A Subprime Bet for Paulson?

A hedge fund that has cleaned up by shorting subprime has given $15 million to a nonprofit lobbying for passage of bankruptcy legislation

by Eamon Javers

A $20 billion hedge fund may have hit on a unique investment strategy for playing the subprime mortgage bust: fund a consumer-protection group. Paulson & Co., which has seen its assets under management soar this year through fortuitous bets in the subprime market, has given $15 million to the Center for Responsible Lending, a Washington nonprofit that has been lobbying on Capitol Hill for passage of bankruptcy legislation.

Paulson, run by former Bear Stearns (BSC) investment banker John Paulson, stands to rake in a windfall if the measure passes. The key bill, introduced last month, would allow federal judges to restructure mortgage terms and lower payments on the primary homes of borrowers in bankruptcy, a significant legal change. The process, known as a "cram-down" in industry jargon, is opposed by investment banks that trade in mortgage-backed securities.

Banks Oppose Legislation

The banks say that such wholesale mortgage revisions would wreak havoc in the already brutal subprime secondary market, where home mortgages are packaged together and sold as securities. They fear that allowing cram-downs would further dry up liquidity in the market and cause the value of mortgage-backed securities to collapse. In August, such fears led to severe paralysis in the credit markets and produced massive losses across Wall Street (BusinessWeek.com, 10/11/07).

Center spokeswoman Kathleen Day disputes the banks' analysis of the bill's potential effects. "People saying the markets are going to dry up is just a scare tactic," she says. "We think that's hogwash." The consumer group argues that bankruptcy judges are allowed to reset loan values for other assets, including credit cards and vacation homes, and that such discretion has not harmed the secondary markets for those products.

Paulson Senior Vice President Michael Waldorf says that the hedge fund decided to contribute to the Center for Responsible Lending's legal aid effort as a way to help homeowners. "We decided to make a positive contribution in addressing a serious economic problem. People are being thrown out of their homes," Waldorf said. "And if they don't have enough money to pay their mortgages, then they don't have enough money to pay a lawyer." He also explained that the firm invests in securities, and is not involved in loans or foreclosures. "We just invested because we saw that the subprime loans underlying these mortgage backed securities were unsound," Waldorf said.

Day says the $15 million contribution, disclosed on Oct. 11, comes with "no strings attached" and will be used to finance community groups across the country that provide legal aid to homeowners facing mortgage foreclosure.

Other Bills in Play

The issue has gained prominence in Congress as foreclosures have soared and many Americans face adjustable-rate loans that are due to reset in 2008. There are several bills in play that would change the mortgage bankruptcy rules. One key piece of legislation was introduced Sept. 21 by Representative Brad Miller (D-N.C.) and co-sponsored by influential House Financial Services Committee Chairman Barney Frank (D-Mass.).

"Responsible lenders who made loans on reasonable terms have nothing to worry about in bankruptcy court," Miller said of his proposal, "but predatory lenders will end up with the loans they should have made in the first place." If key senators on the Judiciary Committee can hammer out a deal on their side of the Capitol with a similar bill, the legislation could pass Congress this fall.

While the Center for Responsible Lending has lobbied for the bankruptcy proposal, the group says no funds from Paulson will be used for that purpose. "Not one penny will be used to lobby on bankruptcy or anything else," Day says.