Geoff's Reviews > The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History

The Greatest Trade Ever by Gregory Zuckerman
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Jul 09, 12

Read in April, 2010

This book was awesome. Did not expect that at all. Had the idea that it would be a long WSJ article in book form, but the author put life into the narrative and the exciting (ha) world of hedge fund management. The book outlines the back-story of John Paulson’s adroit navigation of the housing bubble and the staggering profits he earned for his fund investors. His bearish view on the housing market was diametrically opposed by the street, hence his ability to reap so much rewards for his prescient navigation of the housing bubble. Paulson’s conviction allowed him to stay in his CDS positions during’ tough’ times (when the mortgage indices rose in value) and maximized profits when most investors in his position would have sold much earlier and realize profits pre-maturely.

Paulson was traditionally a M&A guy, making money on mergers and acquisitions during the 1990’s. His method shorted the acquiring firm and longed the firm being acquired. (the stock of the acquiring firm traditionally rises on news of a buyout and the purchasing company stocks dips in value.)

Hedge funds where first introduce d 1940’s, a fund managed by a private firm for private investment. The rules for hedge funds where different from mutual funds, with clients money being locked up for a certain period, and typical split of 80/20 gains. Hedge funds receive capital from wealthy individuals, institutional endowments, pensions, and governments. The number of hedge funds raised precipitously during the late 90s’ and 2000’s, no doubt due to the bull markets. SEC requirements for hedge funds are murky, with less stringent guidelines.

It all started with home loans. Borrowers that banks used to deny mortgages were eagerly sold ‘sub-prime’ mortgages with teaser rates, or interest only loans. Credit was easy to get a hold of. Annual incomes where not verified. No down payments where required. In addition to getting easy home loans, banks were also offering home equity loans, further indebting borrowers. By 2005 25% of all mortgages where ‘non-prime’. Everyone in the country was excited about home ownership. 69% of Americans owned a home…(That figure is a misnomer. I’d call home ownership when you own it outright, not just making monthly payments). Greenspan opaque rhetoric at the FED indicated all was well.

Wall Street is involved when the home loans where ‘securitized’. Mortgage companies would package the loans and sell them to investment banks. The investment banks would then re- package all the home loans and sell the resultant tranche slices to investors. The complex vehicles were created called Collatorized-Debt Obligations (CDOs). The raw revenues of these mortgage payments, with the most lucrative interests originating with sub-prime borrowers provided revenue. The investors of these CDOs and other mortgage derived loans where Swiss banks, pension plans, Australia, US insurance companies, and some iBanks kept them themselves (Leaman, Bear Sterns, etc.). These tranches and where mixed in with other loans (auto mobiles, air plans, etc.) and received high ratings from Moody’s. (AAA).

The market demand for this securitization product could not be met. Investors loved the high interest rates and couldn’t get enough of them. Enter the ‘Synthetic” investment, the Credit-Default Swap. Gregg Lippman, also a subject of the book albeit a minor one compared to Paulson, with a group of other Ibanks struggling to provide for the demand of Securitized home -loan based products, wanted to further capitalize on the housing market. CDS is essentially insurance on the payments of the CDO type investment vehicles. The value of the contract is inversely related to the value of the mortgage back security and tradable. As the value of the CDO went down, the insurance (CDS) gained in value. The CDS is called a ‘Negative carry” type investment, as opposed to the traditional “Positive Carry” preferred by most investors. The buyer of the CDS paid monthly installments to the issuer of the insurance. Not sure what exactly the ratio, but 1 Billion worth of insurance could be purchased for say 20 Million dollars. (2%). If the CDO would lose value, the price of the CDS contract would go up. The CDS contracts could be traded. This allowed for the bearish positions. The CDS issuers where glad to receive the monthly payments on this insurance, enjoying the steady stream of revenue paid by Paulson hedge and other CDS holders. Payday would come though.

The market for CDS is not as liquid as the stock market, but there was a market for them, and as you would expect, especially during the unraveling of the housing market. A common mantra within the Paulson firm was that “they’re going to zero” refereeing that the mortgage back bonds would lose all their value, and the CDS contracts would be worth 100% of the original insured value. This is how Paulson’s hedge could theoretically make their money. If the housing based CDO where to lose value, and Paulson CDS positions could be sold for profit, the fund would do well. Definitely not as easy as it sounds, as the book showed that navigating a bubble is not for your weak of heart investor nor for your common retail investor.

CDS vs. Shorting Securities
The advantage for the CDS contract over short sells is the risk is limited to the monthly insurance payments to the insurance issuer, as opposed to short position in stocks where the risk is theoretically unlimited. A stock could infinitely rise in value, while the CDS insurance position is capped. With rates so cheap, Paulson wondered why everyone wasn’t buying protection.

As the housing market heated up, the pressure on Paulson and his hedge increased. One evident problem was that the relation to housing backed securities did not fall even though the number of defaults increased. This was because people defaulting on the original covenant where able to refinance their mortgages. As long as home prices increased, banks were willing to refinance. However, when home prices declined, the music stopped. Few on Wall Street envisaged the magnitude of this event, hence the ability of Paulson to buy 1 Billion worth of CDO insurance for only 10 million. Needless to say, when the time came for the CDS holders to start paying the investors of the loan protection, the gains where astonishing.

After reading the book, I maintain that the provenance of the “Great Recession” was a result of easy lending practices coupled with greed, by both the ‘Average Joe’ and Wall Street. The populist argument blaming Wall Street and capitalism for the bust still does not ring true with the evidence provided by the book. True, Warren Buffett called CDOs CDS and other derivatives “Financial weapons of mass-destruction”, the idea of the American Dream, of making home ownership available to everyone laid the foundation for the bubble. With the risk foreign bodies investing in the housing backed derivatives, the risk spread globally. The housing boom and bust illustrated there the truism “there is no free lunch”.

Another item in the headlines related to the book was the part the I Bank played in issuing CDS/CDOs. Goldman Sachs CEO Lloyed Blankenstien testimony before congress regarding the banks relationship between the two sides of the CDS. I cannot remove the accountability on the purchasers of the contracts, two parties mutually willing to engage in the financial transaction. No one forced government pensions, banks, etc. to purchase debt backed by mortgages, or in the case of CDS, derived from housing debt. What probably needs more investigation is the independent objectivity of the broker involved in the trade. However, this is outside the scope of this book.

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