The Greatest Trade Ever (6 page)

“I finished number one in my class,” Paulson said, Aaron recalls. A few minutes later, Paulson repeated how well he had done in school, boasting that he had graduated from Harvard University.

Aaron, a Southerner with deep connections in the hedge-fund world who courted investors with a charm and politeness that masked a keen understanding of the business, was amused by Paulson’s obvious self-confidence.

“Really? Well, I graduated from the eleventh-best school in Georgia.”

The tactics Paulson outlined sounded run-of-the mill to Aaron, who figured Paulson wasn’t willing to share his insights—or just didn’t have any.

“I’m not the guy for you,” Aaron told Paulson at the end of the dinner.

At times, Paulson didn’t seem completely put together. When Brad Balter, a young broker, came to visit, Paulson chain-smoked cigarettes and had spots of blood on his shirt collar from a shaving mishap. Paulson’s head of marketing was stretched out in agony on a nearby couch, moaning about his back.

“I didn’t know what to think; it was a little surreal,” Balter recalls.

At times, Paulson became discouraged. His early investment performance was good but uneven, and he continued to have few clients.
He was sure of his abilities but questioned whether he could make the fund a success.

One especially glum day, Paulson asked his father, “Am I in the wrong business? Is there something wrong with me?” Alfred Paulson, who at that time was retired but helped with his son’s accounting, tried to cheer him up, telling Paulson that if he stayed with the fund, it would succeed.

“It was hard to be rejected; it was a lonely period,” Paulson recalls. “After a while I said, this is too much. He lifted my spirits.”

Paulson clung to the message of a favorite quote from a commencement speech given by Winston Churchill: “Never give up. Never give up.”

Paulson had more success in the then-struggling real estate market. In 1994, he heard about an attractive home available in Southampton. The couple who owned the house were in the middle of a divorce. Paulson contacted the wife, who sounded eager to sell the property, and together they agreed to a $425,000 price. At the closing, though, Paulson was shocked to learn that the home wasn’t the woman’s to sell—there already was a big mortgage on the property. For months Paulson kept an eye on the home, as it went through foreclosure and then was handed between banks before landing with GE Capital. He was told that the house would be auctioned the following Tuesday on the steps of the Southampton courthouse.

Paulson showed up early that August morning, just as rain began to fall. When he asked if the auction could be moved indoors, he was told that by law it had to be held outside the courthouse. Soon the rain picked up and some prospective bidders took off. The auction, with bids to increase in increments of $5,000, began with a bid by GE Capital at $230,000. Paulson quickly responded with an offer of $235,000. GE didn’t respond, no one else emerged, and Paulson was able to walk away with his dream home at a bargain-basement price. Later that year, he purchased a huge loft in the SoHo neighborhood of Manhattan that also had been in foreclosure.

Paulson realized that if he could improve his investment performance, investors eventually would find their way to him. Because the firm was so small, he could focus on attractive merger deals that competitors
wouldn’t bother with or didn’t have much faith in, such as those involving overlooked Canadian companies. Sometimes he would stray into investments unrelated to mergers, such as buying energy shares and shorting bonds of companies that seemed to have flimsy accounting.

By 1995, Paulson & Co. was big enough to hire two more employees; he pushed his young analysts to find investments with a big upside yet limited downside. “How much can we lose on this trade?” he would ask them, repeatedly.

The gains were solid but usually unspectacular, and sometimes Paulson appeared glum or cranky. When a trade went awry, he often closed the door to his office tightly and slumped in his chair. At times he would clash with his analysts. The yelling would get so loud that people down the hall sometimes popped their heads into the office to make sure that nothing was amiss. One time, Paulson turned beet red and got so close to analyst Paul Rosenberg’s face that Rosenberg became scared. “Why are you acting like this? I’m on your side,” Rosenberg said, according to someone in the room. Paulson just glared back.

Paulson once told an employee to go to a doctor’s office on the Upper East Side to take a drug test, without giving him any explanation. The employee came back to the office and handed Paulson the cup of urine. He never heard about it again. Paulson castigated another employee for excessive use of the firm’s printer, one more inscrutable action that left some on his team scratching their heads.

Paulson at times even became frustrated with his father’s deliberate work. He also criticized his attractive new assistant, Jenny Zaharia, a recent immigrant from Romania who had landed a job at the firm after delivering lunch from the Bear Stearns cafeteria to Paulson and his employees. A college student in Romania, Zaharia left her family behind and was granted political asylum in the United States after her brother, George, a track star in Romania, defected during a European competition and later moved to Queens. Jenny, who had spent some time as a television reporter for a Romanian television station in New York, was tempted to quit, but she told others that she didn’t have other options and needed the salary.

By late 1996, Paulson had just $16 million of assets. He was a small-fry
in the hedge-fund world. Then he found Peter Novello, a marketing professional determined to help Paulson get to the big leagues.

“He had a reasonable track record but it wasn’t phenomenal; it was a period when a lot of managers were making 20 percent a year,” Novello recalls.

As Novello tried to lure new investors, they sometimes asked him about Paulson’s activities outside the office. Rumor had it that Paulson partied hard.

“What difference does it make?”

“Well, we just want to see a level of stability,” one investor replied.

“John didn’t fit the profile of the average hedge-fund manger. He was living downtown in SoHo and in the Hamptons. He had a different lifestyle than [what the] institutional investors were used to seeing,” Novello says.

Paulson’s fund was hurt by 1998’s Russian-debt default, the implosion of the giant hedge fund Long-Term Capital Management, and the resulting market tumult. His patience wore thin with one employee, Dennis Chu, who was left frazzled and unable to make clear recommendations to his boss.

“Just tell me what you think!” Paulson screamed at Chu, who eventually left the firm.

Sometimes Paulson hinted at what might have been aggravating him, noting that competitors and friends seemed to be pulling away. He told one analyst that an old roommate from Harvard, Manuel Asensio, was making a million dollars a year at his hedge fund shorting tiny stocks, “and we’re killing ourselves here.”

The fund lost 4 percent in 1998, enough to spur some clients to rush for the exits, leaving Paulson & Co. with about $50 million at the end of the year—down from more than $100 million at the end of 1997. Some deserted Paulson for larger merger specialists, some of whom managed to make a bit of money during the year.

“I was not a major player,” Paulson acknowledges. “We were a little shell-shocked from the LTCM collapse so we were less aggressive getting back into the market later in the year like others.”

On days the firm made money, Paulson was friendlier, even charming,
a change in personality that both relieved and confused his employees. Some of them attributed his mercurial personality to his drive to be a major player. It was also, they realized, the nature of merger investing, which requires split-second decisions based on imperfect information. Others learned to appreciate Paulson’s brutal honesty, such as when he dissected their investment recommendations, looking for holes.

While the market shakeout of 1998 cost Paulson clients, it also left him with ripe investment opportunities, enabling him to score impressive gains over the next few years. Just as important, he made a dramatic decision to alter his lifestyle. Paulson had continued to host blowout bashes at his SoHo loft in his early days of running the fund. But as he approached his mid-forties, almost everyone in his group of friends had married, and he, too, was beginning to tire of the social scene. Paulson took out a pad and pen and wrote down the characteristics he was looking for in a wife. The word “cheerful” topped the list. Paulson sensed he needed a partner who could help him deal with the ups and downs of his life.

“I figured I’d always make money, so that was unimportant to me,” Paulson says.

He quickly realized there was a woman he was attracted to who fit the bill and was sitting nearby: his assistant, Jenny.

“Jenny didn’t drink, smoke, or go out late at night; for me she was a breath of fresh air,” Paulson says. “She was almost always smiling and cheerful.”

Paulson quietly pursued Zaharia, asking her out almost every other week for more than a year, but she wouldn’t agree to go on a date. Zaharia told Paulson that she’d only date him if he fired her and found her a new job. But Paulson couldn’t bear to let Zaharia go and work for someone else. He offered her all kinds of enticements, including trips to Aspen, Miami, and Los Angeles. Zaharia had never been to those cities and was tempted to go with her boss, but ultimately refused, saying she didn’t want to cross the lines of professional behavior.

Zaharia did agree to have lunch with Paulson, however, and the two began getting together at least once a week, though other employees were in the dark about the budding relationship. After more than two
hundred meals together, and an occasional Rollerblading outing in Central Park, Paulson realized he was in love and proposed; six months later they wed. When Paulson finally told his employees, they were floored, having completely missed any signs that an office romance had been brewing.

Paulson went out of his way to embrace Jenny and her family. The couple agreed to wed in an Episcopal church in Southampton, and Paulson became friendly with the priest. Light streamed through the seaside church’s Tiffany windows as the sun set and the ceremony began.

By 2001, Paulson was on more solid footing in his personal life. And his fund had grown as well. He managed over $200 million and had refined his investment approach.

Few outside the firm picked up on the change in Paulson, though. Erik Norrgård, who invested in hedge funds for New York firm NorthHouse Advisors, met Paulson around that time and decided his was “just another ham-and-cheese operation in a crowded space” of merger investors. Norrgård passed on him. Others heard rumblings about Paulson’s wild past and steered clear, unaware that he had settled down into a quiet family life.

“If people knew him at all, it was as just another merger arb,” says Paulson’s friend and initial investor Howard Gurvitch. “He wasn’t really on anyone’s radar screen.”

But something remarkable was about to happen to the nation, and to the financial markets, an upheaval that would change the course of financial history and transform John Paulson from a bit player into the biggest star in the game.

T
HE HOUSING MARKET DIDN’T SEEM LIKE AN OBVIOUS BENEFICIARY OF
the age of easy money. As the World Trade Center toppled on September 11, 2001, and Osama bin Laden’s lieutenants boasted of crippling the U.S. economy, the real estate market and the overall economy wobbled—especially around the key New York area. Home prices had enjoyed more than five years of gains, but the economy was already fragile in the aftermath of the bursting of the technology bubble, and most experts worried about a weakening real estate market, even before the tragic attacks.

But the Federal Reserve Board, which had been lowering interest rates to aid the economy, responded to the shocking September 11 attacks by slashing interest rates much further, making it cheaper to borrow all kinds of debt. The key federal-funds rate, a short-term interest rate that influences terms on everything from auto and student loans to credit-card and home-mortgage loans, would hit 1 percent by the middle of 2003, down from 6.5 percent at the start of 2001, as the Fed, led by Chairman Alan Greenspan, worked furiously to keep the economy afloat. Rates around the globe also fell, giving a green light to those hoping for a cheap loan.

For years, Americans had been pulled by two opposing impulses—an instinctive distaste of debt and a love affair with the notion of owning a home. In 1758, Benjamin Franklin wrote: “The second vice is lying; the first is running in debt.”
¹
The dangers of borrowing were brought home in the Great Depression when a rash of businesses went bankrupt under the burden of heavy debt, scarring a generation. In the 1950s,
more than half of all U.S. households had no mortgage debt and almost half had no debt at all. Home owners sometimes celebrated paying off their loans with mortgage-burning parties, setting loan documents aflame before friends and family. The practice continued into the 1970s; Archie Bunker famously held such a get-together in an episode of
All in the Family
.

Until the second half of the twentieth century, borrowing for anything other than big-ticket items, such as a home or a car, was unusual. Even then, home buyers generally needed at least a 20 percent down payment, and thus required a degree of financial well-being before owning a home.

But the forces of financial innovation, Madison Avenue marketing, and growing prosperity changed prevailing attitudes about being in hock. Two decades of robust growth justified, and encouraged, the embrace of debt. Catchy television commercials convinced most people that debt was an ally, not an enemy.

“One of the tricks in the credit-card business is that people have an inherent guilt with spending,” said Jonathan Cranin, an executive at the big advertising agency McCann-Erickson Worldwide Advertising, in 1997, explaining the rationale behind MasterCard’s “Priceless” campaign. “What you want is to have people feel good about their purchases.”
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