The Greatest Trade Ever (19 page)

“We looked at ten-to-one, twenty-to-one, even higher, but twelve-to-one seemed right to us, and we thought it would be right for investors,” Paulson says.

And the upside? If Paulson purchased CDS contracts that fully protected $12 billion of subprime mortgage bonds and the bonds somehow became worthless, Paulson & Co. would make a cool $12 billion. Paulson and his team became more enthusiastic as they prepared to get in touch with prospective investors.

Paulson figured he could use some help running the fund, though, especially if it became as large as he hoped. He interviewed senior research executives at various Wall Street firms, dangling a top job at the fund. Some of the candidates had been recommended by Pellegrini, who scoured the industry for capable mortgage experts sharing a bearish bent.

But Pellegrini had mixed feelings about the assignment. He was thrilled that Paulson trusted him enough to help with the job search, and he was just as convinced as Paulson that the subprime trade would work. But Pellegrini had helped create the idea. He wanted Paulson to offer him a senior role at the fund; he was convinced he was up to the task. Instead, Pellegrini would have to work for the new hire, dropping down a notch on the hedge fund’s totem pole.

“It was tricky for me,” Pellegrini says. “If I resisted, it wouldn’t have
worked out. If I got credit for a great hire, that would be better than nothing, I figured.”

For weeks, the response from the candidates Paulson approached was tepid, at best. Some analysts weren’t nearly negative enough on housing. Others felt leaving well-paid jobs to help run a bearish fund that might not succeed was too risky. Moreover, abandoning a cushy Wall Street job for a hedge fund wagering against housing could brand the trader with a scarlet letter, a stain capable of preventing them from returning to an industry that generally made money when real estate rose, not fell.

“Everyone who might have been qualified said the strategy wouldn’t work,” Pellegrini recalls.

Privately, Pellegrini was elated by the response from Wall Street. He secretly hoped that it might improve his own chances for a senior role in the new fund. One day in the spring of 2006, after the latest disappointing interview, Paulson stopped Pellegrini in the hallway. Paulson was smiling warmly, filling Pellegrini with instant hope.

“I’ve thought about it,” Paulson told Pellegrini. “We aren’t going to hire anyone. We’ve decided you should be co-manager of the fund.”

For a moment, Pellegrini was confused. He had no clue who the “we” was that Paulson was referring to and worried there might be someone else at the firm he had to impress. But when it dawned on him that he finally was getting the senior position he yearned for, Pellegrini turned ecstatic.

For the first time at the hedge fund, the terms of his compensation were put in writing. Pellegrini even moved into an office, in a corridor across from the firm’s accounting bullpen. He proudly put his new title, “Co-manager of the Paulson Credit Opportunity Fund,” under his name in his e-mails.

A few days later, however, Andrew Hoine approached Pellegrini. “You need to remove that new title from your e-mails,” he said. “It might confuse investors.” Later that day, Jim Wong, Paulson’s investor-relations chief, relayed the same message. Clients might think Paulson wasn’t running the fund, Wong said. Pellegrini turned ashen with embarrassment and agreed to drop the title from his e-mails. For all his valuable
research and long hours, he hadn’t yet achieved a position of security at the firm.

A
LTHOUGH PAOLO PELLEGRINI
understood the trade as well as anyone at the firm, his touch with potential clients was a little rough. At a Red Cross fund-raising event in Connecticut, hedge-fund investor Martin Tornberg stood with an executive of a university endowment during the cocktail hour. Pellegrini walked over, holding a glass of red wine, to join the conversation.

They quickly began discussing Paulson’s new fund. The investors were intrigued. But as Pellegrini went on, they couldn’t understand how he picked securities to short or how the firm was placing its trades.

“It was too hard to follow him,” Tornberg recalls. “It was like torture.”

Paulson’s delivery was much smoother, and he proved expert at explaining his thesis and trade in simple terms. But some investors proved difficult to convince. Hoping to claim his alma mater, Harvard University, as a client for the new fund, an imprimatur that might encourage other investors, Paulson traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard’s endowment. Taborsky already had met with Paulson and Pellegrini in their New York office and had come away impressed.

But the fund cost of 8 percent a year concerned Taborsky. He also thought Paulson might be excessively gloomy about the housing market. Moreover, Paulson’s trade idea wasn’t especially new, Taborsky felt.

“Look, guys internally are doing this already,” Taborsky told Paulson, as he turned him down.

Afterward, Paulson shared his frustration with Howard Gurvitch. “They ought to be in,” Paulson told him. “They should get it.” (Harvard eventually purchased some mortgage protection, but focused on more inexpensive versions that didn’t have a big payoff.)

Paulson reached out to his existing investors. Pellegrini’s chart suggested that housing prices could plunge 40 percent, but Paulson and his team rarely expressed that view to investors. Even they didn’t fully trust
the chart. As a result, Paulson decided not to short the slices of the bond deals rated A or AA, the safest ratings, but instead to bet against the riskiest BBB-rated pieces, bonds with risks that Paulson and Pellegrini were convinced investors would recognize.

Some were skeptical, nonetheless. Richard Leibovitch, who invested in hedge funds for a Boston firm called Gottex Fund Management, grilled Paulson in a meeting, repeatedly telling him it would be a difficult trade to pull off. Leibovitch said he had spoken with Mike Vranos of Ellington Management, the preeminent mortgage trader, and he wasn’t nearly as alarmed about housing.

“John, why do you think you know more than Vranos?”

“Look, you don’t have to be a mortgage guy to read the tea leaves. I don’t care if he’s a mortgage genius,” Paulson said. “Listen to the logic of my argument.”

In the end, Leibovitch turned down the fund, though he stayed a client of Paulson’s other funds. Before the meeting ended, he urged Paulson to meet with Vranos, but Paulson passed on the offer.

“Paulson was a merger-arb guy and suddenly he has strong views on housing and subprime,” Leibovitch recalls. “The largest mortgage guys, including Vranos at Ellington, one of the gods of the market, were far more positive on subprime.”

Paulson, Wong, and other members of the team described their investment thesis to Nolan Randolph, another client, who was an executive of a Texas firm called Crestline Investors. But Randolph kept shaking his head over and over again, unnerving the group. Randolph turned them down, arguing that the downside seemed too big if the trade didn’t pay off.

“We don’t think your fund will add alpha,” Randolph said, using the industry lingo for value.

Even some investors who agreed with Paulson’s bearish view doubted he would make much money because there was relatively little trading in the investments he was buying. They felt he might have a hard time selling them without sending prices tumbling, shrinking any profits.

“How are you going to get out?” asked one London-based investor.

Paulson patiently explained how the trade likely would play out, even predicting the dates at which nervous investors and banks would suffer housing-related losses and line up to purchase his mortgage protection. That would enable Paulson to sell it profitably, he argued. The investor wished him well, but passed on Paulson’s new venture.

“It looked like a dangerous game, taking one single bet that might be difficult to unwind,” says Jack Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said no to Paulson’s fund.

Still others grumbled that the new fund wouldn’t let investors withdraw money until the end of 2008, a “lockup” that Paulson insisted on to ensure he wouldn’t have to exit the trade due to client withdrawals before it began to work.

“Investors said, ‘If you’re so smart, why isn’t everyone doing it, and why are firms in the mortgage business making a different argument?’ ” Paulson recalls. “I said, my job isn’t to convince you.”

Paulson’s growing fixation on housing began to impact his business; some clients worried he was focusing on mortgages because opportunities were drying up in the merger area. Others thought he was becoming distracted. One longtime client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Paulson was “straying” from his longtime focus, and that it should pull its money from his firm, fast. The bank stuck with Paulson, but turned down his new fund.

Paulson even received flak from old friends.

“What could they do to mess with the trade?” Peter Soros grilled Paulson on regular phone calls and in meetings; he noted that politicians might feel compelled to aid mortgage holders. In the run-up to the election year, would Congress let two to three million home owners get thrown out of their homes? Soros asked.

Soros didn’t give Paulson an investment.

Paulson wanted his fund to be big, so he could purchase the most mortgage protection possible. But he also felt pressure to raise the money quickly. Competitors might figure out the trade for themselves
and buy the same insurance, driving up the cost. That made Paulson reluctant to provide many details of his trade. It was a stance that made it more difficult to raise money.

“It doesn’t take much for hedge-fund managers to catch on, and it was such a glaring mispricing, I was afraid too much attention would cause it to disappear,” Paulson says. “I didn’t tell some potential investors the whole story, with all the details, because the more I discussed it, the more likely it would go away.”

James Altucher, a writer who also invests money in hedge funds for clients, met the Paulson team and was shaken by their arguments. Coming out of the midtown New York offices, Altucher turned to a colleague and said, “We’re screwed. The whole country is screwed.”

Back at the office, though, Altucher called pros for their opinions. They said the insurance likely would drop in value before it began to rise, and that pension funds and other believers in the BBB slices wouldn’t easily sell, limiting how much the bonds could fall in price. The advice dissuaded Altucher from investing in Paulson’s fund.

“Only a little bit of asking was enough to put the gas on neutral,” Altucher wrote in a column in
The Financial Times
. “It all made a lot of sense but I didn’t invest … Who knew how long the irrational behaviour would last?”

Paolo Pellegrini honed his pitch and became smoother in presenting the trade to investors. But at one point, he couldn’t bear all the dissing the firm received. In a meeting at the Ford Foundation, a Ford executive, Larry Siegel, said his organization wouldn’t invest in the Paulson fund because it was wagering against home owners, something that Siegel said was “inconsistent with our social mission.” To Pellegrini, the comment smacked of false piety; a colleague at Paulson & Co. had relayed an earlier conversation in which Siegel said he found a better trade to take advantage of housing weakness. After the meeting broke up, Pellegrini quickly approached Siegel outside the conference room, grabbing his attention.

“I heard you have a better trade … why is it better than what we’re doing?”

Siegel said he didn’t want to get into it, just that his was a more sophisticated
approach than Paulson’s. (Siegel now says he was just trying to get out of the meeting, and that his bosses never would have approved an investment in a fund that wagered against mortgages.)

Paulson wasn’t getting much more respect from Wall Street’s establishment. Rosenberg invited two Morgan Stanley traders, John Pearce and Joseph Naggar, to visit the office, hoping to learn more about the market and include Morgan Stanley as one of its brokers on the trade.

Pearce and Naggar showed up in khaki pants and polo shirts, saying they didn’t have much time to talk because they were late for a golf outing with other clients.

“Let’s try to make this as brief as we can,” Naggar said.

Pellegrini and Rosenberg, in suits and ties, handed the Morgan Stanley traders a list of subprime mortgage–backed bonds that the firm was hoping to bet against.

“Here are the names we’d like to put more shorts on,” Pellegrini said.

Pearce and Naggar didn’t seem to have much interest in trading with Paulson’s team, though, or in spending much time on their questions.

“It sounds like a good trade; maybe
we’ll
do it,” Pearce said, with a laugh. Pearce was just humoring them, Rosenberg thought.

As they ended the meeting, Pearce said, “Well, if we get more capacity, we’ll put it on for you.”

Pearce and Naggar already had placed a few bearish subprime trades for their own firm, though they didn’t want to let that on in the meeting. To the Paulson team, it was another exasperating experience.

“That was a waste of time,” a glum Pellegrini said to Rosenberg as they walked out of the room.

By June, Paulson hadn’t raised much money. Jeffrey Tarrant wanted to invest for his firm, Protégé Partners, but he faced complaints from clients.

“One of our investors said, why would you agree to a trade with negative carry?” Tarrant recalls. “People on trading desks warned, ‘He doesn’t have expertise in the area,’ or ‘He doesn’t know what he’s doing.’ ”

Every day, Paulson walked into the office of Jim Wong showing unusual urgency, as if a clock was ticking on his trade.

“Lemme see the latest list” of investors, Paulson said to Wong
insistently. After looking it over, Paulson asked in frustration, “Where
are
we with these people?”

On another occasion, passing Philip Levy in the hedge fund’s hallway, Paulson stopped the marketing executive, asking for an update of the level of interest in the new fund. After Levy delivered the latest disappointing news, Paulson complained, “I don’t know why they don’t get it … this is the trade of a lifetime,” before walking away, abruptly.