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.