The Greatest Trade Ever (2 page)

When the soft-spoken Paulson met with clients, they sometimes were surprised by his limp handshake and restrained manner, unusual in an industry full of bluster. His ability to explain complex trades in straightforward terms left some wondering if his strategies were routine, even simple. Younger hedge-fund traders went tieless and dressed casually, feeling confident in their abilities thanks to their soaring profits and growing stature. Paulson stuck with dark suits and muted ties.

Paulson’s lifestyle once had been much flashier. A bachelor well into his forties, Paulson, known as J.P. among friends, was a tireless
womanizer who chased the glamour and beauty of young models, like so many others on Wall Street. But unlike his peers, Paulson employed an unusually modest strategy with women, much as he did with stocks. He was kind, charming, witty, and gentlemanly, and he met with frequent success.

In 2000, though, Paulson grew tired of the chase and, at the age of forty-four, married his assistant, a native of Romania. They had settled into a quiet domestic life. Paulson cut his ties with wilder friends and spent weekends doting on his two young daughters.

By 2005, Paulson had reached his twilight years in accelerated Wall Street–career time. He still was at it, though, still hungry for a big trade that might prove his mettle. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never had seen. Home owners felt flush, enjoying the soaring values of their homes, and buyers bid up prices to previously unheard-of levels. Real estate was the talk of every cocktail party, soccer match, and family barbecue. Financial behemoths such as Citigroup and AIG, New Century and Bear Stearns, were scoring big profits. The economy was roaring. Everyone seemed to be making money hand over fist. Everyone but John Paulson, that is.

To many, Paulson seemed badly out of touch. Months earlier, he had been ridiculed at a party in Southampton by a dashing German investor incredulous at Paulson’s meager returns and his resistance to housing’s allures. Paulson’s own friend, Jeffrey Greene, had amassed a collection of prime Los Angeles real estate properties valued at more than $500 million, along with a coterie of celebrity friends, including Mike Tyson, Oliver Stone, and Paris Hilton.

But beneath the market’s placid surface, the tectonic plates were quietly shifting. A financial earthquake was about to shake the world. Paulson thought he heard far-off rumblings—rumblings that the hedge-fund heroes and frenzied home buyers were ignoring.

Paulson dumped his fund’s riskier investments and began laying bets against auto suppliers, financial companies, anything likely to go down in bad times. He also bought investments that served as cheap insurance in case things went wrong. But the economy chugged ever higher, and Paulson & Co. endured one of the most difficult periods.
Even bonds of Delphi, a bankrupt auto supplier that Paulson assumed would tumble, suddenly surged in price, rising 50 percent over several days.

“This [market] is like a casino,” he insisted to one trader at his firm, with unusual irritation.

He challenged Pellegrini and his other analysts: “Is there a bubble we can short?”

P
AOLO PELLEGRINI
felt his own mounting pressures. A year earlier, the tall, stylish analyst, a native of Italy, had called Paulson, looking for a job. Despite his amiable nature and razor-sharp intellect, Pellegrini had been a failure as an investment banker and flamed out at a series of other businesses. He’d been lucky to get a foot in the door at Paulson’s hedge fund—there had been an opening only because a junior analyst left for business school. Paulson, an old friend, agreed to take him on.

Now, Pellegrini, just a year younger than Paulson, was competing with a group of hungry twenty-year-olds—kids the same age as his own children. His early work for Paulson had been pedestrian, he realized, and Pellegrini felt his short leash at the firm growing tighter. Somehow, he had to find a way to keep his job and jump-start his career.

Analyzing reams of housing data into the night, hunched over a desk in his small cubicle, Pellegrini began to discover proof that the real estate market had reached untenable levels. He told Paulson that trouble was imminent.

Reading the evidence, Paulson was immediately convinced Pellegrini was right. The question was, how could they profit from the discovery? Daunting obstacles confronted them. Paulson was no housing expert, and he never had traded real estate investments. Even if he was right, Paulson knew, he could lose his entire investment if he was too early anticipating a bursting of what he saw as a real estate bubble, or if he didn’t implement the trade properly. Any number of legendary investors, from Jesse Livermore in the 1930s to Julian Robertson and George Soros in the 1990s, had failed to successfully navigate financial bubbles, costing them dearly.

Paulson’s challenges were even more imposing. It was impossible to directly bet against the price of a home. Just as important, a robust infrastructure had grown to support real estate, as a network of low-cost lenders, home appraisers, brokers, and bankers worked to keep the money spigot flowing. On a national basis, home prices never had fallen over an extended period. Some rivals already had been burned trying to anticipate an end of housing’s bull market.

Moreover, unbeknownst to Paulson, competitors were well ahead of him, threatening any potential windfall. In San Jose, California, three thousand miles away, Dr. Michael Burry, a doctor-turned-hedge-fund manager, was busy trying to place his own massive trades to profit from a real estate collapse. In New York, a brash trader named Greg Lippmann soon would begin to make bearish trades, while teaching hundreds of Paulson’s competitors how to wager against housing.

Experts redirected Paulson, pointing out that he had no background in housing or subprime mortgages. But Wall Street had underestimated him. Paulson was no singles hitter, afraid of risk. A part of him had been waiting for the perfect trade, one that could prove Paulson to be among the greatest investors of all. Anticipating a housing collapse—and all that it meant—was Paulson’s chance to hit the ball out of the park and win the acclaim he deserved. It might be his last chance. He just had to find a way to pull off the trade.

A
GLIMPSE OF WALL STREET’S TRADING FLOORS AND INVESTMENT
offices in 2005 would reveal a group of revelers enjoying a raging, multiyear party. In one corner, making a whole lot of noise, were the hedge-fund managers, a particularly exuberant bunch, some with well-cut, tailored suits and designer shoes, but others a bit tipsy, with ugly lampshades on their heads.

Hedge funds gained public consciousness in the new millennium with an unusual mystique and outsized swagger. But hedge funds actually had been around since 1949, when Alfred Winslow Jones, an Australian-born writer for
Fortune Magazine
researching an article about innovative strategies, decided to take a stab at running his own partnership. Months before the magazine had a chance to publish his piece, Jones and four friends raised $100,000 and borrowed money on top of that to create a big investment pool.

Rather than simply own stocks and be exposed to the whims of the market, though, Jones tried to “hedge,” or protect, his portfolio by betting against some shares while holding others. If the market tumbled, Jones figured, his bearish investments would help insulate his portfolio
and he could still profit. If Jones got excited about the outlook of General Motors, for example, he might buy 100 shares of the automaker, and offset them with a negative stance against 100 shares of rival Ford Motor. Jones entered his bearish investments by borrowing shares from brokers and selling them, hoping they fell in price and could be replaced at a lower level, a tactic called a short sale. Borrow and sell 100 shares of Ford at $20, pocket $2,000. Then watch Ford drop to $15, buy 100 shares for $1,500, and hand the stock back to your broker to replace the shares you’d borrowed. The $500 difference is your profit.

By both borrowing money and selling short, Jones married two speculative tools to create a potentially conservative portfolio. And by limiting himself to fewer than one hundred investors and accepting only wealthy clients, Jones avoided having to register with the government as an investment company. He charged clients a hefty 20 percent of any gains he produced, something mutual-fund managers couldn’t easily do because of legal restrictions.

The hedge-fund concept slowly caught on; Warren Buffett started one a few years later, though he shuttered it in 1969, wary of a looming bear market. In the early 1990s, a group of bold investors, including George Soros, Michael Steinhardt, and Julian Robertson, scored huge gains, highlighted by Soros’s 1992 wager that the value of the British pound would tumble, a move that earned $1 billion for his Quantum hedge fund. Like Jones, these investors accepted only wealthy clients, including pension plans, endowments, charities, and individuals. That enabled the funds to skirt various legal requirements, such as submitting to regular examinations by regulators. The hedge-fund honchos disclosed very little of what they were up to, even to their own clients, creating an air of mystery about them.

Each of the legendary hedge-fund managers suffered deep losses in the late 1990s or in 2000, however, much as Hall of Fame ballplayers often stumble in the latter years of their playing days, sending a message that even the “stars” couldn’t best the market forever. The 1998 collapse of mega–hedge fund Long-Term Capital Management, which lost 90 percent of its value over a matter of months, also put a damper on the industry,
while cratering global markets. By the end of the 1990s, there were just 515 hedge funds in existence, managing less than $500 billion, a pittance of the trillions managed by traditional investment managers.

It took the bursting of the high-technology bubble in late 2000, and the resulting devastation suffered by investors who stuck with a conventional mix of stocks and bonds, to raise the popularity and profile of hedge funds. The stock market plunged between March 2000 and October 2002, led by the technology and Internet stocks that investors had become enamored with, as the Standard & Poor’s 500 fell 38 percent. The tech-laden Nasdaq Composite Index dropped a full 75 percent. But hedge funds overall managed to lose only 1 percent, thanks to bets against high-flying stocks and holdings of more resilient and exotic investments that others were wary of, such as Eastern European shares, convertible bonds, and troubled debt. By protecting their portfolios, and zigging as the market zagged, the funds seemed to have discovered the holy grail of investing: ample returns in any kind of market. Falling interest rates provided an added boost, making the money they borrowed—known in the business as leverage, or gearing—inexpensive. That enabled funds to boost the size of their holdings and amplify their gains.

Money rushed into hedge funds after 2002 as a rebound in global growth left pension plans, endowments, and individuals flush, eager to both multiply and retain their wealth. Leveraged-buyout firms, which borrowed their own money to make acquisitions, also became beneficiaries of an emerging era of easy money. Hedge funds charged clients steep fees, usually 2 percent or so of the value of their accounts and 20 percent or more of any gains achieved. But like an exclusive club in an upscale part of town, they found they could levy heavy fees and even turn away most potential customers, and still more investors came pounding on their doors, eager to hand over fistfuls of cash.

There were good reasons that hedge funds caught on. Just as Winston Churchill said democracy is the worst form of government except for all the others, hedge funds, for all their faults, beat the pants off of the competition. Mutual funds and most other traditional investment
vehicles were decimated in the 2000–2002 period, some losing half or more of their value. Some mutual funds bought into the prevailing wisdom that technology shares were worth the rich valuations. Others were unable to bet against stocks or head to the sidelines as hedge funds did. Most mutual funds considered it a good year if they simply beat the market, even if it meant losing a third of their investors’ money, rather than half.

Reams of academic data demonstrated that few mutual funds could best the market over the long haul. And while index funds were a cheaper and better-performing alternative, these investment vehicles only did well if the market rose. Once, Peter Lynch, Jeffrey Vinik, Mario Gabelli, and other savvy investors were content to manage mutual funds. But the hefty pay and flexible guidelines of the hedge-fund business allowed it to drain much of the talent from the mutual-fund pool by the early years of the new millennium—another reason for investors with the financial wherewithal to turn to hedge funds.

For years, it had been vaguely geeky for young people to obsess over complex investment strategies. Sure, big-money types always got the girls. But they didn’t really want to hear how you made it all. After 2000, however, running a hedge fund and spouting off about interest-only securities, capital-structure arbitrage, and attractive tracts of timberland became downright sexy. James Cramer, Suze Orman, and other financial commentators with a passion for money and markets emerged as matinee idols, while glossy magazines like
Trader Monthly
chronicled, and even deified, the exploits of Wall Street’s most successful investors.

Starting a hedge fund became the clear career choice of top college and business-school graduates. In close second place: working for a fund, at least long enough to gain enough experience to launch one’s own. Many snickered at joining investment banks and consulting firms, let alone businesses that actually made things, preferring to produce profits with computer keystrokes and brief, impassioned phone calls.

By the end of 2005, more than 2,200 hedge funds around the globe managed almost $1.5 trillion, surpassing even Internet companies as the signature vehicle for amassing fortune in modern times. Because many funds traded in a rapid-fire style, and borrowed money to expand
their portfolios, they accounted for more than 20 percent of the trading of U.S. stocks, and 80 percent of some important bond and derivative markets.
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