The Greatest Trade Ever (29 page)

A salesman called Rosenberg expressing caution.

“Do you realize that Einhorn is on the board of New Century?” he asked. “He does serious due diligence.”

The respect New Century commanded on Wall Street grated on Paulson. Every few hours, he got up to walk by Rosenberg’s desk and check on his trades or receive an update on market chatter. Sometimes Paulson pulled up a chair and put his feet on the desk, watching CNBC on a nearby monitor.

Paulson’s apparent calm reassured his staff. But in fact he was impatiently counting down to February 7, the day New Century was scheduled to release its 2006 results. You can lie about first-quarter, second-quarter, and third-quarter earnings, Paulson theorized, but year-end results are audited by an accounting firm, forcing a company to come clean.

Sitting at his desk late in the afternoon on February 7, a paper bag of red cherries nearby, Paulson looked up to see Andrew Hoine almost running toward him. Hoine placed a press release from New Century on Paulson’s desk and watched him digest the news: New Century had reported an unexpected loss for the fourth quarter of 2006.

“John, these guys are blowing up!” Hoine blurted excitedly.

Paulson, peering over his tortoiseshell bifocals, read on: So many of New Century’s borrowers were running into problems paying their loans that the company was forced to take back loans it had sold to various banks, reducing the company’s previously reported profits for almost a full year. It turned out that New Century
was
just like the other subprime lenders.

Paulson looked up at Hoine, a look of relief across his face.

“Finally.”

The news was a glass of cold water to the face of investors. The next day, New Century’s stock plunged 36 percent on huge trading volume, Paulson’s first big score.

As bond trading got under way in the morning, Rosenberg dialed a broker to get the latest quote on the ABX index. The response left him agape.

“Repeat that?! Did you say it’s down five points?!”

Paulson held insurance on $25 billion of subprime mortgages. So a 1 percent move in the ABX index—or each single point drop—meant a 1 percent profit for the firm. That worked out to about $250 million. The 5-point move meant Paulson & Co. had just pocketed $1.25 billion—$250 million more than George Soros scored with his legendary bet against the British pound. All in a single morning!

Watching the ABX on the screen in his office, Paulson was transfixed by the figures flashing by.

“This is unbelievable,” he muttered.

As the ABX plunged further over the next few weeks, Paulson kept his emotions under wraps. Employees sometimes caught glimpses of his building excitement, though. Leaving at the end of the day, he often had a big smile on his face. Instead of snapping at the small mistakes of his staff, Paulson became patient with them.

One afternoon in February, after the close of trading, Paulson wandered into Hoine’s office and sat in a chair near him, crossing his legs and flashing a mischievous grin. Slowly, he raised then dropped his hands on the armrest, without saying a word, his grin turning into a broad smile. Hoine didn’t have to ask—it was another good day.

Paulson and a few staff members followed the ABX index on their computer screens. His other investments, such as those betting against select subprime mortgage bonds and various CDOs, were harder to track because they didn’t trade as frequently and weren’t tracked with an index.

To get a sense of how the entire portfolio was doing, the firm’s risk manager, Adam Katz, came around twice a day to deliver a printout of
each position to Paulson. The mere sight of Katz rounding the bend, making his way to Paulson’s office, sent the hearts of Paulson’s team aflutter, just as the bells of an ice-cream truck get a child’s heart racing. They knew the better the firm did, the larger their bonuses would be. Some staff members squinted to try to see Paulson’s reaction to the printout, but he usually maintained his poker face.

Many of Paulson’s clients were unaware of the growing troubles for subprime mortgages, news that didn’t yet grab many headlines. A few weeks later, after they received a letter describing the fund’s results for February, Jim Wong, the head of investor relations, received a call from a major client who sounded bewildered.

“Is this a misprint?? It’s 6.6 percent, right, not 66 percent??”

But it wasn’t a mistake—Paulson’s credit fund had climbed 66 percent that month alone. Investors were incredulous. Paulson never before had gained anywhere near 66 percent, even in a full year. Some investors remained so dubious that Wong and his staff had to reiterate that the figure was indeed accurate.

“They wanted to hear it again, to make sure it was real,” Wong recalls. “They were shocked.”

Wong became uneasy delivering the results, sure investors wouldn’t believe him or would think the firm had done something incredibly risky to produce those kinds of profits.

“It was just so off-the-wall that I felt uncomfortable,” he recalls.

Panic soon swept the rest of the financial world. On Morgan Stanley’s huge trading floor in Midtown Manhattan, hedge funds made urgent calls to their brokers, desperation in their voices.

“We missed it!” one bellowed into the phone, frustrated that he hadn’t purchased any mortgage insurance. Some barely knew what a CDO or a CDS was, pleading for immediate tutorials. Calls also came from traders at big banks like Citigroup, Merrill Lynch, and UBS, who were frantic to get their hands on CDS insurance. The buying sent the price of the ABX still lower, adding to the angst.

Paulson’s trade finally was working. His two credit funds had spent about $1 billion to buy CDS protection on $11 billion of assorted
subprime mortgage investments. His merger and other funds together spent another $1 billion or so for insurance on $14 billion more mortgages. Already he was sitting on extraordinary gains of about $2 billion.

Banks and others now owed Paulson an amount of money that rivaled any sum owed in a financial trade. Some of them balked at forking all that cash over to Paulson before the CDS contracts were ended. Pellegrini and his team insisted, though, citing terms of their agreements, and the money was handed over. One bank dared Paulson to cause a default but ultimately backed down and posted the required collateral, a huge reverse margin call. The amateurs were putting the screws to the pros.

Paulson sold a bit of his CDS protection, to lock in some profits, but he clung to most of it, convinced that much worse was ahead for housing. The trade had become much riskier, however. When the cost of mortgage insurance was dirt cheap, Paulson was able to pay very little for protection, limiting his risk. But now that the ABX had tumbled from 100 to 60, Paulson had a lot more to lose—the index easily could snap back to 100. If the mortgage investments recovered in price, Paulson would be known as the investor who let the trade of the year slip through his fingers. For days, Pellegrini grew increasingly anxious about this prospect. Finally, he walked into Paulson’s office with a recommendation.

“We should probably do some selling here, John.”

Paulson looked Pellegrini straight in the face before giving him a curt reply: “No.”

Pellegrini knew he wasn’t going to get anywhere by protesting. He walked out, disappointed.

Pellegrini’s fears soon proved well placed as it became clear that the industry was rallying behind subprime mortgages. Those with the most at stake, such as Bear Stearns, seemed the most eager to race to the defense of the market. The firm was the fifth-largest underwriter of subprime mortgages and generated a big chunk of its profits trading this debt. Bear also operated two large hedge funds run by investor Ralph Cioffi that owned all this debt.

Gyan Sinha, Bear’s top mortgage analyst, convened an urgent conference call for clients to discuss the ABX index. Paulson and Pellegrini were among those who listened closely as Sinha addressed nine hundred investors. Most were hanging on his every word, eager for guidance in dealing with the crumbling market.

Sinha’s advice was blunt: “It’s time to buy the index,” according to a participant on the call. Based on Bear’s models, “the market has overreacted” to the news from HSBC and New Century. There was nothing fresh out there for investors to react to, Sinha repeated.

Paulson couldn’t believe what he was hearing. During the question-and-answer period, he was tempted to argue with Sinha, but he held back, still unwilling to let others know much about his moves.

Paulson recalls, “[Sinha] said, ‘My duty is to tell people how oversold the market is.’ I had to bite my tongue.”

Sinha blamed the sell-off on selling by inexperienced investors with no background in mortgages. It seemed to be a direct shot at Paulson’s team.

“Almost the entire price movement can be blamed on nothing other than pure sentiment-driven selling,” Sinha continued. “Maybe I’m naive and really I should stop thinking about fundamental valuation in all these markets.”
¹

To Paulson, Sinha was a hopeless bull. Pellegrini had a less generous appraisal.

“He was full of shit,” Pellegrini says.

Others also came to the defense of subprime mortgages, helping the ABX stage a rebound. At an industry conference in late February at the Roosevelt Hotel in New York, both Cioffi and Ricciardi made comforting comments about the market. Some snickered that Paulson and the other shorts were “tourist investors” who really didn’t understand their market.

Then Sam DeRosa-Farag, the president of New York hedge fund Ore Hill Partners, stood to give an address, urging the crowd of hundreds of fellow investors to step up their buying. Though rough times were ahead, the short-term outlook looked rosy.

“We’re not taking enough risk,” he said. “We are all really a bunch of wimps.”

At his desk, Rosenberg fielded calls from traders passing along gossip about rival funds that were gearing up to buy mortgage investments.

“Cerberus is going to be a buyer,” one trader told Rosenberg, referring to the huge New York hedge fund. “There’s a ton of money on the sidelines.”

Rosenberg turned nervous—perhaps the traders were right about all the money ready to pounce. If Paulson didn’t sell now, it might be too late later.

“I’m hearing about a lot of buyers out there,” Rosenberg told Paulson as he pulled up a chair one morning. Paulson seemed amused by the chatter. Picking up a stack of papers in his hands, he pointed to a figure on one sheet.

“What’s the average home price last month, Brad?”

The point was obvious: Home prices were still too expensive, and finally were falling. Now was not the time to get cold feet.

The ABX kept rallying, though. It rose past 70, hit 75, and rose as high as 77 in mid-May, slicing Paulson’s gains by half. The climb came even after New Century announced that it couldn’t pay its creditors and then filed for bankruptcy protection. The worst seemed over for the mortgage markets.

B
EHIND THE REBOUND
were investors like John Devaney, who once swore off subprime mortgages but now saw value and rushed to get in. As a teenager, Devaney was thrown out of a boarding school for partying and had had his ups and downs in the wake of his parents’ divorce.

But in 1999, he started a Key Biscayne, Florida–based trading firm, United Capital Markets, which soon became among the largest traders of “asset-backed” bonds—bonds backed by streams of cash from credit cards and leases. While others ran for the hills, Devaney excelled at buying unloved investments, including the debt of mobile-home makers and aircraft leases after the September 11 terror attacks.

By 2007, Devaney boasted of a $250 million fortune. When he wasn’t flying in his Gulfstream jet or sitting around his 16,000-square-foot Victorian mansion in Aspen, Devaney entertained guests on his 140-foot yacht,
Positive Carry
, named after the bond-market term for borrowing money at a low rate and investing it at higher rates. At conferences, he sponsored performances by comedian Jay Leno and bands such as the Counting Crows and the Doobie Brothers. At a 1970s-themed benefit he sponsored for the local Boys & Girls Club, Devaney made his entrance dressed as a rhinestone-studded Elvis Presley, while his wife, Selene, played a disco diva.

Devaney placed paintings by Renoir, Cézanne, and others on his mansion walls. He donated money to a range of causes, from literacy programs to the Republican Party, becoming a player in the Florida social circuit.

In the financial world, some positively gushed about his trading prowess.

“I don’t think there is anyone in the business who wouldn’t want to be John Devaney,” Mark Adelson, then a senior analyst at Nomura Securities in New York, told the
New York Times
, “to have the insights and guts to do what he did, as well as the managerial skills, the analytic skills to pull it off.”

By 2006, Devaney had a $600 million hedge fund that was on a roll, scoring heady annual gains of 60 percent. But he resisted purchasing risky mortgage investments, going as far as to tease those doing the buying.

“I personally hate subprime—and I’m kind of hoping the whole thing explodes,” Devaney said on a panel discussion at an industry conference in early 2007.

As investors turned nervous after New Century’s collapse, however, Devaney sensed bargains. Over the spring, he spent about $200 million to buy what he considered to be higher-quality subprime-mortgage investments. Not all subprime mortgages were dangerous, he argued, no matter what investors like Paulson were saying.
²

“ ‘Oh! Oh! Another news tidbit of New Century news. Oh, my god!’ ” Devaney said in a mockingly hysterical tone to a reporter, poking fun at the worrywarts.
³

• • •

B
ACK IN JANUARY
, at a conference devoted to subprime securities at Las Vegas’s Venetian hotel, Rosenberg was chatting with a banker outside a conference hall when an investor approached and relayed a troubling conversation he had had the previous evening with some Bear Stearns traders.

“It’s not so simple to short mortgages,” one of the Bear Stearns traders allegedly told the investor. “A servicer can just buy mortgages out of a pool, so you guys never will be able to collect” on the insurance contracts.