As Paulson sat in Andrew Hoine’s nearby office one day, discussing how much was being spent by the United States and other nations to rescue areas of the economy crippled by the financial collapse, Paulson discovered his next target, one he was certain was as doomed to collapse as subprime mortgages once had been: the U.S. dollar.
Paulson made a simple calculation: The supply of dollars had expanded by 120 percent over several months. That surely would lead to a drop in its value, and an eventual surge in inflation.
“With all this spending, we’re going to have massive inflation,” Paulson told Hoine, arguing that almost every major currency was at risk, other than the Chinese yuan. “What’s the only asset that will hold value? It’s got to be gold.”
Paulson never had even dabbled in gold, and had no currency experts on his team. Some of his investors were skeptical of his argument, noting a burst of inflation was unlikely with unemployment high, wages stagnant, and businesses running at a fraction of their potential capacity. Others said too many other investors already had flocked to gold. Some of Paulson’s investors withdrew money from the fund, pushing his assets down to $28 billion or so.
Paulson acknowledged that his was a straightforward argument, but he paid the critics little heed and proceeded to buy more than $1 billion of shares of gold miners, or 12 percent of his largest fund. He also purchased billions of dollars of gold investments to back new classes of his funds denominated by gold and chose these classes for his own money.
Betting against the dollar would be his new trade.
“I couldn’t be more confident,” Paulson said in the summer of 2009. “Three or four years from now people will ask why they didn’t buy gold earlier. Over time our currency will lose value and inflation will rise—that’s our future.”
His passion for yet another big trade was hard to mask.
“It’s like Wimbledon,” he says. “When you win one year, you don’t quit; you want to win again.”
afterword
The fact that an opinion has been widely held is no evidence whatever that it is not utterly absurd; indeed, in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible.
—Bertrand Russell
A FEW SAVVY INVESTORS—MOST WITH LITTLE RELATIVE EXPERIENCE in real estate, derivatives, or mortgage investing—anticipated a historic housing and financial collapse. Their remarkable success begs an obvious question: Why did this unlikely group predict the crumbling of the housing market and the resulting pain felt around the globe, even as the experts were stunned by the developments?
Top regulators, including Alan Greenspan, Ben Bernanke, Henry Paulson, and Timothy Geithner, were caught flat-footed. Senior bankers like Robert Rubin, Charles Prince, Stanley O’Neal, Richard Fuld, and James Cayne oversaw firms that lost hundreds of billions of dollars from mortgage holdings. Top analysts, traders, economists, and academics expected housing to hold up. Real estate, mortgage, and derivative investors all missed the huge trade, as did so-called short sellers, investors who go to sleep at night dreaming of calamities they can bet against.
Some blame the difficult period on overcompensated bankers and the toxic products they created; others point the finger at cynical traders who rolled the dice with their firms’ money. These explanations are simplistic and overstated. Certainly, some Wall Street pros had concerns about housing and nonetheless peddled unsafe products, hoping to squeeze out one last, hefty bonus. Others embraced risky trades without worrying about the potential downside. But many more were shocked by the turn of events and squandered enormous wealth when subprime mortgages collapsed.
Why did the experts get it so wrong? And what can we learn from the episode?
The answers are varied. Products on Wall Street evolve, becoming more complicated with time, partly so hefty commissions can be charged and salesmen have something new to pitch customers. In the case of the housing market, residential mortgage-backed bonds begat collateralized debt obligations, leading to CDOs squared, and then synthetic CDOs. By the middle of the 2000s, top executives at global banks had few clues how dangerous these mortgage products had become, even as their own banks sold them to clients and retained huge pieces of them.
Rubin, chairman of the Citigroup board of directors’ executive committee at the time of the housing bubble, testified before Congress in the spring of 2010 that until the fall of 2007 he didn’t recall learning about CDO investments his bank was creating, owning, and selling. Sure, Rubin made $15 million a year at Citigroup. But examining these complex products wasn’t what he was paid to do, he testified, partly because credit-rating companies deemed them supersafe.
“More senior level consideration of these particular positions was unnecessary because the positions were AAA-rated and appeared to bear de minimis risk of default,” Rubin testified.
At the same hearing, Prince, who walked away with more than $100 million in compensation for his work as Citigroup’s CEO during the housing bubble, added: “We believed that the top level would be immune to the problems.… Sitting here today, that belief looks unwise, but I think at the time Moody’s was quoted as saying these problems would never reach the super-senior” slices of CDOs and other debt products.
Citigroup ended up losing $30 billion from CDOs, triggering a $45 billion federal bailout, the largest of any financial firm.
Within the boardrooms of global banks, Rubin and Prince were no exceptions. Most senior bankers were clueless about CDOs and other complicated mortgage products.
“If you find this confusing, you should,” John Paulson told investors in 2010, referring to CDO investments. “Most people do. Even the people who participated in this market didn’t understand it either.”
Instead of mastering these products, senior bankers generally deferred to midlevel specialists. How did these pros get it so wrong? They often relied on top-notch grades placed on the investments by ratings companies. Others depended on sophisticated computer models suggesting that a national or international plunge for housing was unlikely—largely because such a downturn hadn’t occurred in seven decades. The models couldn’t have been more wrong.
Another key reason a widespread housing downturn seemed improbable: Few of the industry’s experts had a memory of the early 1990s, when large swaths of the California, Texas, and Massachusetts real estate markets tumbled in value. Wall Street bankers, traders, and investors tend to make so much money that they retire early, or find other things to do, leaving the financial business to younger executives. At The Wall Street Journal, I go days without speaking with anyone who experienced the difficulties of 1998, when hedge-fund power Long Term Capital Management collapsed and almost brought down world markets. Those who remember the real estate troubles of the early 1990s are an even rarer breed. Too few bankers in 2005 judged a real estate collapse to be a realistic possibility because so few recalled previous housing difficulties.
Indeed, it’s no coincidence the biggest winners of the downturn—John Paulson, Paolo Pellegrini, and Jeffrey Greene—were approaching fifty years of age. They retained vivid memories of past real estate problems. Youth was a detriment to pulling off the greatest trade ever and to preparing for the downturn.
It’s also not an accident that many of those wracked by fears about the financial system in 2005 and 2006, such as Andrew Lahde and Michael Burry, didn’t work at big banks, government agencies, or large companies. Those who climb to the top of big institutions, win elections, or are picked for important government posts tend to be optimists. They’re leaders who inspire others, usually with an upbeat, can-do outlook. Placing one’s feet on a desk, dimming the lights, and thinking hard about what could go wrong and how to prepare for it usually aren’t steps that help an executive obtain a promotion. Ideas about how to top last quarter’s profits, meet a short-term revenue goal, and stay a step ahead of rivals do.
On Wall Street, worrywarts tend to leave and work at hedge funds. Many of these ind
ividuals like to invest but don’t entirely enjoy dealing with others, even their own clients. They get bored in meetings, have a hard time selling themselves to investors, and enjoy poking holes in bullish arguments. They may not be much fun to grab a beer with, but they’re best suited to predict a coming disaster, as some did with the subprime collapse.
Wall Street talks a big game about the importance of taking a contrarian stance with investments. When it comes to a career in finance, however, there are few reasons to be a contrarian or to try to anticipate problems. Greg Lippmann took perhaps the most risk of any investor in pursuing the bearish housing wager. He was being paid millions of dollars annually by Deutsche Bank in 2005 when he first had concerns about subprime mortgages. If Lippmann had continued to make investments predicated on housing staying firm, he would have lost money, like others at his bank and on Wall Street. But he likely would have kept his well-paid job. All he had to do was trot out the well-worn excuses of the business. Sorry, boss, but the downturn was a hundred-year flood. Who could have predicted the perfect storm that damaged the global economy? By describing the collapse of the financial system as a natural disaster, rather than as a series of man-made errors, countless pros acted blameless and retained lucrative jobs.
Rather than take this route, Lippmann bought unpopular protection on subprime mortgages. He was teased and insulted. If real estate had remained strong, Lippmann likely would have been fired. His wager was profitable and he ended up making millions, but his decision wasn’t the most rational one. Too much downside, not enough upside, most traders would say. Too often it makes little sense to make gutsy, unorthodox bets in business, or prepare for difficult times.
Another reason Wall Street does a poor job foreseeing meltdowns is few firms are very good at recruiting and promoting risk managers, or enabling them to examine the exposures of various parts of their global businesses. In early 2007, some traders thought their groups were facing danger, but they were sure colleagues elsewhere weren’t embracing similar risks. Too often they were. The problem: There are too many silos within big financial firms and too few executives eager to share information and concerns.
Goldman Sachs’s risk managers enjoyed a fuller picture of the risks of various trading groups, partly because traders work more closely together, helping to explain why Goldman became concerned about housing before rivals, though still late in the game.
Perhaps the biggest reason outsiders saw the approaching storm was they weren’t mortgage or real estate practitioners. They didn’t buy into the groupthink of those industries that the Federal Reserve or U.S. government wouldn’t let housing collapse, and that derivative investments were scary and dangerous. Paulson, Pellegrini, Burry, and Greene didn’t know much about derivatives, but they took the time to educate themselves.
Paulson also ignored concerns that buying insurance on mortgage bonds would enable competitors to score better short-term results. The excessive focus on near-term results handcuffed many executives who tried to prepare for the downturn.
There wasn’t a single personality type required to pull off the greatest trade in history. Paulson, Lippmann, and Greene were upbeat, outgoing investors comfortable chatting up investors and grilling mortgage lenders. Pellegrini, Burry, and Lahde were downbeat and had difficulty communicating their dire outlooks, preferring late nights slumped over arcane housing data.
But those who anticipated the collapse all were outside of the mainstream. They shared a supreme conviction in their gloomy, unorthodox views, a historic perspective, and an ability to ignore immediate setbacks. Only by encouraging these contrarians within business and government can we hope to avoid future meltdowns.
• • •
SOME DISMISS PAULSON and the other prescient investors as flukes. In early 2010, former Fed Chairman Greenspan called them a “statistical illusion.”
“Everybody missed it,” he said. “Academia, the Federal Reserve, all regulators.”
Fed Chairman Ben Bernanke said there was little that could have been done, anyway. “We had neither the mandate nor the tools to be the financial system’s supercop,” he said in 2010.
It’s not encouraging that key officials haven’t taken full responsibility for their mistakes. They ignored warnings about loose lending standards and failed to caution borrowers about the risks of aggressive mortgage products. A better tack would be to learn from the few investors who got it right and avoid an overreliance on industry experts.
Despite that, many of the financial reforms embraced to prevent future financial debacles depend on new agencies and savvy regulators spotting future troubles. It’s not obvious why they will be more successful anticipating the next bubble than they were at predicting the last one. A better step would be to force large financial companies to set aside more cash as a buffer for the next brutal downturn, one that sadly may be inevitable in an age of financial bubbles.
AFTER PULLING OFF his historic coup, John Paulson set out to write a new chapter in his career. He turned bullish on the global economy in 2009, scoring a reported $2.3 billion in personal profits as markets turned higher, frustrating rivals who hoped he’d slip up, finally. Even as global financial markets crumbled in the summer of 2010, amid worries about various European countries and the United States, Paulson maintained a stubborn optimism, as if he was intent on shaking his image as an uber pessimist.
Paulson said it was a great time to buy a second house or help relatives purchase a home, predicting that housing prices in the United States would rise by as much as 12 percent in 2011 and that the economy would turn robust. He called the European debt crisis “manageable,” even as his optimism led to trading losses in 2010.
“We are pretty excited by the opportunities in front of us,” he told his clients, reassuring them. “If you don’t own a home today, now is the time to buy one.”
By the spring of 2010, investors had gained so much respect for Paulson that they had entrusted $33 billion in his hands, making Paulson & Company the second-largest hedge fund in the world. When he purchased a mere $44 million shares of Boyd Gaming Company, shares of the gambling company soared 12 percent, as other investors figured Paulson must be on to something.
But Paulson’s tactics came under scrutiny in April 2010. That’s when the Securities and Exchange Commission charged Goldman Sachs with civil fraud for its work with Pellegrini to create a $1 billion CDO, a deal that Paulson & Company bet against and scored $1 billion in profits. Goldman sold the deal in question, called Abacus 2007-AC1, to investors, including the big German bank IKB Deutsche Industriebank AG, which saw most of its $150 million Abacus investment evaporate.
It was just one of the series of deals that the Paulson team asked banks to create. The transactions led to huge losses for some of those very banks, such as Deutsche Bank, which didn’t sell all of those products to investors and kept some on the bank’s own books. But Goldman felt the biggest pain from the Paulson deals, emerging as the most despised banker in the world after the SEC levied its charges over the Abacus transaction.
Regulators suggested that unless new incriminating information arose, Paulson and his team wouldn’t be charged with wrongdoing.
“Goldman was responsible for the representation to the investors, and Paulson was not,” the SEC’s head of enforcement, Robert Khuzami, told a group of lawyers and deal-makers.
Nonetheless, Paulson’s involvement in the controversial transaction sparked a furious backlash in some quarters.
“He was involved in designing the security. For all we know right now, it was probably his idea,” Simon Johnson, a well-known author and professor at the MIT Sloan School of Management told television host Bill Maher. “If he walks away without being charged, it shows how broken our system is.”
Paulson even heard it from some outspoken moms. On a website popular in his Upper East Side neighborhood called UrbanBaby.com, a parenting message board where discussions normally center on strollers, diapers, and lactation consultants
, some posters asked whether Paulson should remain on the board of the Spence School, a prestigious school for girls on the Upper East Side, and whether Paulson’s profits from the housing bust were ethical. The question drew about seventy anonymous replies, some sounding off on the morality and utility of short-selling, credit default swaps, and hedge funds.
Paulson defended his actions to his investors, saying they were “appropriate and conducted in good faith.… We have always been forthright in expressing our opinions, and we never misrepresented our positions.”
Paulson was no superstar investor at the time Goldman sold the CDO, he reminded investors.
“When we expressed our concerns about the mortgage markets, many of the most sophisticated investors in the world, who had analyzed the same publicly available data we had, were fully convinced that we were wrong, and more than willing to bet against us,” he wrote to his clients.
Indeed, Paulson never sold any of the CDO investments under examination, including the Goldman CDO, to investors. Those who purchased Abacus were sophisticated institutions capable of examining the CDO’s collateral, much as Paulson and Pellegrini did. As such, while Goldman withheld information from investors like IKB, such as the fact that Pellegrini played an important role in helping to create the controversial CDO, it’s not clear they withheld material information.
By the late summer of 2010, Goldman had settled the charges, paying the SEC $550 million, and Paulson had largely put the controversy behind him. He turned his attention to his shiny new investment—gold. Paulson was so convinced that inflation would rise and that major currencies were set to fall that he and his firm plowed more than $5 billion into gold-related investments. That made Paulson the largest individual owner of gold in the world, with holdings that by some accounts topped those of Australia, Brazil, and Argentina. Paulson departed for London in the summer of that year intent on retaining his perch atop Wall Street upon his return.
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