The Greatest Trade Ever

by Gregory Zuckerman

  “If we’re making all this money, who’s on the other side?” Paulson wanted to know. Maybe there was a chance to pull off another big trade by wagering against some of these apparent losers, Paulson thought. Even if it was half as alluring as betting against subprime mortgages, it could be a coup.

  Hoine spent days pestering the salesmen selling Paulson all that protection. Was there a big, bullish investor on the other side of the trades? Was it a group of hedge funds or some other investor?

  The salesmen weren’t allowed to give Hoine much intelligence, in keeping with custom in the marketplace, where trades are supposed to take place in anonymity. But after asking enough questions, Hoine began to surmise the answer: Banks were selling subprime protection to investors like Paulson and often keeping the positions for themselves. The banks then fed the positions to CDOs and other products and kept slices of the CDOs on their balance sheets, like retailers holding on to the merchandise for their own families.

  “They wouldn’t say the specific banks, but we got ideas,” Hoine says. “You could tell from traders that Merrill and some others couldn’t sell it all.”

  It all made sense to Paulson. Much like Greene on the West Coast, Paulson has been struck by how far the ABX index had fallen for much of the year, even though prices of most CDOs and other mortgage pools made up of subprime mortgages were barely budging. The CDOs and other pools didn’t trade as frequently as the ABX, so there was a lag in their pricing, Paulson understood. But he became concerned that banks were overstating the value of the CDO slices they quoted, to avoid owning up to big losses of pieces that they themselves owned. Paulson had an associate join a group of hedge funds to write a pointed letter to the Securities and Exchange Commission. Now they were asking questions of the banks.

  Even if the inquiries didn’t lead anywhere, Paulson knew that as long as the ABX kept tumbling and home owners continued to have difficulties meeting their monthly mortgage payments, all the pools of dangerous mortgages, and the CDOs built from them, were bound to eventually fall in price, too. Then, the banks and others holding these investments would have to record deep losses because they held so much of it themselves. It was just a matter of time before the pain began.

  It was no secret that banks and investment banks like Merrill Lynch, Morgan Stanley, Countrywide, and Bank of America had pushed into subprime lending. They hadn’t acknowledged any huge losses just yet, though, reassuring some investors. But as the ratings companies lowered their grades on various pools of subprime home loans, it would have to happen, Paulson told Hoine.

  Hoine and another analyst at the fund took a guess at how exposed various banks were to CDOs, and to every kind of home loan—subprime, “Alt-A,” “jumbo,” and “Prime-rate.” They added up all the potential losses and compared them to the capital of the banks, instantly identifying which institutions likely would run into problems. Then they figured out how many of the banks’ assets could be difficult to price or sell, called Level One and Level Two assets, adding more demerits to certain banks.

  Paulson kept shaking his head as he read the latest figures on how much money investment banks had borrowed to run their businesses. It made him more certain of trouble ahead. Hedge funds like his could never get away with all that leverage, he said.

  “This could be the next wave!” Paulson exclaimed to Hoine as he showed him a spreadsheet of all the debt problems.

  They also realized that those selling the CDS contracts didn’t have to set aside much money to cover payments they might have to make. An investor selling Paulson CDS insurance on even $1 billion of subprime bonds didn’t have to have nearly as much money ready to pay for it.

  When Rosenberg told Paulson how inexpensive it was to buy CDS protection on a range of financial companies, it reminded Paulson of his subprime trade—very little downside and tons of upside.

  So the Paulson team began accumulating protection on all kinds of companies. CDS contracts to insure $100 million of Bear Stearns debt cost just $200,000? We’ll take it! Lehman protection costs $400,000? We’ll take that, too, please. UBS, Credit Suisse, and all kinds of other big financial players? Most definitely. They could have it all for well under 0.50 percent of any amount they wished to insure. It was as if Paulson’s team was shopping at a dollar store, but finding the choicest goods from Tiffany down each row.

  “Look at these spreads!” Paulson said to Rosenberg after getting an update on the latest pricing. “You don’t need a smoking gun” proving that a bank was in trouble—the insurance was so cheap, it was worth holding just on the off-chance trouble developed.

  As Paulson recounted it all to Tarrant on the train out to Long Island, his friend turned anxious. He recently had met a senior banker who hinted at “systemic” problems if the housing market turned still lower. Now he had confirmation of his worst fears.

  “Oh my God, these guys really have retained it all,” Tarrant said.

  Paulson moved closer to Tarrant’s seat, trying to keep their conversation private.

  “It’s even beyond that, Jeff,” Paulson said quietly. Even if it turned out that the banks had somehow sold off much of the mortgage protection to clients, the losses likely would run so deep that the clients wouldn’t be able to handle them, leaving the banks on the hook.

  “They’re stuck,” Paulson said, referring to the big banks, which seemed in trouble either way.

  In one sitting, Paulson had described why the entire financial system was in jeopardy. And yet, Paulson seemed calm, even upbeat. Tarrant couldn’t figure out why.

  “What are you going to do?” Tarrant asked.

  Paulson confided that his firm had purchased CDS protection on all the investment banks his firm traded with. That way, even if they went under and couldn’t pay him his winnings, he’d profit on the way down.

  “How can these smart guys get into these positions?” Paulson asked with a shrug of his shoulders and a little smirk, as if he had it all figured out. Tarrant was left shaken, unable to muster much of an answer.

  When they got off the train, Paulson and Tarrant were met by their wives and whisked away to their respective estates.

  But Tarrant couldn’t shake a morose feeling.

  Over a martini that night, he described Paulson’s doomsday scenario to his wife. That night, Tarrant, normally a deep sleeper, tossed and turned, waking her. Tarrant had figured that investing with Paulson was like a security blanket, one that could protect him and his firm in case housing and the economy went south. But the conversation he had with Paulson on the train left Tarrant rattled. He realized he was going to need much more protection for the coming storm.

  BACK IN NEW YORK, Paulson received another tip that bigger problems were brewing. In September, a nanny for Paulson’s two young daughters quit and moved out. Bills began to come for the woman, an immigrant from Eastern Europe. It turned out that she had given Paulson’s address to a string of credit-card companies, cellular-phone providers, department stores, and others, and she never paid any of the bills.

  Paulson couldn’t track down the woman, so he began to trace her billing history, trying to get the creditors off her back and halt the sometimes threatening letters coming to his home. It turned out that the nanny had a pattern of ordering cell-phone service, ignoring the subsequent bills, and then simply moving on to the next provider when they cut off her service. Sprint to T-Mobile to AT&T and then to Verizon, thousands of dollars in unpaid bills left in her wake. She sometimes defaulted on her account and found new providers eager to win her business. She also had ignored her dozens of credit cards and store cards.

  “I can’t believe this,” Paulson said to Jenny, a touch bewildered. “It’s out of control what’s going on.”

  Each company Paulson called seemed more bureaucratic than the next. He couldn’t get to the bottom of how much his former nanny owed, or how to stop the bills from coming.

  When Paulson got to his office, he shared the story of his nanny, ranting about the endle
ss chain of bills.

  “Can you believe she doesn’t pay her bills and she’s still getting new credit-card promotions left and right?” Paulson asked Andrew Hoine.

  Paulson looked befuddled, as if he had just gained a glimpse of how the other half lived, much like President George H. W. Bush when he encountered a supermarket scanner during his presidency.

  Hoine wasn’t surprised. A good friend who made automobile loans to low-rated borrowers in Florida told him that a cook at a local Applebee’s restaurant recently obtained a loan to buy a new Bentley, agreeing to pay sky-high rates. And there was heated competition among lenders to make the loan, despite its low probability of being paid in full.

  Paulson now was even more convinced that the nation’s debt problems weren’t confined to subprime home mortgages. He told his team to begin shorting shares of banks with significant exposure to the credit-card business, as well, and those making commercial real estate, construction, and almost other kind of risky loans.

  Gary Shilling, the downbeat septuagenarian economist from New Jersey, kept telling Paulson’s team that subprime mortgage problems would infect the entire housing market. So Paulson’s hedge fund shorted shares of Fannie Mae and Freddie Mac, the big mortgage lenders, as well.

  At the time, others were becoming more upbeat about the future of the economy. At a panel discussion at an industry conference, Jim Wong, Paulson’s head of investor relations, endured a series of presentations about the big returns that hedge funds were making buying “leveraged loans,” or those made to companies dealing with heavy debt from recent takeovers. Asked his opinion, Wong said his firm viewed these loans as too risky.

  After the discussion, an investor pulled aside Wong, saying, “Paulson’s gonna miss the boat on leveraged loans … he doesn’t understand these securities are safe.”

  Back at the office, Wong relayed the conversation to Paulson. He appeared more amused than angry at the insult. “Go tell him that I don’t want to be on that boat,” Paulson replied with a grin.

  BY THE FALL OF 2007, the dominoes were beginning to topple. As more borrowers ran into problems paying their home mortgages, ratings firms scrambled to lower their ratings on all kinds of mortgage debt. It turns out that the debt was risky after all, they acknowledged. In October, Moody’s downgraded the ratings on $33 billion worth of mortgage-backed securities. By mid-December, ratings had been dropped on $153 billion of CDO slices. Because banks and investment banks around the globe, such as Citgroup, UBS, Merrill Lynch, and Morgan Stanley, owned many of the slices of CDOs made up of toxic mortgages, they were forced to write down more than $70 billion in three short, painful months.

  Blame was soon apportioned. Chuck Prince, Citigroup’s chief executive—who once said his bankers would dance until the music stopped—was ousted. So, too, was Stanley O’Neal, Merrill Lynch’s CEO, who was paid $46 million just a year earlier and lauded for pushing Merrill to hold $40 billion of CDO slices, up from $1 billion two years earlier. Shares of many major financial companies were cut in half in a matter of weeks.

  (O’Neal left with $161 million in his pocket, on top of $70 million that he took home during his four-year tenure; Prince was given $110 million, an office, an assistant, a car, and a driver.)

  Other losses soon sparked concern about companies like Ambac that insured bonds for investors, adding to the market’s angst.

  Pellegrini had spent countless hours worrying about what could upend the firm’s trades and making sure its winnings were secure. About $10 billion of profits was waiting for them at various firms, the sum of the daily exchange of cash from those who sold the hedge fund protection. Now, Pellegrini had it placed in institutional Treasury-bond funds to which the hedge fund had easy access, rather than allow it to sit within reach of investment banks under increasing pressure. The profits they had accumulated so far seemed safe.

  But some of Paulson’s team had concerns about how they were going to exit their remaining investments without pushing down the price. The debt markets they focused on had limited trading, and it wasn’t clear how they would get out of the trades. Selling so much mortgage protection might push down prices dramatically, slicing their gains. They had sold a number of their more liquid positions, but who would buy the rest of it, especially the mortgage protection that traded so infrequently?

  It was time for Paulson to test the waters. He walked out of his office to the desk of Brad Rosenberg and asked the trader to begin circulating BWIC lists, or bids wanted in competition. Various ABX indexes had crashed below 50. Investors’ perception of risk seemed at panic levels. Paulson wanted to see what kind of demand he might find for his CDS insurance.

  Rosenberg made a round of calls and walked into Paulson’s office with news he wanted to hear: Banks and investors were clamoring for their insurance, to protect their holdings of mortgage securities. Over the next few weeks, Paulson sold about 40 percent of his CDS insurance. The rest proved harder to get rid of, frustrating Rosenberg at times.

  Paulson got some help from a surprising place, however. Among the traders most eager to buy Paulson’s CDS insurance were some at Bear Stearns, of all places, the firm he squabbled with and was among the most critical of his original thesis. Scott Eichel and other senior traders at Bear Stearns, who once scoffed at Paulson and Lippmann, realized the severity of the real estate problems. It was late in the game, but the traders now called the Paulson team, desperate to buy their positions.

  Eichel’s group eventually made about $2 billion of profits owning protection that Paulson had discarded. It was a valiant effort to save their firm.

  Tension was building elsewhere within Bear Stearns, as executives argued about how to right their sinking ship. The investment bank held too many risky mortgages, and clients, including major hedge funds, were losing faith. Some discussed pulling their money from the firm. Within the executive suites, some argued for urgent action.

  “Cut the positions, and we’ll live to play another day,” argued Wendy de Monchaux, a senior trader.

  “We’ve got to cut!” agreed Alan “Ace” Greenberg, the firm’s former CEO and fifty-nine-year veteran.

  But the firm’s chief, Alan Schwartz, urged caution. Many of the markets for mortgage debt had become difficult to trade in. Unloading tens of billions of dollars’ worth of mortgages and related bonds at fire-sale prices would create devastating losses, he argued.

  “Stand calm … we’ve got it under control,” he told some at the firm.

  WHILE IT WAS MONEY that drove John Paulson, he also wished to be recognized as one of the investment wizards, an objective that long eluded him over the years as he toiled in obscurity.

  In the fall of 2007, that all began to change. One day he got a phone call from George Soros, the man renowned for his own famous trade, a 1992 bet against the British pound, one that earned $1 billion for his Quantum hedge fund. The figure paled in comparison to the $12 billion or so of gains that Paulson had accumulated at that point. But Paulson didn’t have the heart to bring that up when Soros invited him to lunch at his office, at Seventh Avenue and 57th Street.

  Although Soros’s nephew, Peter, was a longtime friend of Paulson’s and an investor in his funds, Soros had heard about Paulson’s coup through his contacts on Wall Street. Soros, quasi-retired at the time, was itching to get back in the game. He turned to Paulson for help.

  Soros was painfully aware that the investing game had dramatically changed in recent years; he was like a ballplayer attempting a comeback and realizing that the rules had been altered. Stocks and other investments listed in the daily newspaper and running across the bottom of business-television screens were no longer as crucial to making the big money. Instead, credit-default swaps, instruments that didn’t even exist a few years earlier, were where the real action was. After complimenting Paulson on his coup, Soros asked for a tutorial.

  Over grilled halibut and vegetables, Paulson described the ABX indexes, how CDS was traded, and some of his moves. At fi
rst, Soros seemed preoccupied, even perturbed. It turns out the fish wasn’t up to his standards and he complained about it to his assistant.

  But Soros enjoyed the patient and thorough lesson and was struck by Paulson’s understated manner. Weeks later, Soros became more engaged at his firm, and in the last three months of the year, he racked up several billion dollars of profits of his own.

  During the lunch, when Paulson argued that banks were in trouble and shared that he was betting against some of them, however, Soros thought he was a bit too downbeat. “I thought the risk-reward was better in other trades,” Soros recalls.

  Even in Paulson’s moment of triumph, skeptics thought they knew better.

  JEFFREY LIBERT bought some protection on subprime mortgages rated BBB– in early 2007, and then converted it to insurance on even more AA-rated loans in August.

  He remained torn about whether to add more or whether to give in to his misgivings and just get rid of the investments. He watched the market closely, trying to decide what to do. The ABX index tracking top-rated loans was at 90, implying that few thought they would run into any trouble. But these were dangerous mortgages made to home buyers with scuffed or limited credit. There’s no way they were genuine AAA bonds, Libert concluded.

  Libert was set to spend $1 million to buy CDS contracts on $10 million of these loans. But he didn’t have an opportunity to speak with his broker before leaving with his wife to spend a week at their home in Provincetown, the picturesque town at the tip of Cape Cod. Libert was recovering from back surgery and hadn’t worked for several months as he tried to deal with the pain. He figured he’d just call his broker and make the trades a few days later.

  On their first day in Provincetown, Libert received a call from his broker in New York. Tomassetti sounded unusually stressed as he filled in Libert on startling losses announced by Citigroup and Merrill Lynch.