The Greatest Trade Ever (23 page)

From the moment Paulson gave him the green light, the pressure was on Rosenberg to buy as much mortgage protection as possible before it rose in price. At the same time, he had to avoid tipping off competitors to prevent them from copying the idea and driving up prices of the CDS contracts. Rosenberg began working the phones, placing orders with major banks up and down Wall Street to spend the $147 million on insurance for mortgage slices with BBB ratings, trying to be as casual about it as possible.

“So what’s the level here?” he asked one trader, as calmly as he could,
fishing for a price quote. Later, Rosenberg placed a contact on hold, trying to convey marked indifference, before getting back on the line to do some buying. Rosenberg’s customary lack of emotion came in handy—few of the brokers seemed to have a clue how desperate he was to buy boatloads of the CDS insurance. Paulson often stood over Rosenberg’s shoulder, a slightly intimidating presence; Rosenberg ignored him and kept on calling.

He hit immediate pay dirt. Each time Rosenberg asked to buy protection, as many as a half-dozen banks offered shockingly inexpensive prices. The reaction confounded Paulson—it was as if the bull market for housing was just beginning, rather than showing signs of age.

Didn’t anyone else see the news today about housing prices?

Paulson raced to do even more buying.

“It was like a vacuum, people just sucked it up,” Paulson recalls. “We’d send lists of what protection we wanted to buy and it would get snapped up. I couldn’t believe it.”

When the ABX index tracking subprime mortgages was introduced in July 2006, Paulson’s team immediately bought CDS protection on that, too. It was yet another arrow in their quiver. The cost was a bit more expensive than for the CDS contracts he had been buying on slices of selected mortgage bonds, but the ABX was more heavily traded, promising Paulson an easier exit later on. The fund even purchased a bit of insurance on the index tracking supposedly safer, A-rated slices of subprime mortgage bonds.

At first, traders were happy to sell CDS insurance to Paulson, thrilled at the mounting commissions. By selling Paulson mortgage protection, they also could create product for bullish investment vehicles to buy.

At Morgan Stanley, a trader hung up the phone after yet another Paulson order and turned to a colleague in disbelief.

“This guy is nuts,” he said with a chuckle, amazed that Paulson was agreeing to make so many annual insurance payments. “He’s just going to pay it all out?”

Soon, however, the traders began to wonder when all the buying would stop. The more CDS insurance they sold Paulson, the more they were on the hook to find bullish investors willing to take the other side
of the transactions. Some worried that they might be stuck with Paulson’s trades if they couldn’t find enough investors to take the contracts off their hands, a dangerous position if housing crumbled.

Others seemed to be making the trades for their own banks’ investment vehicles, relying on mathematical models that deemed it safe to sell protection to Paulson. If he bought much more, though, the price of the insurance investments the banks were selling might go up, dealing losses to their own investment vehicles.

Josh Birnbaum, Goldman Sachs’s top trader of CDS protection on the ABX index, kept calling Rosenberg, asking how much protection Paulson ultimately planned to buy. When Paulson and Pellegrini got wind of Birnbaum’s inquiries, they told Rosenberg to keep him in the dark. They worried that Birnbaum might raise his prices on the CDS insurance if he knew more buying was on the way.

Birnbaum persisted, asking to come by the office. A slim thirty-four-year-old who looked several years younger despite streaks of silver in his hair, Birnbaum came alone. Sitting across from Paulson, Pellegrini, and Rosenberg in a small conference room, he quickly got to the point.

“If you want to keep selling, I’ll keep buying,” he said. “We have a few clients who will take the other side of your trades. And I’ll join them.”

Birnbaum was trying to tell Paulson he was making a big mistake. Not only were Birnbaum’s clients eager to wager against him, but Birnbaum was, too. He urged caution if Paulson’s team was going to stay bearish on even safer parts of the subprime market.

“Look, we’ve done the work and we don’t see them taking losses,” Birnbaum said.

Some on Paulson’s team couldn’t figure out what Birnbaum was up to. Was he truly looking out for them or did he want to discourage the firm from shorting more of the ABX index? Was he afraid their trading might cost Goldman?

“It felt foolishly presumptuous to suggest we knew better than Goldman,” with its army of professionals and sterling reputation, Pellegrini recalls.

After Birnbaum left, Rosenberg walked into Paulson’s office, a bit
shaken. Birnbaum was the expert on the market—should they change their stance?

Paulson seemed unmoved. “Keep buying, Brad,” Paulson told Rosenberg.

Almost as soon as Birnbaum returned to Goldman’s trading floor, Rosenberg phoned him to place more bets against the ABX.

“Really??” Birnbaum responded, apparently surprised that he hadn’t persuaded them to stop.

Paulson invited mortgage experts from Bear Stearns to challenge his team to make sure they weren’t missing anything. The group walked into the “Park” conference room, next to Pellegrini’s office. The room featured a long set of windows looking north. In past meetings, the view sometimes proved distracting. Inside a gleaming, glass building across the street was a huge showroom with a long runway where female models sometimes gathered, wearing revealing Christian Dior swimsuits.

This afternoon there was less to ogle. The Bear Stearns team, among the most bullish on Wall Street, began by saying that subprime-mortgage losses of more than 3 percent were highly unlikely and that BBB slices of mortgage deals wouldn’t fall much.

“You guys are good customers and we’re concerned about you,” one Bear pro said. “You guys need to do more research on historical price appreciation.”

“What are your models based on?” Paulson responded. “The market has changed—now you can get a loan without any documentation. Are you including that in your models?”

“Our models are fine,” the Bear Stearns expert responded, polite but self-assured. “We’ve been doing this for twenty years.”

Scott Eichel, a senior Bear Stearns trader, chimed in that buying a huge amount of mortgage protection on a few mortgage pools was misguided. Don’t concentrate your bets, he warned.

Eichel was struck by the thesis of the Paulson team. It sounded too simple for a firm that he suspected had placed billions of dollars of trades. Didn’t they understand the complexities of the mortgage market?

Pellegrini listened closely to the conversation, displaying little emotion. He became convinced that some of the executives didn’t fully believe their own arguments. They simply were aiming to stop Paulson from shorting so much and causing trouble for Bear Stearns, Pellegrini concluded. He quietly seethed.

Two could play this game, Pellegrini eventually decided. He started to act as if he was having second thoughts about his bearish stance, pretending he was being swayed by the arguments of the guests.

As the meeting wrapped up, Pellegrini turned to the Bear Stearns executives with a smile. “We really appreciate the help; thanks, guys.” He didn’t dare reveal what really was on his mind.

“We said, ‘Oh, thank you for your help,’ but really we were saying ‘Fuck you,’ ” Pellegrini recalls. “We were both pretending.”

Paulson remained poker-faced during most of the firm’s meetings with the Wall Street pros. He digested their points and made doubly sure he hadn’t missed anything, but he didn’t hint at how bearish he truly was. If he wanted to keep buying at inexpensive prices, Paulson couldn’t reveal his true appetite for the insurance.

“They concluded that I was an inexperienced manager,” he recalls. “I had to play dumb. But I got tired of people saying I was stupid or wrong.”

Although the new fund wasn’t large, there weren’t many others doing much buying of mortgage protection, so Paulson’s activity quickly became the buzz of the market. Over the next few months, he received checks from new clients who sensed that housing might be peaking. He put the money to work, placing even more trades. Paulson’s team soon became more fearful about rivals catching on. When some of his investors shared details of the fund’s tactics, Paulson turned furious, installing technology to prevent clients from forwarding his e-mails.

Paulson called on Hank Greenberg, the founder of insurance giant American International Group, to see if his investment firm, C.V. Starr, wanted to invest in the Paulson fund. AIG had spent the last few years selling tens of billions of dollars of CDS contracts on subprime mortgages, and Paulson knew AIG could be at risk if housing crumbled. An investment in Paulson’s fund might be a good way to offset that position, he argued.

Greenberg and his team didn’t know Paulson, though, so they asked an outside specialist, Anauth Crishnamurthy, to vet the idea. Visiting the firm after the close of trading one day, Crishnamurthy grilled Pellegrini and Jim Wong, Paulson’s head of investor relations, pushing for details of their moves. When Paulson dropped by the meeting, Crishnamurthy asked why C.V. Starr should pay the hedge fund to invest in the ABX index when it could do that on its own.

“What’s your trading advantage?”

“That doesn’t matter,” Paulson responded. “The bonds are going to zero.”

Listening to Crishnamurthy’s detailed questions, the Paulson team worried that he might steal the trade and teach his bosses to do it themselves.

After the meeting broke up, Pellegrini pulled aside Wong, saying, “Don’t waste your time with him.”

Paulson pored over mortgage-servicing reports and noticed rising delinquencies among borrowers. The Fed already had raised its short-term interest rate back to 5.25 percent from 4.25 percent at the beginning of the year. Borrowers surely would come under more pressure.

In July 2006, Paulson got more enthused. Option One Mortgage Company, a subprime lending unit of H&R Block that was accounting for about half of the profits of the tax-filing company, reported poor earnings and acknowledged problems with loans it had issued. So many customers were skipping even their first payments that the company was being forced to take mortgages back from banks to which it had sold them.

“It was one of the first signals that something was wrong with the business,” Paulson recalls.

As Paulson’s confidence grew, he couldn’t resist bidding on a 6,800-square-foot, seven-bedroom home in Southampton with an indoor glass-enclosed pool, agreeing to a $12.75 million purchase.

In the summer of 2006, Paulson and his wife and daughters joined Bruce Goodman and his family at the fashionable Southampton Bath and Tennis Club for lunch. After their meal, the old friends walked to the beach to watch Paulson’s daughters play on the sand. As they chatted
about work, Paulson seemed cagier than usual, as if he was hiding some big secret.

Finally, Paulson opened up: “I’m working on a situation where I’ve made a major investment of my personal funds,” Paulson confided. “Bruce, if this works out, it will be extraordinary.”

Paulson beamed—Goodman hadn’t seen his friend this excited in years. He pushed for details of what Paulson was up to but all he got was an impish smile.

“I’d love to tell you, Bruce, but I can’t,” Paulson said.

Paulson’s trade started off with a thud, however, as the price of his protection slipped in August. Complicating matters, the Federal Reserve stopped raising interest rates, worried that if they got too high, home owners would feel pressure. Some investors expected the Fed to lower rates at some point, and mortgage costs fell in anticipation. It seemed that housing might survive. Paulson’s trade might be a bust.

At home, Paulson’s wife, Jenny, expressed concerns, asking her husband if he was having second thoughts.

“It’s just a matter of waiting,” he reassured her, before heading out to Central Park for his three-mile run.

Friends phoned to see if Paulson was going to cut his losses and exit some of his positions.

“How are you holding up?” Peter Soros asked. “What are you going to do?”

“I’m adding to the bet,” he responded.

The way Paulson saw it, it wasn’t bad news that these CDS investments remained unpopular and he was losing a bit of money. Instead, it was an “absolute gift” because it allowed him to buy even more, he told a friend.

Peter Soros was so impressed by Paulson’s conviction that he invested in the fund, after months of sitting on the fence. Soon, Paulson’s fund was up to $700 million, and he made plans to start a second fund to make additional wagers.

Paulson and Pellegrini soon realized that they had made a major mistake in their trade, however. Data emerged that home prices had dropped almost 2 percent in 2006. But most of the subprime mortgages
that the firm had bet against were handed out before 2006, and were for homes that already had appreciated in value. These borrowers were unlikely to run into problems because they easily could refinance their mortgages. Paulson had taken aim at the wrong target.

“We were too early,” Pellegrini acknowledges. “Even though home prices were down over the previous year, people in the market didn’t care.”

Paulson walked out of his office toward Rosenberg’s desk, a new plan in hand. “We’ve got to roll everything,” he told his trader. “We need protection on the latest vintages”—in other words, on houses that had not enjoyed any appreciation; those owners would not be able to refinance because they had no equity in their homes.

Quietly, Rosenberg traded the firm’s CDS protection for similar insurance on more recent mortgages. Once again, Paulson and Pellegrini chose the riskiest subprime bonds to insure. Not only were they made to borrowers with sketchy histories but they were made at a time when home prices no longer were rising.

Rosenberg called every contact he had to get his hands on more mortgage protection.

“What do you have, what do you have?” Rosenberg asked trader after trader. He made himself something of a pest. On Fridays in the summer, when some senior traders took their time getting back to him, hoping to push off the transaction to Monday and get an early jump on the weekend, Rosenberg kept after them, prodding them with repeated calls.