Gary Weiss calls John Paulson the man who made too much:
Paulson is smart enough to know that at this particular moment in history, the less he’s heard from, the better. The simple reason: He is not suffering. In an era in which losers are universal and making a profit seems somehow shady, Paulson is the most conspicuous of Wall Street’s winners. Paulson & Co.’s funds (with an estimated $36 billion under management and growing by the day) were up a staggering $15 billion as the markets teetered in 2007; one fund gained 590 percent, another 353 percent. All this reportedly garnered him a personal payday of $3.7 billion, among the biggest in history. In 2008, his funds didn’t climb nearly as much but were still successful enough to put him at the very top of his profession. By scoring returns of this magnitude, Paulson has dwarfed the success of George Soros, whose currency trades in the 1990s made him so much money that he has spent much of the rest of his career atoning for them.Paulson makes no apologies. During our conversation in his conference room, he describes in detail how he pulled off the greatest financial coup in recent history — a two-year bet that the calamity we are now experiencing would take place. It was a megatrade involving dozens of financial instruments, along with prescient wagers that banks like Lehman Brothers would eventually go under.
Everyone wants to blame the short-sellers, who profit when others lose, when they’re obviously not the cause of the problem.
This anecdote — it involves another short-seller, Chanos, not Paulson — demonstrates what kind of people run things on Wall Street:
The day before the Fed’s rescue of Bear Stearns, Chanos says he was walking to the Post House restaurant in New York City, when, at 6:15 p.m., his cell phone rang. He saw the Bear Stearns exchange come up on his caller I.D. and took the call.“Jim, hi, it’s Alan Schwartz.”
“Hi, Alan.”
“Well, Jim, we really appreciate your business and your staying with us. I’d like you to think about going on CNBC tomorrow morning, on Squawk Box, and telling everybody you still are a client, you have money on deposit, and everything’s fine.”
“Alan, how do I know everything’s fine? Is everything fine?”
“Jim, we’re going to report record earnings on Monday morning.”?
“Alan, you just made me an insider. I didn’t ask for that information, and I don’t think that’s going to be relevant anyway. Based on what I understand, people are reducing their margin balances with you, and that’s resulting in a funding squeeze.”
“Well, yes, to some extent, but we should be fine.”
“This is now 6:15 on Thursday night, the night before the collapse,” Chanos says. “It was after a meeting with Molinaro”—Bear Stearns C.F.O. Sam Molinaro—“who basically told him at that meeting, ‘We’re done. We’re gone. We need money overnight we don’t have.’? So here he is, calling one of his biggest clients to go on CNBC the next morning to say everything’s fine when clearly it’s not. And he knew it wasn’t.”
Chanos refused to go on CNBC. By 6:30 the next morning, word was out that the Fed was engineering the rescue of Bear Stearns. Chanos realized that he could have been on CNBC while that was announced. “I thought, That fucker was going to throw me under the bus no matter what.”
“So here it is,” Chanos says. “Alan Schwartz takes the position ‘Short-sellers were our problem,’ and who did he try to get to vouch for him on the morning of the collapse? The largest short-seller in the world. You want to talk about ethics and who’s telling the truth on these things? It’s unbelievable.”
Anyway, here’s how Paulson made his recent fortune:
Long before the financial crisis hit, Paulson, according to one person briefed on the trade, invested $22 million in a credit default swap that eventually paid $1 billion when the federal government opted not to rescue Lehman Brothers. That amounts to a staggering $45.45 for each dollar invested.
[...]
Paulson got wind of the coming storm in the credit markets through the infallible barometer of prices. By 2005, the amount of money he could make on the riskiest securities was not enough to justify the risk he was taking. Pricing, in his view, made no sense. Paulson concluded that he could do better on the short side — wagering that prices of risky securities would fall.“We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down,” he says. “We couldn’t short a house, so we focused on mortgages.” He began taking short positions in securities that he believed would collapse along with the housing market.
The best opportunities were in the junkiest portion of the housing market: subprime. Pricing of subprime securities “was absurd,” Paulson says. “It didn’t make sense.” Subprime securities graded triple-B — in other words, those that the credit-rating agencies thought were just a tad better than junk — were trading for only one percentage point over risk-free Treasury bills. This absurdity appealed to Paulson as easy money.
While Paulson was hardly the only fund manager to bet against subprime, he seems to have made the most money, most consistently, from the banking industry’s troubles. One reason for this is that Paulson was able to recognize and act on the unimaginable — that the banks, which took on most of the subprime risk, had no clue what they were holding or how much it was worth. Big banks like Merrill Lynch, UBS, and Citigroup held triple-A-rated securities, but these were backed by collateral that was subprime at best, making the rating of the securities almost irrelevant. “They felt,” Paulson explains, “that by having 100 different tranches of triple-B bonds, they had diversification to minimize the risk of any particular bond. But all these bonds were homogeneous.” It was like having 100 different pieces of the same poisoned apple pie. “They all moved down together.”
What separated Paulson from the rest of the hedge fund crowd was his realization that nobody was able to value these complex securities. His advantage came when he was willing to admit that. Other traders refused to short the big banks because they couldn’t believe that such huge institutions would be so unaware of their own risks.
A cute analogy:
Since all that toxic waste on the balance sheet imperiled the survival of the banks, Paulson wanted to be sure he was prepared. So he bought credit default swaps, like the $22 million he bet against Lehman — essentially an insurance policy that paid off when Lehman’s bonds defaulted.Even though Paulson didn’t actually own any Lehman bonds, he made more than $1 billion on that bet. It’s as though he’d bought insurance policies on houses he didn’t own along the Indian Ocean just moments before the tsunami hit.