The Greatest Trade Ever (15 page)

The experience was painful, one more of a series of aggravating moves that year. But it convinced Paulson of the advantages of using CDS contracts to express a negative view. Unlike shorting a stock or a bond, losses from CDS contracts were capped at the annual payment of the insurance, Paulson realized. He was fast becoming a convert to the benefits of derivatives trading.

In truth, CDS contracts weren’t quite ready for prime time. One
reason Delphi’s bonds had soared was that investors holding CDS contracts protecting against a loss in Delphi’s debt needed to get their hands on the company’s bonds, to present them for payment to investors who had sold them the CDS protection. They scrambled to buy up Delphi’s bonds, bidding up their price, despite the bankruptcy.

“What a waste—we’re obviously too early,” Paulson told another analyst. “The market’s getting more wild.”

Paulson’s frustrations grew as he watched a series of leveraged-buyout firms make acquisitions at nosebleed levels during 2005. An $11.3 billion takeover of SunGard Data Systems became the biggest buyout since RJR Nabisco sixteen years earlier, while household names like Hertz Corp. and Metro-Goldwyn-Mayer also were gobbled up, thanks to cheap debt financing from generous lenders and investors.

“This is insane!” Paulson said, as he pulled up a chair next to Brad Rosenberg and they watched news of a new acquisition on a business-television channel. “There’s so much money out there chasing things; they’re lending too freely.” Paulson told Pellegrini that they were up against a “wall of liquidity.”

Paulson shook his head as he noted a surge of borrowing by Wall Street’s banks, saying “Do you realize these guys are leveraged thirty-five to one?”

Rosenberg brought Paulson stories from the Internet about how borrowers were receiving mortgages without having to document their income or assets. Lending was getting out of hand in cities such as Phoenix, San Diego, and Las Vegas. The subprime frenzy seemed to be spreading. Paulson, Pellegrini, and Rosenberg held a series of conversations with Wall Street’s top mortgage analysts, trying to understand why so few of them were worried. They were the experts, Paulson’s team realized, and Paulson a rank outsider. Was there something he was missing? Paulson wondered.

“Our models say don’t be worried,” said Bear Stearns’ Gyan Sinha, a top-rated analyst, on a phone call. “Home prices have never gone negative,” another analyst said. Others emphasized that investment-grade mortgage investments had rarely defaulted. “They won’t even go flat,” one expert told Pellegrini.

“They thought we were crazy. They kept talking about ‘our models,’ ” and said we didn’t know what we were talking about,” Rosenberg recalls.

F
OR PELLEGRINI
, a subprime trade that once was a mere sideshow to the fund’s merger investments had become a potential lifeline, at least to him. Pellegrini’s contributions to the merger team were negligible, and it was obvious how low in the pecking order he was. Most of the analysts reported directly to Paulson. Pellegrini, however, had to first run his ideas past Andrew Hoine, the firm’s research director, as if he was a remedial student in need of a tutor.

In late summer, the young man he had replaced, Nikolai Petchenikov, returned to the hedge fund from a one-year stint in business school, adding to Pellegrini’s anxiety. Paulson began to give the twenty-seven-year-old, rather than Pellegrini, key assignments in the international-merger area. Pellegrini’s window of opportunity at the hedge fund seemed to be closing quickly.

Seeing the writing on the wall, Pellegrini approached Paulson, suggesting that he focus on the subprime and financial areas, an offer Paulson accepted with enthusiasm.

“This could be a gold mine for us,” Paulson responded, encouraging him.

It was an enormous gamble for Pellegrini, despite his boss’s enthusiasm. Merger investing was at the core of Paulson & Co. The CDS trade was a diversion, one that Paulson might drop at a moment’s notice. The firm employed fewer than a dozen people; any deadwood wouldn’t survive long. Pellegrini was forty-eight years old and on tap to earn about $400,000 that year. It was a substantial sum, although much of it went to pay his sons’ private-school tuitions. His bank account still showed an embarrassingly small sum for a finance-industry lifer.

“It wasn’t clear to me that I was a keeper at the firm,” Pellegrini recalls. “John wasn’t comfortable with my work, and I was just as frustrated with myself. Anyone else would have fired me, but John saw I was making an effort.”

Pellegrini was confident the subprime trade would work; he just
hoped he would be allowed to stick around long enough to profit from it.

“I had everything on the line,” Pellegrini recalls. But he had been certain before in his career, only to have something foil him.

Rather than become nervous, however, Pellegrini was more excited than he had been in years. He came to work a bit earlier and stuck around later, unable to stop thinking about the housing market. Over the summer, on a second date with Henrietta Jones, who ran the retail division for the Donna Karan clothing label, Pellegrini spent the evening replaying a presentation he made earlier in the day about the state of real estate; over dessert, he encouraged Jones to sell her Manhattan apartment.

Interest rates and mortgage products weren’t the most romantic topics of conversation, but Jones was taken with Pellegrini’s passion.

Pellegrini soon realized that he and Paulson had missed something important, however. In November, Pellegrini joined a group of investors at a meeting at the Grand Hyatt hotel in Midtown Manhattan hosted by Robert Cole, the chief executive officer of New Century. Pellegrini sat quietly, listening to Cole’s rosy presentation and a series of softball questions tossed by a group of upbeat investors, some of whom congratulated Cole on the low level of defaults among New Century’s customers.

Pellegrini was convinced that his rivals were missing it.

Wait till rates reset
, he thought.

He resisted speaking up, though, lest they figure out how bearish his firm was, and perhaps warm to the CDS protection that Paulson was becoming enamored with, pushing prices higher.

But Pellegrini had nagging concerns that he might be missing something. Was there a way to run his ideas past Cole?

After the speech, Pellegrini made a beeline to the lectern, grabbing Cole’s attention before other investors had a chance.

“What will happen when the mortgages reset?” Pellegrini asked, thinking he had found the fatal flaw in Cole’s bullish thesis. “Will there be defaults?”

Cole seemed remarkably unfazed.

“No, we’ll just refinance the loans,” he responded, matter-of-factly.

Cole explained that New Century, like other subprime lenders, earned so much in upfront fees from refinancings that his company was happy to refinance home mortgages before they had a chance to reset at higher interest rates even though it meant lower profits from new, lower-rate loans. That way New Century made sure that borrowers could still make their payments. They could keep refinancing their customers’ loans as long as their underlying properties were worth more than when they took out their original loans, Cole said.

“Interesting,” Pellegrini replied, meekly.

The Paulson team’s original thesis, that a spike in interest rates would cause problems for home owners, seemed dead wrong. If rates moved higher, Pellegrini realized, lenders would just bail out borrowers, letting them refinance their homes at lower rates. Given that, a wave of defaults seemed unlikely, at least for homes that had climbed in price.

Pellegrini had a sinking feeling as he hustled back to the office to tell Paulson.

It wasn’t the kind of news anyone at Paulson & Co. wanted to hear, and it couldn’t have come at a worse time. The various hedge funds run by the firm gained 5 percent or less in 2005, trailing gains of 9 percent or more for other hedge funds. Chatter on Wall Street was growing that Paulson was falling behind the times.

“It was very frustrating,” recalls Jim Wong, Paulson’s point man with investors.

At Concord Management, LLC, an associate, Martin Tornberg, was grilled by the New York firm’s investment chief about Paulson’s disappointing performance.

“Why are we in this fund?” Tornberg’s boss asked him about one of Paulson’s funds. Tornberg suggested that they give Paulson some more time before pulling out.

By the end of the year, even friends were asking questions about Paulson’s investing strategy. Visiting Paulson’s office one day in November, Howard Gurvitch, his original investor, suggested that the firm’s subpar performance might be due to the rush of easy money that
was chasing every kind of deal, making mergers and other areas more difficult for conservative investors like Paulson.

“Maybe it’s a new world, John?” Gurvitch asked his old friend, gently.

Paulson told Gurvitch that he remained confident in his unpopular stance. His challenges soon would grow, however. Unbeknownst to Paulson, a few other investors were coming around to his view on housing and soon would be hot on his heels.

I
N MAY
, after Greg Lippmann had helped develop the perfect means to bet against housing, he and his colleagues began racking up commissions trading their new CDS contracts on pools of subprime mortgages. Lippmann, who also operated a trading account for Deutsche Bank, initially joined the pack, selling the CDS contracts to the few bearish investors like Burry in San Jose.

By June, though, Lippmann’s contrarian instincts had kicked in. He decided to do his own research to make sure the bullish crowd had it right. Lippmann loved to boast about a research analyst at the bank named Eugene Xu, proudly telling colleagues that at just eighteen years of age, the Shanghai native finished second in a national math competition in China. Maybe Xu, who received a doctorate in mathematics from the University of California in Los Angeles, could test the bullish thesis.

Lippmann asked Xu to dig up as much data as he could about home-mortgage defaults, something Lippmann and most others in the business never thought to examine before, as housing seemed to be on an inexorable climb. Xu split the country into quartiles. He discovered that states with the lowest rates of default, like California, Arizona, and Nevada, also claimed the highest growth in home prices. The quartile with the highest rates of default had the slimmest growth in home prices. Florida and Georgia seemed similar in many ways, but Xu’s numbers showed Florida had a much lower rate of default than its northern neighbor, which seemed due to its soaring home prices.

The clear relationship between home prices and mortgage defaults
didn’t seem to be a recent development, either. Xu found that home prices had been key to loan problems for more than a decade, including during the mini-downturn in real estate in the early 1990s.

“Holy shit,” Lippmann exclaimed to Xu on Deutsche Bank’s trading floor while reading over his work, “if home prices stop going up, these guys are done.”

Lippmann’s thesis seemed logical—but at the time it was quite a radical viewpoint. Most economists and traders figured that a range of factors, including interest rates, economic growth, and employment, determined the level of mortgage defaults. Sure, home prices had an impact, and they were bound to plateau at some point. But if the other factors all held up, then default rates shouldn’t climb very much, according to the conventional wisdom.

Xu’s data clearly showed those other factors didn’t mean nearly as much as home prices. Indeed, California’s employment rate was about the same as a number of states with much higher default rates, but which had more limited gains in home prices. The lesson to Lippmann was that hot real estate areas like California actually were poor credit risks, not good ones. If home prices ever leveled off, defaults would shoot up.

“Why hasn’t anyone done this research before?” he exclaimed to Xu. A sudden convert, Lippmann wasn’t shy about sharing his views within the bank.

“These things are gonna blow up!” he bellowed across the trading floor one day, as the other traders shook their heads.

Lippmann rushed to tell others at the bank, anticipating that they would appreciate his insight. He patiently explained to them that when home prices came back down to earth in California and other raging real estate markets, mortgage defaults and delinquencies would be as high as they were in states like Indiana, where about 6 percent of home owners were delinquent on their home mortgages, double California’s rates.

His colleagues remained skeptical, however. Even veteran analyst Karen Weaver, who had been warning investors to avoid all kinds of
aggressive mortgage-related investments, wasn’t convinced. At weekly meetings, the other Deutsche Bank executives snickered or laughed at Lippmann’s diatribes about the problems ahead.

“There goes Greg again,” Weaver joked to the group one day. Others began poking fun at Lippmann, sparking a round of laughter.

“You’ll see; I’ll be right,” Lippmann shot back.

Some at the bank insisted that Lippmann must be missing something—maybe the explosion in population in California and Florida helped keep defaults low. So Lippmann and Xu went back to their data, controlling for population changes and other factors. But they continued to find that housing prices alone were key to mortgage defaults. Nothing else seemed even close. To Lippmann, it was as if his colleagues and rivals were insisting that the earth was flat.

“All you need is for California [real estate] prices to start looking like Indiana’s and you get twelve percent defaults, at least,” Lippmann insisted to one colleague. Home prices in Indiana were growing about 5 percent compared with more than 15 percent in California. Lippmann argued that when prices stopped climbing, a rash of problems would result, in even soaring real estate markets.

By the late fall of 2005, Lippmann was even more convinced of this, but he needed permission from the bank to buy up CDS contracts and lay a big bet against housing. He took a deep breath and proposed to one of his bosses, Rajeev Misra, buying protection on more than $1 billion of risky mortgages.