The Greatest Trade Ever
But life, being what it is…
Lehman, bankrupt; AIG, bailed out; Wachovia, welcome to Citigr… Wells Fargo. In 2008, while these dramas were unfolding, I wondered, who got this right? Who is standing tall? Who positioned themselves for this very event? How did they do it?
The Greatest Trade Ever is about John Paulson’s epic fifteen billion dollar hedge fund win and personal cut of over four billion dollars for 2007. “It was,” the book’s author Gregory Zuckerman notes, “the largest one-year payout in the history of the financial markets.”
While Paulson is the focus of the book, Zuckerman breaks up the action by weaving in a solid cast of secondary characters that each deserve their own book. Chief among them is Paolo Pellegrini. “I was forty-five and had zero net worth,” Pellegrini recalls, “from my perspective, I had no prospects.” Desperate, Pellegrini forced his way into an open analyst position at Paulson’s fund.
…a series of intersecting lives and incidents…
It was surely an odd fit, sad really. A man in his late forties in a position typically staffed by someone half his age. Zuckerman writes, “being financially successful was at the top of Pellegrini’s life goals, right up there with having a happy family life. He had failed miserably at both.” Whether it was luck or divine fate, the path of Pellegrini’s life had led him to Paulson’s fund, at this time, at the pinnacle of housing excess. All the mistakes of his past may have driven him to seek new angles, more creative ways to turn his ideas into the cash that had always eluded him. “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… Why not buy credit-default swaps?”
Paulson liked Pellegrini’s idea. Paulson then tasked him with finding the proof that housing was in a bubble and that betting on a correction would payout handsomely. Pellegrini went to work and found exactly what they were looking for:
“Housing prices had climbed a puny 1.4 percent annually between 1975 and 2000, after inflation was taken into consideration. But they had soared over 7 percent in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40 percent to return to their historic trend line. Not only had prices climbed like never before, but Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop would be brutal.”
With that proof, Paulson and Pellegrini became eager to pile on their trades. Zuckerman includes anecdotes which will lead to nothing short of outrage. The NYTimes recently ran a piece that suggests Goldman Sachs created and sold products that they knew were losers while betting against them. According to Zuckerman, “Paulson and Pellegrini were eager to find ways to expand their wager against risky mortgages; accumulating it in the market sometimes proved a slow process. So they made appointments with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they could create CDOs that Paulson & Co could essentially bet against.”
If this is accurate, it appears certain banks were willing to package losing mortgages into CDOs to sell to clients… packages constructed for the explicit purpose of being shorted by Paulson. Some bankers were hesitant, including Scott Eichel at Bear Stearns, who Zuckerman quotes, “but it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side.”
While Bear Stearns was hesitant, Zuckerman is clear, “other bankers, including those at Deutsche Bank and Goldman Sachs didn’t see anything wrong with Paulson’s request and agreed to work with his team… Paulson & Co eventually bet against a handful of CDOs with a value of about $5 billion.”
By the end of 2007, Paulson and Pellegrini’s bets had paid off. But even still, most of Pellegrini’s income would be in the form of a year-end bonus. The idea to go long CDS insurance and short selected CDOs was Pellegrini’s to start with, but he was still plagued with uncertainty: “He didn’t know what kind of bonus check Paulson might give him.”
He had little to worry about. As the financial landscape began to tremble, the redemption of Pellegrini was manifest: his keep for 2007, paid out by Paulson, was over $175 million dollars.