Hedge-Fund Manager John Paulson's Greatest Trade Ever

In a span of just three years, hedge-fund manager John Paulson went from practically unknown to practically unparalleled. After a series of smart bets against the housing market made Paulson's hedge fund billions of dollars—including days where it made more than $1 billion—he earned a place alongside George Soros and Warren Buffett as an oracle of investing. In his new book, The Greatest Trade Ever, Gregory Zuckerman, a reporter at The Wall Street Journal, examines how the unlikely team of Paulson and assistant Paolo Pellegrini—as well as a few other investors—bucked conventional wisdom and saw through the housing hype. (Click here to follow Daniel Gross).

Who is John Paulson, and why is he worthy of an entire book?
John Paulson spent a career on Wall Street underappreciated as an investor, in relative obscurity. Only on Wall Street can you be worth about $100 million and still be in relative obscurity. He had slowly built up his hedge fund, and by 2005 or so he started getting nervous about this whole housing market and tried to think, maybe I should bet against it. And he wound up making the greatest trade in financial history. In 2007 alone he made $15 billion for his firm—by way of comparison, George Soros made a billion dollars betting against the British pound [in 1992]—and in the next, in 2008, he transformed the trade into more of a bet against financial firms and made another $5 billion. And yet he wasn't a mortgage expert, or a real estate expert, and didn't have much background in the derivatives he used to make the bets, like credit-default swaps (CDS).

The employee who helps execute the idea is an even more unlikely player in this drama.
Paolo Pellegrini was a native of Italy, got top grades at Harvard Business School, went on to work at Lazard Freres, but he never really made it. And in 2005, he was just looking for a job. And he calls up John Paulson, who he knew vaguely from way back when, and John Paulson's like, "Hey, you can work here as an analyst, but that's about it." And yet he helps John Paulson make the greatest trade ever.

The greatest trade involves betting against subprime mortgages and then, ultimately, the companies that were backing and insuring them. When was the eureka moment?
They backed into this in a lot of ways. They started off in 2005 having a vague worry about the state of the economy and the housing market, and they were going to buy puts on the S&P 500—those are just ways to profit when the market goes down—and they were just too expensive. So they started buying these CDS contracts, which are basically insurance policies on debt. They were very cheap. Paulson knew nothing about this stuff, Pellegrini knew a little about this stuff, and basically the two of them together, they threw themselves into it.

They decide that they want to raise a fund to do this trade on a very large scale, but they have a tough time convincing people to go in.
His idea was that if he could raise a specific hedge fund dedicated to betting against housing, he could make a fortune. So he went to everyone and anyone to make that argument. They had all these interesting arguments why he was wrong—the contracts are illiquid and hard to trade, the government would act to stop any collapse, etc. Paulson ended up with about $147 million, which sounds like a lot. But at the time, hedge funds were raising billions of dollars for different funds.

I think it was Keynes who had the line about "The market can stay irrational longer than you can remain solvent." It's not enough just to call the bubble or to have the insight that something's going to fall in the long term—you have to get the timing right in order for it to be profitable.
There's no incentive to bet against a bubble. If you're a pretty well-paid guy on Wall Street, if you bet with the masses, with the market, and you lose, well, OK, so everybody else has too and you give some good explanation and on to the next gig. But if you bet against the bubble and you're wrong you lose your job.

So he decides essentially to devote an entire fund to this strategy. When did things start to come good?
In the middle of '06, he started making these trades. Just to back up a bit, he wasn't the first. There's was a doctor-turned-hedge-fund manager up in Northern California named Dr. Michael Burry who comes up with this thesis that housing's going to fall apart and that he should be investing in CDS contracts a good year or so before Paulson. He just couldn't convince his investors to back him. And while he starts the strategy in the middle of 2006, it's not working so well early on. But in the winter and spring of 2007 the indexes he's betting against start to move dramatically. His own investors were skeptical. He was up 66 percent in February of 2007 and his investors called up thought it was a misprint. They thought it was 6.6 percent. This is a singles hitter—his whole life is banging out singles, and here he is with this unbelievable grand slam. Some of his investors actually were nervous. They thought he was taking too much risk. He was making billions of dollars a day on some of these days.

His biggest gains are in '07, which now strikes us as a relatively placid time in the market. But in 2008, he was still bearish on housing and pivots to buying credit-default swaps on the institutions that were peddling subprime mortgages, like Bear Stearns. One of the most interesting passages in the book is where he's at this meeting with Bear Stearns.
In early 2008, and John Paulson is a big name at that point, he got invited by Bear Stearns, along with a number of other hedge funds, to come over for a nice lunch. Bear was having problems, and it was trying to make sure these hedge-fund managers would come back into the fold as clients. I really think that was the key to the weakness at Bear Stearns, that hedge funds up and down the street were pulling their money out. Halfway through this lunch, when it looked like they were making some good arguments and the hedge-fund guys were coming around, John Paulson stands up and starts objecting to what the Bear Stearns executives are saying. He says, "You don't understand the problems in your own firm," and he starts listing them. By the end of the lunch everybody else in the room was like, "Wow, John Paulson actually knows what he's talking about, the Bear Stearns guys don't. Instead of bringing my money back to Bear Stearns, I'm going to start shorting that stock." And that to me is a final nail in the coffin.

Some Wall Street people really want to be thought of as intellectuals or deep thinkers, as wise elder statesmen—not just as people who make a lot of money. Clearly Paulson has some of these pretensions. Do you think he's achieved it? He made a brilliant bet shorting subprime. But as the book closes, he's buying gold, which doesn't strike me as a particularly out-of-the-box bet in this climate.
He's very good at synthesizing and making some complex topics very simple. And he's made it into a simple argument: the expanded supply of money and the fiat currency is under pressure, and what's the only thing that holds up when the fiat currency is under pressure? It's gold. You could argue that he hasn't achieved that kind of renown as an intellectual, and I'm not sure he's so focused on it. I think he wants it, but he is fascinated by big trades, and his whole life he has been. It's not about the money—listen, he likes his big homes, trust me—but more importantly he just wants to keep making big trades.