The Greatest Trade Ever (11 page)

But Pellegrini didn’t make many friends at Tricadia when he suggested that the firm find ways to short collateralized-debt obligations, even as others at the firm were buying and creating versions of these debts. After a derivative-focused company that Pellegrini hoped to set up for Tricadia failed to get off the ground, he began searching for a job
once again. It was that development that led him to the interview that Paulson set up for him with two of Paulson’s executives, Andrew Hoine and Michael Waldorf.

The meeting started with Hoine and Waldorf asking Pellegrini for his views on various European industries. Pellegrini had no clue—his most recent experience was with CDS trading. He hadn’t taken the time to brush up on other areas. Pellegrini tried to compensate by acting more cocky than he actually felt, but he could see Hoine and Waldorf becoming annoyed with him as the meeting progressed.

Afterward, Pellegrini waited at home for days, hoping to hear back from Paulson. Pellegrini almost gave up. Ten days after the interview, he finally received a call. “Well, you managed to piss off my partners,” Paulson said. “If you hadn’t been such a jerk, you would have gotten a job earlier.”

“If I came off as a jerk, I didn’t mean to,” Pellegrini responded, quietly.

Paulson agreed to give Pellegrini a chance. His employees didn’t like him very much, but Paulson viewed Pellegrini as a smart gamble, a bright, well-educated analyst who might yet become an asset. He told Pellegrini it would take him a year or so to learn the merger-arbitrage business, and welcomed him aboard. Pellegrini was forty-seven, a year younger than his new boss and thrilled at the opportunity to show he wasn’t washed up.

T
HE EARLY MONTHS
at Paulson & Co. were tough on Pellegrini. Worried about being overwhelmed by the details of his job, as he had been at Lazard, Pellegrini arrived at the office before 6:30 a.m. each morning, among the first to arrive. He wanted to try to have a few recommendations ready when Paulson walked in. He had another motive: Pellegrini found early-bird $18 parking a fifteen-minute walk from their office at the corner of 57th Street and Madison Avenue. The price doubled if he arrived after 7 a.m. Pellegrini wasn’t sure how long he would have the job, so he needed to save his cash.

Pellegrini took advantage of a full, catered lunch from a local upscale eatery that Paulson offered his employees. When Pellegrini returned
home to his apartment in the Westchester suburb of Mamaroneck around 8 p.m., he usually made something light, like tomato salad, cheese, and bread.

He had no television in his small one-bedroom rental. He chose to live close to a train station and his favorite golf course. For entertainment, Pellegrini began to catch up on classic American writers, such as Edith Wharton and Henry James, authors he never had a chance to enjoy in school. Pellegrini found a connection with their stories of outsiders struggling to break into high society, including New York’s upper-crust scene, something he had failed to do at Lazard Freres and through his marriage to DeWoody.

“I could see the divide between people who are successful and optimistic and those at the other end, having trouble keeping up,” Pellegrini says. “There’s sadness about not realizing one’s hopes and expectations.”

Pellegrini didn’t have many friends in the area, but his sons stayed over on weekends, sleeping on a pullout couch in the living room. Pellegrini felt the likelihood of turning his life around was dropping with each day, but he wasn’t ready to give up.

“Somehow I needed to manage to stay in the United States and support myself; I didn’t want to be in another country and not be able to see my kids,” he says. “That kept me going.”

Pellegrini put in long hours analyzing international mergers but couldn’t come up with many good ideas for the fund. It took him longer to get up to speed than he expected, and he was as disappointed in his work as Paulson was. When Paulson met his investors, he often brought along a few associates to introduce them and show off their education and backgrounds. Pellegrini usually was left back at the office, even though he was two decades older than most of the other analysts. He didn’t complain.

“I didn’t have a great story to tell about myself and my experience,” Pellegrini says. “I produced usable work, but it was difficult for me to carry on conversations with clients. It was nice of John to give me the job and stick by me.”

Pellegrini was so relieved to land the position that he missed fleeting signs that Paulson himself might be losing his touch.

Some ridiculed Paulson’s focus on mergers, which seemed out of step with the instant wealth being created in housing. At a cocktail party in Southampton in late 2004, Paulson and a friend, Jeffrey Tarrant, stood in the corner of the room discussing how overheated the real estate market had become, when Stephan Keszler wandered over, a drink in his hand. Keszler, a dashing, six-foot-three, fair-skinned native of Munich, wearing tattered jeans and a blue blazer, was well-known in the Southampton scene as a real estate success story. He had spent twelve years purchasing and renovating upscale homes in the area.

Inserting himself into the conversation, Keszler was dismissive of his friends’ caution.

“What are you guys trying to do, a 10 percent to 12 percent return? How does that help anyone—you can’t do better than that?” he asked. “I’m doing more than 25 percent a year; I can double my money in a few years.”

Paulson and Tarrant turned uncomfortable. In high school, mother jokes were the meanest put-down, but among the Southampton set, it didn’t get much lower than knocking someone’s investment prowess.

“Good for you,” Paulson responded, “but I hope you know when to get off. Real estate has gone down in the past; why won’t it end badly this time, too?”

Keszler chuckled and shook his head, before walking away.

Part of the reason Paulson had grown concerned about real estate was that the Federal Reserve finally had begun to raise interest rates, which eventually would push borrowing rates higher, taking away the economy’s punch bowl.

“Who’s the most vulnerable to higher rates?” Paulson asked a group of staffers back at the office.

Paulson became intrigued about whether consumers, many of whom already were struggling with debt, might have difficulties handling a rise in rates. Investment banks and financial firms also were heavy borrowers, Paulson told one of his traders. Some had more than $25 of assets for each $1 of equity they held. They might also be vulnerable as rates rose, Paulson said.

He started to look into buying protection for his firm, in case all the borrowing
in the economy led to deep troubles. He wasn’t the only one getting worried, however. Enough investors had purchased “put” contracts on the Standard & Poor’s 500—futures contracts that rise in value when stocks plunge—that the contracts had become too expensive to Paulson.

Paulson had examined shorting shares of some financial-service companies, but some companies in that business recently had received takeover offers, sending the stocks racing higher, burning those who shorted them with deep losses. Was there any better insurance?

One day in October 2004, Pellegrini, still nervous about his standing at the firm, got up the nerve to approach Paulson in the hallway to tell his boss that there might be a better way to protect the firm’s portfolio. Why not buy credit-default swaps?

Paulson and his team weren’t very familiar with the world of credit-default swaps, beyond a vague understanding that these instruments provided insurance against losses from debt investments. Though trading of CDS contracts had soared in volume in recent years, it was a complicated, esoteric world. Paulson was one of many investors who shied away from using these “derivative” investments, described as such because their value derives from the change in some underlying asset.

Pellegrini knew something about CDS trading from his previous job, he told his boss, and was glad to help. The beauty of CDS, Pellegrini explained, was that they are like insurance contracts—the annual premium you pay for the protection is the only downside, unlike a bet against a stock that can result in deep losses if the shares soar.

Pellegrini tried to judge his boss’s reaction, and whether he was out of line. But Paulson liked to encourage his staff to develop novel approaches to problems, and he seemed intrigued, a small smile forming on his face. He asked Pellegrini to research how the firm could buy CDS contracts on financial companies, which Paulson was especially worried about due to all their borrowed money.

In truth, Pellegrini didn’t know that much about how credit-default swaps were traded, other than watching others do it at Tricadia. So he arranged for tutorials by various brokerage firms on the ins and outs of credit-default swaps. The fund made its first purchase of CDS
protection on a company called MBIA, Inc., which insured all those mortgage bonds backed by aggressive loans. The annual cost of insuring $100 million of MBIA’s debt was a puny $500,000. In other words, if MBIA ran into problems and its debt became worthless, Paulson would get paid $100 million thanks to CDS protection that cost just $500,000 annually. It seemed a no-brainer to Paulson.

Over the next two months, MBIA’s profits climbed, and the price of its debt remained strong, making it clear to Paulson and Pellegrini how difficult it could be to take a stance against a single company. Soon, their position faced some small losses. They discovered that the value of CDS protection falls as the underlying debt gets closer to maturity. Paulson and Pellegrini were dipping their toes into the water, still figuring out how to bet against the housing market.

But in Northern California, far from Wall Street’s frenzied trading desks, an obscure investor already was zeroing in on real estate, well ahead of Paulson & Co., certain that he had discovered the trade of a lifetime.

W
HEN MICHAEL BURRY WAS BORN, IN 1971, HIS STEEL BLUE
eyes seemed crossed in an unusual way, drawing immediate concern from his parents. A local pediatrician in Johnson City, New York, a suburb of Binghamton, dismissed the Burrys’ worries, assuring them that the boy had a lazy left eye that would improve with time. But James Burry couldn’t shake a feeling that something was wrong with his son.

Over the next year, he and his wife, Marion, brought Michael from doctor to doctor, searching for a better explanation. Finally, an ophthalmologist diagnosed retinoblastoma, a dangerous cancer that strikes one in twenty thousand children. They drove three hours to Columbia Presbyterian Medical Center in New York City, where doctors removed the boy’s left eye, to prevent the tumor from spreading.

Before he turned two, Michael was fitted with a glass prosthesis. It was an approximation of his natural eye, the best they could produce at the time, but it had no movement, making it quite obvious.

Later, Michael had difficulty adjusting to the artificial eye. His depth perception was poor. Intense pain in the socket often forced him to leave class to visit the school nurse. One day in second grade, older children gathered around, cheering Burry to “take it out, take it out.” Reluctantly, he complied, drawing even more unwanted attention.

In 1977, when Burry was almost seven, his father landed a transfer to an IBM plant in Northern California. The family, which by then included three more sons, moved to South San Jose, a middle-class city in Silicon Valley. An IQ test at his public school showed that Michael was
highly intelligent, and he was placed in advanced science and math classes. Reading came slowly to him, but he persisted and soon was devouring books, especially escapist fantasies and biographies of sports heroes.

Burry was forced to wear safety glasses to protect his eye. Frustrated and embarrassed, he sometimes would smash the glasses, which slid down on his nose and sometimes obstructed his field of vision, telling his parents they had broken during a game, hoping the glasses wouldn’t be replaced.

Marion, who had been raised in a poor, Catholic family in Wilkes-Barre, Pennsylvania, sometimes dressed her sons in discount clothing from a local Kmart. They became a focus of derision for his middle-school classmates, who were children of engineers and other employees of local technology companies. Michael turned shy around some of them.

“I never had more than one or two friends, if that,” Burry recalls. “I always was a bit of an outsider.”

His father often worked late, and his mother, a biology major in college who had returned to school to pursue a master’s degree, holed up in the library most afternoons. So after school, Burry was left to pick up his three brothers at the homes of various friends, warm a tray of TV dinners, and help with their homework.

Michael’s parents frequently argued loudly as he huddled in a bedroom listening. They divorced during the summer after he finished fifth grade, and Michael and his brothers moved with their father to a nearby town. His father, the first in his family to graduate from college, was a stern disciplinarian who hated to see his sons idling, especially in front of a television. Some afternoons, he made the boys carry piles of bricks from the backyard of the house to the side. The next day, they’d haul the bricks right back to the backyard, just so James could keep them occupied. Most weekends, he would lock the boys out of the house, forcing them to play outdoors.

Each summer, James brought his sons camping in the Sierra Nevada Mountains, where they lived in an army-surplus tent for weeks at a time, sharing it with their black Labrador retriever. The former Marine taught his boys to shoot deer with a bow and arrow and to ride a Yamaha 80cc motorcycle on mountain trails and dirt access roads. One
night during each trip, they emerged from the woods to dine at a nearby restaurant, drawing stares for their scruffy appearance. Burry lugged a stack of books to the campsite and read for hours by the fire, avoiding gathering wood or cleaning the tent, a dereliction of duty that infuriated his father. James Burry respected education but was suspicious of any act that required a lot of sitting around.

One day, Michael noticed the stock quotations in the business section of the local newspaper and asked his father to explain them. James was skeptical of the stock market but pointed to the symbol for American Motors, the maker of army jeeps, then trading at $4 ⅝ a share. He piqued the interest of his son, and Michael tracked American Motors shares every day for more than a year, fascinated by each little move, and the fortunes that his father explained were made and lost along with them.