The Greatest Trade Ever (42 page)

It’s not encouraging that key officials haven’t taken full responsibility for their mistakes. They ignored warnings about loose lending standards and failed to caution borrowers about the risks of aggressive mortgage products. A better tack would be to learn from the few investors who got it right and avoid an overreliance on industry experts.

Despite that, many of the financial reforms embraced to prevent future financial debacles depend on new agencies and savvy regulators spotting future troubles. It’s not obvious why they will be more successful anticipating the next bubble than they were at predicting the last one. A better step would be to force large financial companies to set aside more cash as a buffer for the next brutal downturn, one that sadly may be inevitable in an age of financial bubbles.

A
FTER PULLING OFF
his historic coup, John Paulson set out to write a new chapter in his career. He turned bullish on the global economy in 2009, scoring a reported $2.3 billion in personal profits as markets turned higher, frustrating rivals who hoped he’d slip up, finally. Even as global financial markets crumbled in the summer of 2010, amid worries about various European countries and the United States, Paulson maintained a stubborn optimism, as if he was intent on shaking his image as an uber pessimist.

Paulson said it was a great time to buy a second house or help relatives purchase a home, predicting that housing prices in the United States would rise by as much as 12 percent in 2011 and that the economy
would turn robust. He called the European debt crisis “manageable,” even as his optimism led to trading losses in 2010.

“We are pretty excited by the opportunities in front of us,” he told his clients, reassuring them. “If you don’t own a home today, now is the time to buy one.”

By the spring of 2010, investors had gained so much respect for Paulson that they had entrusted $33 billion in his hands, making Paulson & Company the second-largest hedge fund in the world. When he purchased a mere $44 million shares of Boyd Gaming Company, shares of the gambling company soared 12 percent, as other investors figured Paulson must be on to something.

But Paulson’s tactics came under scrutiny in April 2010. That’s when the Securities and Exchange Commission charged Goldman Sachs with civil fraud for its work with Pellegrini to create a $1 billion CDO, a deal that Paulson & Company bet against and scored $1 billion in profits. Goldman sold the deal in question, called Abacus 2007-AC1, to investors, including the big German bank IKB Deutsche Industriebank AG, which saw most of its $150 million Abacus investment evaporate.

It was just one of the series of deals that the Paulson team asked banks to create. The transactions led to huge losses for some of those very banks, such as Deutsche Bank, which didn’t sell all of those products to investors and kept some on the bank’s own books. But Goldman felt the biggest pain from the Paulson deals, emerging as the most despised banker in the world after the SEC levied its charges over the Abacus transaction.

Regulators suggested that unless new incriminating information arose, Paulson and his team wouldn’t be charged with wrongdoing.

“Goldman was responsible for the representation to the investors, and Paulson was not,” the SEC’s head of enforcement, Robert Khuzami, told a group of lawyers and deal-makers.

Nonetheless, Paulson’s involvement in the controversial transaction sparked a furious backlash in some quarters.

“He was involved in designing the security. For all we know right now, it was probably his idea,” Simon Johnson, a well-known author and professor at the MIT Sloan School of Management told television
host Bill Maher. “If he walks away without being charged, it shows how broken our system is.”

Paulson even heard it from some outspoken moms. On a website popular in his Upper East Side neighborhood called
UrbanBaby.com
, a parenting message board where discussions normally center on strollers, diapers, and lactation consultants, some posters asked whether Paulson should remain on the board of the Spence School, a prestigious school for girls on the Upper East Side, and whether Paulson’s profits from the housing bust were ethical. The question drew about seventy anonymous replies, some sounding off on the morality and utility of short-selling, credit default swaps, and hedge funds.

Paulson defended his actions to his investors, saying they were “appropriate and conducted in good faith.… We have always been forthright in expressing our opinions, and we never misrepresented our positions.”

Paulson was no superstar investor at the time Goldman sold the CDO, he reminded investors.

“When we expressed our concerns about the mortgage markets, many of the most sophisticated investors in the world, who had analyzed the same publicly available data we had, were fully convinced that we were wrong, and more than willing to bet against us,” he wrote to his clients.

Indeed, Paulson never sold any of the CDO investments under examination, including the Goldman CDO, to investors. Those who purchased Abacus were sophisticated institutions capable of examining the CDO’s collateral, much as Paulson and Pellegrini did. As such, while Goldman withheld information from investors like IKB, such as the fact that Pellegrini played an important role in helping to create the controversial CDO, it’s not clear they withheld
material
information.

By the late summer of 2010, Goldman had settled the charges, paying the SEC $550 million, and Paulson had largely put the controversy behind him. He turned his attention to his shiny new investment—gold. Paulson was so convinced that inflation would rise and that major currencies were set to fall that he and his firm plowed more than $5 billion into gold-related investments. That made Paulson the largest individual
owner of gold in the world, with holdings that by some accounts topped those of Australia, Brazil, and Argentina. Paulson departed for London in the summer of that year intent on retaining his perch atop Wall Street upon his return.

As for Paolo Pellegrini, he watched the frenzy surrounding Paulson, Goldman, and the controversial Abacus transaction with mounting frustration. Early television reports in the spring of 2010 painted Pellegrini as a whistle-blower who had turned on Paulson and supplied key information to investigators. In truth, Pellegrini did little more than answer questions posed by government officials, telling them that he and Paulson did nothing wrong.

By early 2010, Pellegrini had little to do with Paulson or even the New York financial community. A year earlier, Pellegrini began splitting his time between Bermuda and New York, choosing to try to build his own hedge-fund empire by the calm, blue sea. Pellegrini scored big early trading gains, thanks to a more pessimistic outlook for global economies than his old boss Paulson. But Pellegrini only managed to raise about $50 million from investors for his new firm. And when a bearish wager against the U.S. dollar and Treasury bonds went awry in the summer of 2010 and his fund suffered losses of 11 percent, Pellegrini pulled the plug on his nascent firm and returned all of his clients’ cash.

Building his own hedge-fund empire wouldn’t be possible, Pellegrini concluded, regretfully. Managing his own money while enjoying Bermuda’s low taxes, island setting, and opportunity to socialize with fellow financiers, such as New York City Mayor Michael Bloomberg, would have to suffice.

“Commuting to work with my outboard dinghy across Hamilton Harbor does facilitate a relaxed and productive setting for my Bermuda workdays,” he said in an e-mail.

Andrew Lahde, from time to time, returns from his own island retreat to Los Angeles to meet investors, discuss business opportunities, and attend speeches about drug legalization. During the summer of 2010, he even contemplated starting a bank.

“After all, you can borrow from depositors and the Fed at 0.25 percent, then buy long Treasuries at 3.5 percent, and go to the beach,” Lahde
said in an e-mail message. “Of course, that would last only until rates rose and the value of your long bonds fell. But who in a capitalist economy cares about the next quarter if your bonus is tied to this quarter?”

In the end, though, he chose the island life, spending the entire winter by the sea as he dabbled in precious-metal investments and interests, including snorkeling, relaxing by the beach, and ogling women. Lahde even started a photography company “to pursue several of these interests simultaneously,” he said in an e-mail.

“I have no motivation. I like not working. Stress is not fun,” Lahde said, adding that he was trying to nurse himself back to health after “taking a beating” from two years of stress related to his big trade.

By the summer of 2010, Greg Lippmann finally tired of working for Deutsche Bank. After years of bluffing that he would bolt over disappointing bonuses, Lippmann told his bosses he was leaving to launch his own hedge fund. Like Paulson, however, questions surrounded Lippmann. He and Deutsche Bank weren’t accused of any inappropriate actions. But some CDO-related transactions created by others at the bank came under investigation by federal authorities, presenting Lippmann with a potential challenge as he tried to round up clients.

Michael Burry spent months deciding what to do with the rest of his life, but he still had no concrete answer by the middle of 2010. Some of his bitterness had dissipated, thanks to belated public recognition for his early work detecting the financial bubble, recognition related to this book and one by author Michael Lewis. His trade didn’t turn Burry into the next George Soros, but it did make him a wealthy man.

Burry even felt confident enough to publicly tangle with Alan Greenspan.

“As a nation, we cannot afford to live with Mr. Greenspan’s way of thinking,” wrote Michael Burry in an op-ed in the
New York Times
in April 2010. “The truth is, he should have seen what was coming and offered a sober, apolitical warning. Everyone would have listened; when he talked about the economy, the world hung on every single word.”

But Burry remained gloomy about how his clients had treated him and how little had been learned from the dark period.

“I would say that I’ve lost a lot of faith in the human race, and that
has yet to be restored,” he said in an e-mail message. “That’s what really hurts—not so much what was accorded to me, but the tremendous failure of American society. It rips my heart out to think we are veering so far from what made America great. It’s remarkably sad on many levels.”

Jeffrey Greene also decided to turn away from investing. Focusing on politics instead, he launched a quixotic effort to win the Democratic nomination for Senate from his new home in Palm Beach, Florida. Running as a Democrat and saying he was prepared to spend $40 million to win the seat, Greene met more than a few snickers. Some brought up his colorful past, including his friendships with boxer Mike Tyson and Heidi Fleiss, the Hollywood Madam, and Greene’s escapades as an eligible bachelor, to suggest he wasn’t a serious candidate. Fresh pictures of Greene chatting with troubled actress Lindsey Lohan in St. Barts didn’t help his credibility.

But the heavy advertising spending and a serious mien helped convince some voters to ignore Greene’s flashy past.

“Government has a very important purpose, and that’s one of the reasons that I’m a Democrat,” Greene told the
Miami Herald
editorial board, even though he hadn’t registered as a Democrat until 2008. “To me, it’s not about a safety net. It’s about a trampoline. We need to create a chance for the people at the bottom to bounce back up.”

By the summer of 2010, Greene was closing in on the Democratic front-runner opposing him. Once again, the experts were shocked.

John Paulson spent more than fifty hours with me, discussing his trade, and for that I am appreciative. Many of the other protagonists in the story were just as generous with their time.

I’d also like to thank Robert Thomson,
The Wall Street Journal
’s managing editor; Nikhil Deogun, the paper’s deputy managing editor; and Ken Brown, the editor of the paper’s Money and Investing section, who gave their blessings for a leave to complete this book. Roger Scholl, my editor at Random House, and David McCormick, my agent at McCormick & Williams, provided expert insight and valued guidance, not to mention a snazzy title. I’m grateful for the invaluable counsel and critiques of colleagues, former colleagues, friends, and family members including Ezra Zuckerman Sivan, Hal Lux, Karen Richardson, Joanna Slater, Craig Karmin, Serena Ng, Richard Regis, Lynn Davidman, Avigaiyil Goldscheider, and Erin Arvedlund. William Lloyd and Janet Tavakoli made sure I kept mistakes to a minimum. And I’m indebted to Sarah Morgan and Shelly Banjo, two remarkable research assistants.

I couldn’t have completed this project without the patience and support of my wife, Michelle, who somehow convinced me to keep going, as well as the love of Gabriel and Elijah, the best boys any father could ask for. I am eternally grateful for the unwavering encouragement and love of my mother and father. Their confidence in me is the backbone of whatever success I achieve.

When I was young and still impressionable, my father worked with
me on my writing. Keep it as tight and simple as possible, he urged. Be creative. My work is an echo of his research and writing, his guidance as close as the keyboard in front of me. The greatest trade ever brought John Paulson billions of dollars. The opportunity to write about it gave me my own fortune—precious extra time with my father, of blessed memory.

1.
Greenwich Associates, “In U.S. Fixed Income, Hedge Funds Are the Biggest Game in Town,” August 30, 2007; Mark Jickling and Alison A. Raab, “Hedge Fund Failures,”
Congressional Research Service Report for Congress
, December 4, 2006.

2.
Dr. David DeBoskey, Charles W. Lamden School of Accountancy, San Diego State University College of Business Administration.

3.
Michael J. de la Merced, “Culturally, Hedge Funds Go Public,”
New York Times
, December 8, 2006.