson’s guests asked if he was needed elsewhere and whether they should reschedule the meeting for a more suitable time.
Paulson finally blurted out what was on his mind: “We just got our marks for the day. We made a billion dollars today.”
The investors were stunned. They had never heard of such a quick profit and didn’t know what to say. In that instant, they knew they could no longer afford to buy a piece of Paulson & Co. Rising to leave a few minutes later, they shook hands and asked Paulson how much further his trade could go.
“I think they’ll all go to zero,” referring to the value of subprime home mortgages. “But I think I may need to get out of the positions” ahead of time, to try to ensure a profit. “That’s the trick,” Paulson told them.
IT WAS THIS VERY ISSUE that caused a growing rift with some of Paulson’s investors, and even Pellegrini.
Most of his clients were thrilled with the sudden gains. But some were worried. Just as Paulson would look foolish if he built up huge gains only to fritter it away, many of these investors would be embarrassed if they stuck with Paulson and the profits later vanished. Investors in Paulson’s other funds, which also owned some of his CDS mortgage protection, were especially on edge. They didn’t have much experience with these kinds of derivatives, or those kinds of fast returns, and it was making them nervous.
Investors from Credit Suisse insisted on moving their money out of Paulson’s merger fund that owned subprime protection and into another merger-investment fund without any CDS insurance, perplexing Paulson.
Another investor called Paulson & Co.: “If I could withdraw from your fund, I would. You’re crazy, you should realize your gains.”
Paulson patiently argued that subprime-mortgage prices were only beginning to drop.
“Take off half your gains then,” the unhappy investor replied, recalling stories of other investors who squandered big gains.
“I couldn’t convince them,” Paulson recalls.
Some investors began to hassle his employees.
“Get out. You guys have made 60 percent; isn’t that enough?” one investor badgered a staffer. “Why isn’t he covering? What’s he doing??”
When Tina Constantinides, a Paulson employee who dealt with investors, went to an industry conference in Florida, Tom Murray, a client of several Paulson funds, kept calling, insisting that she get back to him. Murray worked for the U.S. unit of EIM, a Geneva-based firm that invests in hedge funds and is led by Arpad Busson, a flashy international investor who had fathered two sons with supermodel Elle McPherson, his onetime girlfriend, and later became engaged to actress Uma Thurman.
“You’re taking on a new type of risk,” Murray told her. “How am I supposed to explain it to my investors?” Murray and his team said the investments Paulson was using were outside his area of expertise and had become too large a part of his firm’s focus.
Constantinides tried to explain to Murray that the purchase of the CDS contracts represented little risk for Paulson’s funds. But after several weeks of analysis by Murray and his staff, Murray insisted on moving EIM’s money out of one fund and into Paulson’s merger fund, which held fewer subprime investments.
After a barrage of calls from other concerned clients, an anxious Constantinides walked into her boss’s office, asking what she should tell the investors.
“The data’s getting worse,” Paulson said, soothingly. “Tell them to be patient.”
Paulson’s reassurance gave Constantinides the confidence to push back at the investors. But other employees of the hedge fund, some of whom weren’t as familiar with the subprime trade, whispered that Paulson should sell more positions, in case the subprime market recovered.
Even Pellegrini, an architect of the trade, became convinced the firm was making a big mistake.
THE YEAR HAD STARTED OFF WELL for Pellegrini. The hedge fund’s huge gains in February were Pellegrini’s first outright success in many years. And though the ABX soon rebounded, Pellegrini was promoted to a managing director of the hedge fund, his new stature confirmed.
As the fund added to its holdings of CDS protection, Pellegrini pored over the latest housing data into the evening, sometimes past midnight. One evening, as Wong wished him good-night, Pellegrini was so caught up in his work that he didn’t even notice his colleague.
To relax, sometimes Pellegrini headed to Monticello Raceway, in Upstate New York, to drive a Ferrari around the track once or twice, before heading back home.
Pellegrini had become engaged to Henrietta Jones, a British-born executive in the retail business. That May, they were married and enjoyed a honeymoon in northern Italy at Villa del Balbianello, a historic villa overlooking Lake Como, the breathtaking location featured in Daniel Craig’s rejuvenated James Bond thriller Casino Royale.
Pellegrini always had been superstitious, something he attributed to his Italian heritage. As the trade began to work, he became more so, trying everything he could to avoid bringing bad luck upon himself and the firm: No hats on the beds. Lots of salt thrown about the rental apartment they moved into on the Upper West Side. And never any talk about the trade.
As a result, his wife only had a vague sense that Pellegrini was scoring big. Sometimes she asked how it was going, but Pellegrini only smiled kindly, without giving many details.
One day in the summer of 2007, after reading about troubles in the subprime market, she turned to Pellegrini. “This is really good for us, isn’t it?”
“Yes,” he said, still not giving her much.
Pellegrini now held the title of co-manager for Paulson’s two credit funds. But Paulson was the only one with the authority to direct a trade. Pellegrini sometimes felt left out. He encouraged Paulson to stick with the cheapest protection, rather than buy insurance on the ABX, which was a bit more expensive. But Paulson usually overruled him.
“Forget it, Paolo, what’s the difference? So you pay a hundred and fifty basis points instead of a hundred,” Paulson said, reminding Pellegrini that they’d still make out well.
That’s easy for John to say, he’s rich already, Pellegrini thought.
They also disagreed about the need for secrecy. Laying low enabled the fund to accumulate more positions at cheap prices, in Paulson’s view. But Pellegrini figured the cat was out of the bag, and that everyone on Wall Street knew what they were up to. He had controlled his emotions for more than a year and it was getting harder for him to continue doing so.
One day, Goldman Sachs economist Jan Hatzius and an analyst, Michael Marschoun, hosted a conference call to discuss the housing market. Pellegrini and Paulson listened in, sitting in their respective offices.
During the call, Hatzius predicted falling home prices. Later on in the call, Marschoun said falling home prices would lead to losses for mortgage investments. And yet, Marschoun’s outlook for mortgage debt was surprisingly upbeat, because he was more optimistic about home prices.
To Pellegrini, it was one more example of two-faced investment banks doing all they could to keep prices higher and to avoid putting accurate prices on the mortgage protection that firms like Paulson owned. Pellegrini was convinced that his big score would be taken away by Wall Street’s establishment.
After listening to the question-and-answer session for several minutes, Pellegrini couldn’t hold back any longer, asking a question of his own.
“I just want to know why Mr. Hatzius and Mr. Marschoun don�
�t talk to each other.”
Almost as soon as the words were out of Pellegrini’s mouth, Paulson sent an underling racing into Pellegrini’s office to disconnect his phone.
A few minutes later, Paulson charged in, red in the face.
“You’re being too smart for your own good, Paolo.”
“He was pissed,” Pellegrini recalls. “But from my perspective, it was almost like a conspiracy against us. I was saying, ‘Hey, this stuff is mispriced; let’s get on with it already.’ ”
With each piece of bad news for subprime mortgages and the housing market, Paulson directed Rosenberg to sell select CDS contracts, to lock in profit. By the summer, the firm had exited about one-third of its positions, securing hefty gains. Rumors swept Wall Street of multibillion-dollar CDO losses at Merrill and Citigroup. At Goldman Sachs, a team that included Josh Birnbaum, the trader who once had been skeptical of Paulson’s heavy buying of protection, had turned bearish. Now they, too, were raking in profits.
Almost all of the selling at Paulson & Co. came from its various older hedge funds, such as Paulson’s merger fund, however. He resisted selling much from his two credit funds, the ones that Pellegrini worked on.
Bear Stearns had backed off its threat to buy home loans to influence the value of all those mortgage pools that Paulson had bet against, but the threat still seemed real to Pellegrini. His experience working at a large investment bank made him deeply suspicious. All a bank had to do was buy some troubled loans and keep the losses of a pool under 5 percent, and Paulson’s trades would be in trouble. Pellegrini continued to worry.
Later in the summer, Pellegrini again approached Paulson, walking into his office during a busy morning of trading.
“John, let’s do some trimming,” Pellegrini asked. “Let’s cover some of these.”
Paulson glanced up from the paperwork on his desk, looked at Pellegrini for a moment, and then went back to his work, without even responding. He had heard it all before.
A few weeks later, as Pellegrini huddled with Paulson in his office, quietly debating the market, Rosenberg turned in his seat to call out to his boss.
“John, we have a large bid to take off the index.”
Pellegrini looked at Paulson, plaintively. They had received a big offer to buy a chunk of the hedge fund’s CDS protection.
“John, let’s do it.”
Paulson didn’t hesitate.
“No, I don’t want to take that much off.”
Rosenberg began to sense growing tension; in meetings, sometimes Paulson and Pellegrini cited different pieces of news to support their competing views.
Pellegrini had all his wealth tied in the credit funds, unlike Paulson, and he grew increasingly fearful that his chance to cash in on a fortune was about to be squandered.
Pellegrini knew Paulson could resist selling positions from the credit funds because investors were locked into the funds for two years. And Paulson already had reaped gains for himself by selling subprime positions from his other funds. But Pellegrini’s wealth was tied to the credit funds. With each passing day he worried he might miss out unless they exited positions.
John’s already made money from the trade, Pellegrini thought. But I’m left with all the risk.
IN CUPERTINO, CALIFORNIA, Dr. Michael Burry held some of the same positions that John Paulson did. As problems in the subprime market multiplied in early 2007, his mortgage protection gradually rose in value, two long years after he began buying it up.
But rather than congratulate him, many of his investors hadn’t yet forgiven Burry for moving the investments into a sidepocket account several months earlier. And Burry’s brokers, like Paulson’s, were proving slow to mark down the value of a range of subprime mortgage–backed securities. Burry insisted to his investors that the side account, representing protection on $1.8 billion of mortgage securities, was worth much more than the $120 million value his brokers placed on it. They were having none of it. Burry’s investors pulled another $50 million out of his hedge fund, placing him under more pressure.
Chafing under their criticism, and uncomfortable about locking the investors into the account, Burry reluctantly began selling some of his mortgage insurance. Maybe the sales would prove that his strategy was working, and he could win back his investors, he hoped.
In February, Burry put a small amount of the mortgage protection up for sale, testing the waters. The interest was overwhelming, enabling Burry to sell the protection for twice the price that his brokers had placed on his investments.
I knew they were screwing me! he thought.
Burry sold more pieces over the next few months, pocketing huge gains. The turn of fortune did little to reduce growing tensions within Burry’s office, though. Scion’s chief financial officer fell behind on the firm’s 2006 annual audit. Burry was forced to tell his investors that their tax statements for 2006 would be delayed, and that they couldn’t rely on the preliminary statements already sent to them. If the investors needed another reason to turn on Burry, now they had it.
The CFO soon said he was leaving the company, forcing Burry and his team to scramble to complete the audit and send the statements to investors in time for them to meet a June tax deadline. Then Burry found a discrepancy of about $1 million between the cash he had on hand and what was recorded in the firm’s books. It seemed an oversight by his staff, but Burry wasn’t sure.
Hoping for a respite, he took his family on a weekend getaway to a luxury resort in nearby Berkeley Hills. On the drive to the hotel, Burry’s cell phone rang—it was another irate investor asking about the tax statements. He couldn’t get away from it. As he put down his bags in the hotel room, still another call came through.
“How do I know there isn’t a big fraud going on over there?” another investor asked.
Burry didn’t know how to respond. He didn’t think anything was amiss, but he didn’t feel comfortable reassuring investors since the final audit wasn’t yet complete. His reaction made the investors even more nervous.
Burry’s team finally completed the audit, barely beating the June deadline. But it didn’t prevent clients from yanking still more money from the fund. Burry lay awake at night, trying to figure out what he had done wrong and how to make things right again.
Subprime mortgages finally were falling, as he predicted, but Michael Burry was having difficulty just keeping himself, and his company, together.
12.
ONCE AGAIN, THE PHONE RANG IN ALAN ZAFRAN’S OFFICE. IT WAS late morning and the caller identification flashing on his assistant’s keyboard showed a Los Angeles number. Zafran already knew who it was: Jeffrey Greene, with yet another urgent, angry call.
Months earlier, Zafran had moved from Beverly Hills to Menlo Park, in Northern California’s San Mateo County, to steer his children away from the neuroses so prevalent in the Hollywood scene. Zafran still enjoyed dealing with Greene, though.
The hefty trading commissions were a big part of it, of course. But the more Zafran understood Greene’s trade, the more he pulled for it to succeed. To him, Greene was a lone individual challenging an industry of cockeyed optimists and cynical charlatans, a modern-day David fighting Goliath. Zafran had come to appreciate Greene’s dogged research and enjoyed helping him discover obscure housing data that might give him an edge in his trade.
But by early 2007, the calls were becoming more incessant and more heated. The pressure on Greene was building.
Greene seemed too well-off to have many real concerns. He gave his net worth on his application to Merrill Lynch for approval to buy CDS derivative contracts at $350 million, and he was a major figure in the L.A. social scene.
But at Merrill Lynch, some were not sure whether the figure they came up with for Greene’s net worth was entirely accurate. He had millions of dollars of debt and an expensive lifestyle, paying for two fulltime caretakers at his Malibu home and upkeep on three jets, including a Gulfstream. His real estate was valued at about $250 million, but it was
rapidly falling in value and wasn’t very liquid. Greene had about $100 million of other assets, but a few years of failure with his trade threatened to eat much of that up, too.
Indeed, Greene had committed to pay $14 million a year to buy CDS protection on $1 billion of subprime mortgages. And he put up about $60 million with the brokers to allow him to do the trade. Greene owned so much protection, and put so little down, that when subprime-mortgage prices rose just slightly in late 2006, he received margin calls from Merrill Lynch, forcing him to fork over several million dollars from other accounts just to keep his brokerage firm from closing out his trade.
Greene had bragged to friends and business associates about his moves and how they would pay off. His very reputation and sense of self-worth seemed tied up with the trade. But Greene’s investments weren’t moving, and he couldn’t figure out why. He had tried to find a friend or two to join him in the trade but had failed, so Greene increasingly leaned on his two brokers.
Sometimes the calls would last hours, as Zafran patiently explained why Merrill Lynch’s updated prices suggested that Greene wasn’t making much money on his trade. If real estate tumbled but his trade didn’t pan out, Greene would be in deep trouble.
Greene turned short, nasty, and confused when he heard the disappointing news. Picking up the call this morning, Zafran braced himself for more agita from his relentless client.
“Alan, are you aware of the kinds of loans being written?! I don’t get it, why aren’t these prices moving?”
Zafran tried to explain it as best he could, though he himself was a bit baffled. Housing data was getting worse and yet the Merrill Lynch traders that Zafran consulted continued to say that the insurance contracts Greene owned were not much more valuable than they were a few months earlier.
“It feels rigged! Figure it out for me, Alan!” Greene said, ending the call.
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