John Paulson

The Greatest Trade Ever by Gregory Zuckerman is the story of John Paulson and a handful of other traders who took positions against the mortgage market and made fortunes in a very short period of time.  Their primary method was to buy credit default swaps.  These swaps acted as insurance against the default of mortgage backed bonds, and were sold very cheaply by those who held the mortgage securities in order to spice the yield.

The trade started with the observation that housing prices were a bubble.  Housing had advanced far beyond a trend line and would have to drop 40% or more just to return to the trend line.  They also noted the tremendous growth in subprime mortgages, variable rate mortgages, LIAR loans, interest only loans and other varieties of mortgages that strongly indicated a much weaker ability of borrowers to fulfill their commitments.  In searching for the right tool to profit from shorting the mortgage market these investors stumbled across the credit default swaps.  The market for these swaps was very thin and most of the brokers did not know about them or fully understand them.

At the time John Paulson and other were taking these positions against the mortgage market,  most of Wall Street thought them fools and were too willing to find investors willing to sell swaps on their positions.  Given that housing was constantly rising it seemed like easy money to sell swaps to those who foresaw Armageddon in the housing market.  Major firms like Lehman, Bear Sterns, and almost all of the major names had huge positions in collateralized debt obligations or CDOs; interest bearing securities backed by pools of mortgages.

But very, very few could visualize this house of cards the way Paulson and the other contrarians did, and even fewer still were confident enough in such a contrarian position to make such strong trades, putting a lot of money where their mouth was.

The first to see the opportunity was Michael Burry.  Trained as a doctor, Burry retained an interest in trading and eventually started his own fund, but he had a difficult time attracting traders who both understood his position and had the nerves and patience to endure the trade.

The big Kahuna in the trade was John Paulson who was able to attract investors to two funds and was able to maintain control to ride the trade to its peak.  Paulson’s two funds averaged a gain of 440% in a year that the stock market was up only 3.5%. His firm racked up a profit of $15 billion and his personal take was almost $4 billion.

With the exception of Greg Lippman at Deutsche Bank, these traders were outside the mainstream of investing, unassociated with the big name Wall Street firms. This speaks volumes about the level of group think in the industry even when markets move to extremes.  Well paid analysts sporting sophisticated mathematical models were assuring their investors and the public that the housing market was sound and even if prices stopped climbing that there was very little risk in the market.

Government agency  leaders such as Fed Chief Bernanke, retired Fed Chief Greenspan, and Treasury chief Hank Paulson (no relation to John, at least none was noted in the book) assured the public that nothing drastic was afoot.

When markets move to extreme it often pays to be a contrarian.  But the market did not move precisely timed with their trade. Early in the trade the markets moved against them and their racked up losses.  Even when housing prices declined they could not figure out why the securities derived from mortgages did not drop with the housing market.  Investors in their funds became very nervous, and many headed for the exists. But eventually the thinking proved correct and their bets earned huge returns.

Did these traders contribute to investor losses?  To the extent that firms had to make good in the credit default swaps they chose to sell to Paulson and others, yes.  But the same firms made money on the swaps as they sold them. They just made bad bets.

Seeking more securities to trade in a thinly traded market, Paulson encouraged Goldman to create a CDO with low quality mortgages just so he could short it.  Goldman was held to account for this action, but no charges were brought against Paulson.

While such trades are rare, and those with the nerves and ability to capitalize on them are very, very few, this book is an excellent look at the thinking of contrarians.  While it shows the value of truly independent thinking, it equally shows the danger of blind groupthink that grips our government and financial institutions.

William Hurt plays hank Paulson in HBO's Too Big to Fail

When those who point fingers seek blame for the financial crisis of 2008 (we are yet to have an official historical name for this disaster) the common refrain is deregulation of the financial industry, but some examination seems to be that we were buried in regulation in many areas while bereft in others.

The two most common examples of actual deregulation was the Gramm-Leach-Blily Act of 1999 which effectively repealed the Glass-Steagall Act of 1933, and the Commodities Futures Modernization Act of 2000 which removed the regulation of OTC derivatives among “sophisticated individuals” from the Commodities Futures Trading Commission (CFTC) and the Commodity Exchange Act of 1936.

While partisans commonly blamed Bush for the deregulation that many believe caused the crisis, both of these bills were signed by Bill Clinton.  Yet these laws were largely supported by both parties and Republican Senator Phil Gramm had a leadership role in both.

At the time there were a lot of factors in the market that led both parties to believe these reforms were wise.  It is not entirely certain how significantly these reforms contributed to the depth of the crisis.  Canada, for example, experienced similar deregulations without nearly as severe a consequence.

What strikes me about the background of the deregulation in the Commodities Futures Modernization Act is how complicated the entire system was and how many different regulatory agencies we had.  The FDIC, the SEC, the CFTC, Fannie Mae, Freddie Mac, The Treasury and the Federal Reserve all had spheres of authority.   Banks regulated by the FDIC generated mortgages that were securitized by investment banks regulated by the SEC.  These mortgages were insured by Fannie Mae and Freddie Mac and were often insured by futures products that were regulated by the CFTC.  While the Treasury under Paulson took control when a meltdown was imminent, the Treasury was not normally directed to oversee the  coordination of the other agencies.  Nor was the Fed.

Watching the HBO production of  Andrew Sorkin’s Too Big To Fail, Paulson was taken by surprise by the collapse of AIG.  Within days of announcing that the era of bailouts was over while Lehman Brothers was allowed to go bankrupt, Paulson announced the bailout of AIG.  He really had no choice.  As Barney Frank observed we actually had a free market if only for a few days.

While the list of failures certainly included regulatory failures it certainly was not from want of regulatory agencies.  While some contend that the agencies were not properly staffed to regulate properly, it seems that the bigger problems were the lack of commitment from the leaders of the agencies, the lack of understanding of risk on the part of the legislators and the firms who capitalized on the changes in the law, and most of all, the complicated and decentralized structure of our regulatory agencies.  With multiple agencies overseeing different sectors of the financial system that were becoming increasingly interrelated it seems highly probable that some significant factors would fall between the cracks.  The risk posed by the massive positions taken by AIG to insure risky mortgages found a crack.

There seems to be a need for some centralized coordination of the financial system and the related agencies, but the perspective needs to come from outside normal government channels.  I doubt this would be enough to overcome congressional hubris is passing laws they do not understand, or enough to overcome the political influence of huge financial institutions.  The Fed for all of its flaws is the closest we have come to a financial authority that is removed from political influence, but that may not be saying much.

The real enemy may not be greed, but complexity.  Our regulatory structure may be unsuitable for the level of complexity we allowed. Some of our brightest and most experienced professionals seemed incapable of understanding the risk we were incurring.

(this was published previously in the Macon Telegraph)

Being in the middle of a record economic crisis presents a rare learning opportunity.  Several books are worthwhile for those seeking to understand what just happened.

Too Big to Fail by Andrew Ross Sorkin details the action of the Fed under Benanke and Treasury under Paulson during the crisis period between August and December.  While Geitner as head of the New York Fed was also featured the central player of this crisis was Hank Paulson.

Monumental decisions involving billions of dollars of assets were made in days, sometimes hours.  Both Paulson and Geitner had a sense that the market was due for a correction long before the crisis hit, but they probably did not see it coming as fast and as broad as it did. Bernanke noted that just as there are no atheists in foxholes there are no ideologues in economic crisis either. Neither Republicans or Democrats wanted to bail out Wall Street , but the crisis dictated actions that were against the grain of capitalists of both parties.

Paulson worked tirelessly to find appropriate merger partners for weak players like Merrill Lynch, Wachovia, and Lehman.  He almost had Barclays ready to buy Lehman when the British Financial Services Authority ( FSA) refused to approve the acquisition/merger because of the risk it brought to the British financial system.

Lehman was singular in the fact that it was not acquired or bailed out and thus had to go bankrupt.  Part of this was timing; Congress was just in no mood to bail out a Wall Street player.  Part of the reason was George Bush’s cousin who worked for Lehman and his brother Jeb’s association with the firm. Such close political relations probably worked against the interests of the firm.

In retrospect bailing our Lehman’s may have forestalled the panic that engulfed the rest of the system. With Bear Sterns gone and now Lehman’s gone, depositors wondered who was next and there began a run of the other banks like J.P Morgan and Morgan Stanley.

While Paulson’s association with Goldman was suspect the fact was he had to severe his tie and sell his stock ($485 million worth) in order to take his job at Treasury. Since his actions were so scrutinized he was careful to avoid even conversations that would indicate favoritism toward his old firm.

The most difficult decision was to bail out AIG whose credit default swaps acted as insurance against many of the cdo’s (collateralized debt obligations) that infected the financial markets. As the underlying assets plummeted in value AIG was downgraded and had to put up more capital that it could not provide.

Having to make such massive changes and decision in such short time meant that perfection was not obtainable. Barney Frank justifiably wanted some assurance that compensation to the executives would suffer from their misdeeds, but there simply was not enough time to rule of thousands of contracts during the time period that decisions had to be made.

Wall Street clearly engaged in risks it did not understand, but neither did the regulators such as Greenspan and his successor Bernanke. Complicated risk models gave the CEO’s delusional certainty, but eventually the party came crashing down for the same reason all bubbles burst;  lack of trust and confidence.

But Sorkin spends little space getting into the detail of the causes of the crash and suitably stays focused on the urgency and the actions required in response. 

For more information on the background that caused the crisis I recommend The Housing Boom and Bust by Thomas Sowell,  Financial Fiasco by Johan Norberg, most of all After the Fall: saving Capitalism from Wall Street – and Washington by Nicole Gelinas.

Sowell and Norberg focus more on the misguided Government fiscal and monetary policies that inflated the housing bubble, but Nicole Gelinas also analyzes which good regulations were unfortunately removed (and by who) and which bad ones were inappropriately applied.

A crisis of this nature required the perfect storm of many great errors to all focus their retribution at the same time. Unfortunately the media large engages in partisanship and demonization and few people will take the time to understand what happened and why.  It is complicated but engaging the problem reveals basic principles of sound policy that were violated as they were in previous bubbles.

History repeats itself but never the same way.