How John Paulson Had The Greatest Trade Ever in Subprime Mortgage Crisis

John Paulson and The Greatest Trade Ever is the story of the subprime crisis biggest bet. So who is the man who made a billion dollars from the CDO that is subject to the SEC v. Goldman Sachs fraud case. John Paulson was not charged in the Goldman case.The man is John Paulson and his success from trading against the subprime crisis has been called ‘The greatest trade ever”. To understand the subprime crisis and the deviousness of investment banks like what Goldman Sachs is accused of one needs to understand John Paulson and the greatest trade ever.

Wall Street Journal reporter Gregory Zuckerman last year published a book about the hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).

Basically John Paulson made his multi-billion fortune by shorting the US housing markets by taking a huge CDS position (Credit Default Swaps). CDS were to gain infamy as they enabled the global financial crisis and the massive multi-billion bailouts. Paulson was the exception as he was on the right side of the trade.

** As a post note Paulson added another $5 billion into Paulson & Co. profits and another $2 billion to his personal account over 2008 and early 2009. That is he made over $20 billion on the greatest trade ever

How to Trade Credit Default Swaps and Credit Derivatives 

Paulson’s basis for the trade was simple enough, American real estate prices had diverged from their historical way outside the norm. Charts were put together by former Paulson & Co analyst and later snitch Paolo Pellegrini.

The book ‘The Greatest trade also tells of other individuals who were setting up the same trade. The other traders in the book are of Jeffrey Greene, Michael Burry, and Andrew Lahde (he of the infamous 'F*ck you' goodbye letter to Wall Street).

From ‘The Greatest Trade”

“This is crazy,” Mr. Paulson said to Paolo Pellegrini, one of his analysts.

Paulson’s response was to have Pellegrini look at the long term returns on house prices:

The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.

Paulson decided he wanted to bet that house prices would regress to the mean, but how to find the right instrument to allow him to do that:

By the spring, Mr. Paulson was convinced he had discovered the perfect trade. Insurance on risky home mortgages was trading at dirt-cheap prices. He would buy boatloads of credit-default swaps—or investments that served as insurance on risky mortgage debt. When housing hit the skids and homeowners defaulted on their mortgages, this insurance would rise in value—and Mr. Paulson would make a killing. If he could convince enough investors to back him, he could start a fund dedicated to this trade.

Looking back at Zuckerman’s book I take another look at Paolo Pellegrini. He was the analyst who performed much of the grunt work but now looking back and knowing he turned informant his shaky past is worth revisiting. Before Paulson Pellegrini appeared to be done in the industry but he was determined and fit in at Paulson & Co. The book is insightful to how the trade was formulated, followed through and delivered the billions in profit. Zuckerman's work is both insightful and gripping.

This was no given, in hindsight it was so obvious but in reality there was much uncertainty surrounding Paulson’s negative real estate trade. This should be understood when people criticize Paulson’s role in the Abacus CDO which is the focus of the SEC v. Goldman lawsuit. Zuckerman in his book described the John Paulson and Paolo Pellegrini confidence in their CDS positions;Paulson and the others lost tens of millions of dollars initially as real estate and stocks continued to soar unabated. Paulson held firm and increased his exposure.

“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”

This shouldn’t surprise those that have studied the great trades through history. Given the constrain nature of them. They tend to be the most nerve raking and the most difficult to hold. Paulson ‘Greatest Trade’ was no different.

There were a number of unique factors coming together to form the perfect storm for the perfect trade.

CDO ballooned Subprime debt, to put this in perspective by the end of 2006 the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). However this quickly ballooned with CDOs to more than $5 trillion.

A total breakdown on loan compliance as the housing market took off, greed took over with mortgage brokers and bankers turning a blind eye to loan qualification. What was to become known as “Liar Loans” and ‘ninja loans’. Liar loans were loans based on stated income using the honor system with no background checks. “Ninja loans” referred to no income, no job, and no assets.

The other part of the subprime bubble recipe was the there being no down payments required. By 2005 24% of all mortgages were completed with no down payment. The percentage of first-time home buyers with no down payment was even higher an astonishing 43%. In 2001 no down payments loans were approximately 3%.

The result is summed up in the ‘the Greatest Trade”

"By the middle of 2009, a record one in 10 Americans was delinquent or in foreclosure on their mortgages. U.S. housing prices had fallen more than 30% from their 2006 peak. In cities such as Miami, Phoenix, and Las Vegas, real-estate values dropped more than 40%. Several million people lost their homes. And more than 30% of U.S. home owners held mortgages that were underwater, or greater than the value of their houses, the highest level in 75 years."

The rest is history with Paulson making over $20 billion, subprime collapsing and the fallout growing with the SEC charging Goldman Sachs and one of it's employees for Fraud over the Abacus CDO. This is the story of John Paulson and the greatest trade ever, well worth buying the book and reading it. The market awaits for the next greatest trade and the future direcition of John Paulson.