John Paulson: King Bear of US Subprime

John Paulson has emerged as Wall Street's biggest beneficiary of the subprime crisis, gaining so much from foreclosures that George Soros invited him to lunch, to understand how he had laid his bets with instruments that did not exist a few years ago.

Funds Paulson runs were up $15 billion in 2007 - his investors relishing the bet he made against the seemingly unbridled US housing market. Paulson himself has taken home an estimated $3.7 billion, which is believed to be the largest one-day gain by any Wall Street professional.

You will not find much on Paulson, since before this bet, he was a rather unknown, although successful, hedge fund manager. His Paulson & Co firm employs 60 people and its success has centred on a venture called Credit Opportunities Fund, which returned 590 percent last year, according to trade magazine Alpha.

Paulson's gains came from defying conventional wisdom, like so many others before him: Warren Buffet for buying companies cheap in the 70's and Wilbur Ross, who consolidated steel, and George Soros, famous of shorting the British pound and making $1 billion in one day, in 1992.

In 2006, many thought that housing industry and mortgage markets were rock solid against any trouble, despite the loose lending standards in the markets. One major highlight during the housing boom were CDOs (collaterized debt obligations), which were products that had mortgage securities as the underlying, and these were sliced in to various products of differing risk levels, and sold to others, including foreign buyers.

Then to make these safer, insurance companies came up with credit-default swaps which protected buyers of CDOs against defaulting mortgage owners. The higher the risk of CDO slice, the higher the cost of the swap. The risk perception during the housing boom was so low, that these swaps were in fact being sold very cheap.

In betting on it to crumble, Paulson said: "I've never been involved in a trade that had such unlimited upside with a very limited downside." One of his strategy was to short the CDO slices. Another was to buy the credit-default swaps that complacent investors seemed to be pricing too low.

Paulson's most legendary statement depicts what happens in any manic rise: "Most people told us house prices never go down on a national level, and that there had never been a default of an investment-grade-rated mortgage bond," Mr. Paulson says. "Mortgage experts were too caught up" in the housing boom. Another one he had heard was, "You can't short houses."

Paulson's strategy was all about having the right view as much as it was about timing. He did not turn bearish too early, but waited for the correct technical moment. Many other followers of the housing market invested a few years earlier against the market only to have suffered painful losses waiting for a collapse that they finally closed their bearish bets.

As Peter Morici, professor of finance at the University of Maryland, says: "He saw what many of us suspected, but didn't have the courage of our convictions to put our money on."

Paulson's quest always led to asking his team the same question: "Where is the bubble we can short?" And rightly, they found it in housing. At this time, upbeat mortgage specialists kept repeating that home prices never fall on a national basis or that the Fed could save the market by slashing interest rates. The success came from the waiting game. As Paulson said once, quoting Winston Churchill, in an interview: "Never give in, never give in, never give in." Sounds familiar, isn't it?


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