The Greatest Trade Ever

by Gregory Zuckerman

  Tomassetti told Libert that the ABX indexes were reacting dramatically to all the news, as investors and banks scrambled to buy their own insurance on toxic mortgages.

  “Jeffrey, they’re really moving.”

  It was time to do the buying he planned, Libert decided, sure that big profits awaited.

  “Okay, get me in at ninety.”

  “We can’t, we’re way past that.”

  “What?! You mean we’re at eighty??”

  “No—it’s seventy.”

  “What? In one day?!”

  Libert was in a panic. He was finally prepared to toss his moral qualms into the nearby Atlantic Ocean, but now it was too late. The sharp drop in the index meant that the CDS insurance he already owned was worth millions of dollars. He was miserable, though, thinking about the gains he had squandered by dithering.

  The AAA-rated mortgage loans that Libert wanted to bet against traded at sixty cents by the end of that month. Libert would have made close to $10 million more had he picked up the phone and pulled the trigger on his trade.

  “The truth is, when Greene thinks he’s right, he puts the wad down,” Libert says. “When I think I’m right, I’m not as sure.”

  BY OCTOBER, Jeffrey Greene’s own CDS protection had climbed in value by as much as $300 million. If he cashed out, Greene knew he could live as extravagantly as he wished the rest of his life and never have to think twice.

  But unlike his former friend John Paulson, Greene couldn’t bear to let go of his mortgage protection, convinced that deeper troubles for housing were ahead. Every day in the fall, Greene received a summary of his account. And every day, his positions climbed in value by millions of dollars. This was what Greene spent almost two years waiting for. He wasn’t going to close his glorious trade now.

  Months earlier, Greene had peppered Zafran with calls, trying to understand why his trade wasn’t working. Now it was Zafran’s turn to pursue Greene. He called at least once a week, urging his client to do some selling.

  “Jeff, you really should take some chips off the table. Don’t be foolish, just take a hundred million out,” Zafran advised his client. “God forbid, the government gives one hundred percent mortgage relief to everyone,” then the CDS insurance will be worthless.

  “No way,” Greene responded. “They’re going down further, they’re fundamentally bad.”

  Later in the fall, though, friends helped convince Greene to take some profits. He was up twentyfold and even fortyfold in some of his investments. Why not take some off the table?

  Greene called Zafran, ready to do some selling. Zafran rang various traders within Merrill Lynch to get a price at which they could find a buyer for Greene’s protection. The CDS insurance he had bought on various slices of the ABX index was a cinch to sell, so Greene did some of that. But he owned protection against specific pools of ugly mortgages, and they were such unique investments that it was hard to get prices for the protection, let alone find someone to buy it. Sometimes it took Zafran days to get back to Greene with a quote; other times it took several weeks.

  Greene turned livid, unable to comprehend the delay. “You’ve got to be kidding me,” he barked at Zafran. “What kind of amateurish operation does Merrill run?”

  The pricing issues were part of the reason why Merrill and other firms had been so reluctant to sell these instruments to individuals—they might be hard to exit if no buyers emerged. Zafran didn’t want to mention that and set Greene off again, though. “I told you so” likely would make him even angrier, Zafran figured.

  Sometimes, Zafran came back with quotes on only three of the eighteen pools of mortgages that Greene was betting against—and the three were the best-performing pools, not the ones that Greene figured to make the most from.

  Greene was sick and tired of Merrill’s traders and their quotes. And he wasn’t sure whether Zafran’s true interests lay with his firm or with Greene. For their part, Merrill’s traders had had enough of Greene—over and over again they had to round up quotes for his tricky investments, but he never did any trading. Now he said he wanted to sell, but how could they be sure?

  Greene tried pushing his broker to get better prices: “Alan, you’re a big guy at Merrill; get it done.”

  Zafran understood Greene’s nervousness. If he couldn’t sell the positions, his hard work might be for naught.

  Finally, Greene gave up, exasperated. He told Zafran that he was just going to hold on to his investments and not try to sell any more of them, at least for now.

  “I would have closed the positions at fifty cents on the dollar but I couldn’t even get a bid,” Greene recalls.

  THROUGHOUT THE FALL OF 2007, Greg Lippmann scored huge gains. A growing number of Deutsche Bank executives hinted that he should do some selling but Lippmann fought to hang on to his investments.

  They put even more pressure on Lippmann after a Rose Garden speech by George Bush on August 31, when the president announced measures to help some borrowers and suggested more might be in the offing.

  Meeting with Lippmann and a half dozen senior executives in a conference room in Deutsche Bank’s New York office, Rajeev Misra was clear with his orders: The subprime trade has worked, we’ve made money, let’s move on.

  “It’s been a great race,” but it’s coming to an end, Misra said. He didn’t believe the housing troubles were over, but it was time to move on to another trade, he repeated.

  Lippmann wouldn’t let it go, though, like a dog clinging to a bone.

  “Why?” Lippmann asked, looking straight at Misra. The senior banker backed off.

  In the subsequent weeks, most of Deutsche’s traders who had purchased CDS protection exited many of their trades. Misra himself was forced to cut short many of the positions he held after his own superiors urged caution. Lippmann cashed in some chips. But he convinced his bosses that the market was getting worse. Once again, they let him hold on to most of his positions, grudgingly.

  The sudden panic in the fall of 2007 created a peculiar scene at Deutsche Bank. In one corner, Lippmann and his team of twenty-five traders racked up large gains, almost on a daily basis. But many of the rest of the hundred or so traders in Deutsche’s large trading room looked glum, sometimes because they were holding the very same investments that Lippmann bet against. It was as if they existed in a Bizarro World of finance—everything that went wrong for these traders went right for Lippmann and his crew.

  Lippmann had waited for this moment for two years. Now that it was here, he was going to enjoy his vindication to the utmost.

  “The market is tanking!” he yelled across the trading floor one day, in a teasing tone. “Ha, ha, ha, ha.”

  After seeing Lippmann carrying on, a salesman warned him: “Be careful what you wish for.”

  Lippmann laughed him off. But by the end of 2007, Deutsche had acknowledged making some of the same mistakes that the other investment banks had made. It couldn’t sell all the CDO deals that it had created to help Paulson short more securities. Like a game of hot potato, the big bank found itself stuck with too many CDO slices.

  When Lippmann sat down at year’s end with his bosses, including Rajeev Misra and Richard Dalbear, they were complimentary and appreciative. Then they gave Lippmann the figure he had been waiting to hear all year: his bonus. He had taught dozens of hedge funds how to score billions of dollars of profit in a single year. And he directed a team that made close to $2 billion in profits.

  Lippmann’s reward was more than he ever expected to make in a lifetime, let along in a single year: $50 million, much of it in Deutsche Bank shares. It was an astonishing figure, even for a Wall Street trader.

  But Lippmann couldn’t help feel slighted. If not for him, the bank would have suffered like many other of the biggest financial players.

  “This is not fair,” Lippmann told his superiors, his voice rising. “It’s too low!”

  They ignored his tantrum. Lippmann threw a fit every year, then he settled down and nothing
much changed.

  Lippmann was upset enough that he quietly interviewed for jobs with a number of hedge funds and other firms, to see if he could do better. Word got back to Misra.

  “If he doesn’t get paid, he’s gonna come work for us,” one hedge-fund manager told Misra.

  “Fine,” Misra responded, nonplussed. “We paid him well.”

  In the end, Lippmann stayed at Deutsche Bank, partly out of loyalty and also because he would have been forced to forgo all of the shares had he bolted.

  BY AUGUST OF 2007, Michael Burry’s hedge fund was up 60 percent in the year, making it one of the best performers in the world. The subprime housing market had crumbled, just as Burry predicted.

  His returns were so impressive that his staff hesitated to tell clients, just in case there was another snafu in the accounting department, as they had had earlier in the year.

  “Please check that again,” Steve Druskin, Burry’s general counsel, said to staff members going over the results. “We can’t afford a mistake right now.”

  Burry couldn’t enjoy his belated success, however, still weary from the battles with his investors and too sensitive to ignore their unhappiness. Most nights, Burry came home glum, frustrating his wife.

  “Has Joel called to apologize to you?” she asked him one evening in August. She was referring to Joel Greenblatt, Burry’s original investor.

  Burry shook his head, looking even sadder. “Look how far you’ve come! Try to enjoy it,” his wife said. All Burry could do was shrug. She urged him to splurge on a present for himself, but he couldn’t think of anything he wanted.

  Burry flew to New York to apologize to Greenblatt for the audit snafu, reestablishing more cordial relations with him. By then, though, Burry had had enough of the headache of the side account that antagonized so many of his investors. He shifted the remaining CDS investments from the account back to his main fund, just as the credit crisis erupted in full sight. Over the next few months he successfully exited the positions, slowly selling the mortgage insurance.

  He finished 2007 with a gain of over 150 percent. Scion itself pocketed about $700 million in the year. Burry’s subprime trades had quadrupled in value, scorings gains of about $500 million, over two years. He personally made about $70 million.

  He wasn’t done, though.

  “I patiently await a deepening of the U.S. recession and the string of bankruptcies that are sure to follow,” he wrote his investors in early 2008. “For the record, I do not smile fiendishly as I do so. If you know me, you know I neither smile fiendishly nor easily.”

  Maybe he still had a chance to pull off his historic trade.

  PAOLO PELLEGRINI remained reluctant to tell his wife, Henrietta Jones, much about how the firm’s trade was doing, still unwilling to risk jinxing it. But as the problems of the housing market became as clear as the front page of her morning New York Times, Henrietta couldn’t resist bringing up the matter with her husband.

  One day in September, she turned to Pellegrini, asking, “We don’t really need me to work, do we?” She enjoyed her position running a division for retailer Donna Karan and wasn’t demanding to quit, but her paycheck had become a drop in the family’s bucket and she had a young daughter she enjoyed spending time with. If Pellegrini’s bonus at the end of the year was likely to be sizable, she might like the chance to spend more time at home.

  Pellegrini couldn’t give her a sense of how much he was going to make. He didn’t know what kind of bonus check Paulson might give him. But he agreed that Jones probably didn’t need to work. She soon quit her job.

  In late November, Paulson & Co. held a dinner for five hundred or so thankful investors at Manhattan’s Metropolitan Club. The two credit funds were up an average of 440 percent that year, even as the stock market rose 3.5 percent, such a stunning figure that some investors at the dinner gushed their appreciation when they grabbed a few minutes with Paulson and Pellegrini. Others chatted about how big the firm had become—it now managed a shocking $28 billion, making it one of the largest hedge funds on the planet, all from investors who were far under the radar screen just a year earlier.

  The mood was jovial as a cocktail reception was followed by a three-course dinner featuring boneless duck confit over celery root and black truffles, and roast rack of lamb.

  Paulson gave a downbeat presentation about the economy, warning that a recession was likely. He provided details about how he and his team were shifting to wager against financial companies while trimming their protection against subprime mortgages.

  Paulson named Bear Stearns, Merrill Lynch, Citigroup, and bond insurer Ambac Financial group and credit-ratings company Moody’s Corp. as those in hot water, a suggestion to his investors that the firm was betting against those companies.

  It was still “not too late” to bet against those firms, Paulson said.

  Pellegrini proudly did his part at the event, starting off the evening’s wine tasting by explaining that all the evening’s selections were from his native Italy. It was a tip of the cap from Paulson to Pellegrini. The duck appetizer was accompanied by a $200 bottle of Tenuta San Guido 1999 Sassicaia.

  But Pellegrini soon began to chafe. He had been an architect of the subprime trade, working elbow-to-elbow with Paulson to craft moves that now were reaping billions of dollars. Pellegrini had begun to gain his own recognition on Wall Street and sometimes was asked to speak on various economic topics.

  Paulson & Co. had bet against about $5 billion of CDOs and made more than $4 billion from these trades—including $500 million from a single transaction—according to the firm’s investors and an employee of the firm. One of the biggest losers, however, wasn’t any investor on the other side. It was the very bank that worked with Paulson on many of the deals: Deutsche Bank. The big bank had failed to sell all of the CDO deals it constructed at Paulson’s behest and was stuck with chunks of toxic mortgages, suffering about $500 million of losses from these customized transactions, according to a senior executive of the German bank.

  These were some of Paulson & Co.’s largest scores. And they were moves that Pellegrini had masterminded.

  As 2007 drew to a close and the firm’s focus shifted away from subprime mortgages, Pellegrini felt left out, however. He was just as convinced as his colleagues that the banks were in trouble—he knew where all the bad mortgage loans were buried. And yet Hoine, not Pellegrini, was given the mandate of helping Paulson quarterback the new trade. Pellegrini couldn’t even make the final decisions about which subprime-mortgage protection to sell.

  “John never got to the point where he would trust me,” Pellegrini recalls. “He never gave me trading authority.”

  Paulson continued to tease Pellegrini about how methodical he was. When Paulson moved another analyst to work under Hoine’s wing, to focus on the financial companies and their debt, Pellegrini was hurt. He viewed the decision as an attempt by Paulson to preserve his control of the firm, handing power to Hoine because he was younger and represented the next generation.

  “I wanted an analyst to work with me to short the equities but he gave it to Andrew; John didn’t want to give me that,” Pellegrini says. “So I became disengaged.”

  Pellegrini still helped manage the two big credit hedge funds, though, and they were a whopping $9 billion in size. Late in the year, Pellegrini came to Paulson with an idea: Let’s give back half the money in the fund and extend the fund’s “lockup” for another few years. That way, the firm could cash in some of its gains while ensuring that investors wouldn’t pull all the money out when the existing lockup ended in 2009.

  Pellegrini already was hearing complaints from European investors who were desperate for cash amid the market’s downturn and unhappy they couldn’t pull any of their huge gains from the hedge funds, due to the lockup agreement. Other investors grumbled that the Paulson credit funds had pocketed some cash from various sales of investments but they were not doing anything with the money. Why not give some money back and t
hen raise money anew in 2008? Pellegrini argued to Paulson.

  Paulson seemed taken aback. Maybe it was a sign that Pellegrini didn’t believe in the remaining positions. Or he was just looking to make sure he had a key role at the firm for an extended period, while he helped run those funds.

  “When I hear you saying these things, it makes me question what you’ve accomplished in the last two years,” Paulson responded, tersely.

  Paulson’s comment “made me feel I was no longer special,” Pellegrini recalls.

  ON THE FRIDAY BEFORE CHRISTMAS, Paulson called an emergency meeting in the firm’s reception area. Standing in front of the group, with Pellegrini and Rosenberg nearby, Paulson opened a case of French champagne sent over by an investment bank as a thank-you for all the trading commissions of the previous year.

  Paulson passed around bottles of the bubbly, poured a glass for himself, and raised it to his team. He beamed; some of his staff never had seen their boss look so happy. Paulson then toasted his employees, singling out the firm’s back-office staff and some other areas away from the limelight.

  “I just want to thank everyone,” Paulson said, looking around the room, meeting the eyes of both senior and junior executives. “It was the best year ever.”

  Applause rocked the office. Then the team quickly got back to work, to try to make some more money.

  A few days later, Pellegrini took his wife on vacation in Anguilla. Stopping at an automated-teller machine in the hotel lobby on New Year’s Eve to withdraw some cash, she checked the balance of their checking account.

  She was immediately taken aback. On the screen before her was a figure she had never seen before, at least not on an ATM. It’s not clear how many others ever had, either: $45 million, newly deposited in their joint account. It was Pellegrini’s bonus for the year, including some deferred compensation. He was still special to John Paulson, after all.