Books

Man of the Meltdown


The Greatest Trade Ever
By Gregory Zuckerman
Broadway; 293 pp.; $26 The Great Recession of 2009 destroyed trillions in wealth. But a few lucky or shrewd souls profited from this catastrophe. Perhaps the single largest beneficiary was John Paulson, a hedge fund manager who engineered the greatest trade in history, earning his firm $20 billion by betting against the housing market. In 2007, Paulson took home a staggering $4 billion for himself, the largest one-year payout in the annals of finance. That's more than $10 million a day, if you're counting.

How Paulson and a handful of contrarian investors pulled off this once-in-a-lifetime coup is the subject of The Greatest Trade Ever by Gregory Zuckerman, a senior writer at the The Wall Street Journal. Paulson has released a statement calling the book a disappointment filled with inaccuracies, which he didn't specify. But The Greatest Trade Ever comes off as a fascinating and believable counter-narrative to the growing pile of books recounting the disastrous mistakes made by many of the supposedly smartest minds on Wall Street. It is also a surprisingly dramatic work—although not always in an enjoyable way. It is the drama of waiting to see the horrific destruction scene in an apocalyptic movie.

One of four sons born into a middle-class family in Queens, N.Y., Paulson developed a taste for money at an early age. After graduating first in his class at New York University with a finance degree, he enrolled in Harvard Business School in 1978. One day Paulson attended a lecture by Jerry Kohlberg, founder of the powerful investment firm Kohlberg Kravis Roberts. Kohlberg detailed how his outfit generated $17 million in profit by investing only $500,000 in a company it sold six months later. The possibilities dazzled the young man.

Before Paulson developed the masterful short-the-housing-market strategy that made him a legend in financial circles, he was a mildly successful investor. Paulson's specialty, learned while he was an investment banker at Bear Stearns and Gruss & Co., was merger arbitrage. He set up his own hedge fund, Paulson & Co., in 1994 and produced solid if not spectacular returns betting on shares of companies being acquired. After noticing around 2004 that house prices in Long Island's tony Hamptons were tripling in a matter of years, Paulson began to sense that real estate was getting out of hand, and he grew concerned about how this speculation would affect his firm.

That worry was what sparked his strategy. Paolo Pellegrini, a sharp but insecure 47-year-old analyst whom Paulson had hired, suggested Paulson buy credit default swaps as a hedge. Paulson and his team were not familiar with these complex securities, which provide insurance against losses on debt instruments. But the crew eventually mastered this esoteric new world.

A CHEAP WAY TO BETThe beauty of a CDS is that, like an insurance contract, the most you can lose is the premium you pay for protection. If the debt tanks, the insurer must pay you the full amount of the debt. Paulson began by buying CDS contracts that insured the debt of two big lenders, Countrywide Financial and Washington Financial. After his research indicated house prices were overvalued by 40%, Paulson spent $100 million to buy CDS contracts on $10 billion worth of risky subprime mortgages. Like options on a stock, CDS insurance was a dirt-cheap way to place a bet.

Paulson was benefiting from the herd mentality of Wall Street. Investors were so skeptical of Paulson's thesis that he could raise only $147 million from friends and family to start a new credit fund. In 2006, Paulson used that money to buy synthetic CDS contracts that would go up in value whenever the ABX index, which tracks subprime mortgages, went down. That same year Paulson spotted another arcane market being inflated by clueless Wall Street pros: So-called CDOs, or collaterized debt obligations, were a fancy name for securities that gave investors claims not just on mortgages but also on other kinds of debt, such as monthly payments on cars. Investment banks such as Merrill Lynch got addicted to selling CDOs because they earned a 1% to 1.5% fee on the total amount of any deal. In 2006, $560 billion of CDOs were sold. Paulson's firm bought $5 billion in insurance contracts on the riskiest slices of those CDOs.

Initially, Paulson racked up losses on these wagers as housing prices continued to climb. But in February 2007, when subprime lender New Century Financial announced a surprising loss, Paulson pocketed $1.25 billion in one day as the ABX index finally began to drop. Panic soon spread across the financial world, and Paulson's trades began to work their magic.

The subprime implosion brought down many financial institutions. But in The Greatest Trade Ever, Zuckerman skillfully shows how Paulson and a few cohorts anticipated a disaster and figured out a way to profit. While Wall Street pros got burned cooking up exotic securities they didn't really understand, Paulson's unconventional strategy—and the courage to stick to it in the face of skepticism—allowed him to make a killing on the crash.

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkSerendipitous GambleIn a Slate podcast interview with Gregory Zuckerman, the author considers how John Paulson, a merger-and-acquisition man who had no background in housing, happened to be the one trader who foresaw the coming market implosion and was able to capitalize on it hugely. Paulson's firm "backed into this in a lot of ways," Zuckerman explains.To listen to the podcast, go to http://bx.businessweek.com/us-financial-crisis/reference
Ante is an associate editor for BusinessWeek.

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