The long and the short

Mar 12th 2009
From The Economist print edition

John Paulson made a fortune betting against mortgages. Now he spies opportunities in the wreckage

IN TODAY’S gut-wrenching markets, winners are as rare as a house that sells for the asking price. Even Warren Buffett is looking less than sagacious after his holding company posted its worst year ever. But one investor who continues to win plaudits is John Paulson. His hedge funds have had a superb crisis. They clocked up triple-digit returns in 2007 betting against subprime mortgages, netting him $3.7 billion personally—a sum that made George Soros’s winnings from currency bets in the early 1990s look modest. Mr Paulson’s funds continued to do well last year, rising by 7.9-37.6% even as those run by other hedge-fund titans, such as SAC’s Steve Cohen and Citadel’s Ken Griffin, suffered miserably. His funds were all up again in the first two months of 2009, and they now hold $30 billion—a war chest that Mr Paulson is now starting to use to gobble up the very securities that made him rich when they collapsed in value.

He cut his teeth in risk arbitrage, which involves punting on actual or potential merger targets. This remains an important strategy for him, and he had reason to celebrate this week when Dow Chemical agreed (under legal pressure) to complete its $15.3 billion acquisition of Rohm & Haas, another chemicals firm, in which Mr Paulson’s funds own a big stake. But he is best known for his canny bets against mortgage-backed bonds and financial shares. The firms in which he was “short” (ie, betting on a fall) last year lost, on average, 90% of their value.

Success has not bred arrogance. On the contrary, Mr Paulson is a fitting icon for the post-boom age: mild-mannered, bordering on weedy and so soft-spoken that when testifying before Congress in November he had to be asked to speak up. His first taste of business was to buy sweets in bulk and sell them to classmates at a hefty mark-up, but it is hard to imagine him having had the guts for such a scheme. He has never charged more than 1½% of assets and 20% of profits, a reasonably modest fee for a hedge-fund superstar. His job is, he says, more about preserving clients’ principal than gambling for outsized returns.

Accordingly, his funds generally eschew leverage, or making bets with borro

wed money. He insists that his fruitful subprime trade, far from being stunningly clever, was a no-brainer for anyone who bothered to analyse the complex securities’ underlying collateral. “It was obvious that a lot of the stuff…was practically worthless at the time of issuance,” he says. He finds it “perplexing” that the banks holding the higher-rated tranches could not see this danger, and that so few others were prepared to believe that Wall Street’s finest could have miscalculated so badly.

Another motivating factor for Mr Paulson was the alluring asymmetry of shorting credit. The most you can lose is the spread over some benchmark rate. Yet if the bond defaults, the gains can be mouth-watering. He targeted BBB-rated tranches, the lowest in subprime securities. With credit spreads so low because of a liquidity glut, his possible upside as a buyer of protection using credit-default swaps (CDSs) was as much as hundred times the potential downside. One $22m trade is said to have netted him $1 billion when Lehman Brothers went bust. Though the CDS market has been good to him, he believes it “blew out of control” and needs to be regulated and moved onto exchanges, with margin requirements to limit excessive speculation. He also advocates tighter oversight of hedge funds.

He is, however, robust in his defence of short-selling, which has been vilified for its perceived role in driving down banks’ share prices. He sees it as a “valuable” tool, used not least by banks themselves to hedge their various exposures. More importantly, he argues, it is too small a part of stockmarket activity to move prices. His shorting “made absolutely no difference to the performance of any mortgages, securities or banks.” The blame lies with reckless lending, not with those who capitalise on the resulting mispricing of securities. There is, therefore, no “moral dimension”—though he allows that some of the “more vocal” shorts may have hurt banks’ prospects of raising fresh capital.

Still, his vast profits make him a target in a world where high finance is held in low esteem. Portfolio, a business magazine, dubbed him “The man who made too much”. He retorts that the bulk of the profits went to his investors, which include foundations, endowments and pension funds. They are not the only ones with reason to thank him: a $15m donation is helping families facing foreclosure to keep their homes, by paying for lawyers to exploit the sloppy documentation that accompanied the often-hurried pooling of subprime mortgages into securities. Mr Paulson says he has many other philanthropic arrows in his quiver, but to publicise them would “take away the altruism”.

Distress call

Just as markets used to hang on Mr Soros’s every move, they are now keen followers of Mr Paulson. He does not see the economy reaching bottom this year and is still a net short-seller of financial firms. More encouragingly, he has started buying up bombed-out mortgage securities. The number-crunching that told him subprime-linked paper was overvalued now suggests that some previously AAA-rated tranches are a bargain. He talks of distressed debt—mortgages, leveraged loans and the debt of bankrupt firms—as a $10 trillion opportunity.

At some point, his “number-one focus” will be to provide equity to recapitalise sick but viable banks. He is already dipping his toe in: his latest vehicle, the Recovery Fund, recently took a 25% stake in IndyMac, a Californian bank that the government seized last July. But the timing of any bigger push is uncertain. Mr Paulson is acutely aware of the costs of moving too early: those who have bought into financial firms since the start of the crisis have lost, on average, 80% of their investment. Still, in these dire times it is comforting to know that such a smart investor believes there will be something worth saving.

Thanks & Regards,
Nifty Treasure

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