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?


Read the WSJ story here

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Seeking Alpha in Indian Real Estate

By Mukul Pareek

As US housing prices come down to more sustainable levels after a prolonged boom, one can only wonder if we can expect the same story to be played out in other economies. Maybe there is some alpha waiting to be picked up. One place that stands out from a sustainability perspective is India where real estate, whether residential or commercial, seems to have completely disconnected from local economic fundamentals.

Imagine the dusty suburbs of Bangalore, Delhi and Mumbai. Imagine neighborhoods with high rises that have no reliable power or water supply, battered roads if at all, no public transport and a shadow of crime such that locked houses are not safe even for a day. Now imagine these houses commanding prices that match prices in expensive New Jersey suburbs. Go figure. Perhaps there are positive returns to be had in a bet on these. But as John Paulson was quoted in the WSJ , “you can’t short houses”. But maybe we can short some of the companies that build and sell these houses.

The Indian equity markets have enjoyed a tremendous bull run over the past few years. In 2007 the Indian markets were up 47%. Real estate was up even more on a frenzy that makes New York and London decidedly tame. Seeing the time to cash in, multiple ‘mega-issues’ or IPOs from real estate developers came out in 2007. Exorbitantly priced to begin with, they did not disappoint their investors. These IPO stocks outperformed the index (the one that was up by 47%!) by a handsome margin. We look at how some of the larger public offerings have done since they were listed. Terrific!

Which brings us to the point of this post. How sustainable are half a million dollar apartments in a country with an average wage of about $1000 (a year). Sure there are rich people in poor countries. Maybe enough to keep things going merrily forever. But maybe not.

Most people do believe that this is a bubble that is bound to burst. Perhaps it is only a question of when, and not if. But as said Keynes – the market can stay irrational for longer than you can stay solvent. There is no shortage of alpha seekers (and of academics & economists ridiculed on television) that were hurt calling a false top to the real estate market in the US. The same can happen anywhere, but given the fizz going out of the global markets, the Indian bubble may probably be short lived too.

One bet may be to short some or a diversified portfolio of these real estate companies. The Indian markets have already seen a correction in 2008, and that may or may not continue. These stocks do contain significant beta, so to guard against the risk of the general market going up, perhaps a market neutral short position in some of these companies may be desirable. As is the nature of the game, many of these companies have not been listed for too long, so betas that I calculated in the table below are probably unreliable but perhaps not a bad starting point for making an estimate for the future.

Here are some tickers (on nseindia.com, or add .ns after the ticker for Yahoo Finance) with some data. All information is approximate, US dollar conversions have been done using a single rate of USD 1 = INR 40. Notice the volatility in the stocks, they go up and down fast for sure. Also look at their fantastic profit margins. Who cares about EBITDA when net income to revenue ratios are straight out of wonderland!

There are a number of Indian stocks that are listed either on the NASDAQ or the NYSE as ADRs. Many of them are also included in the broader Indian S&P Nifty-50 market index (referred to above). These include the following:

List of Indian stocks listed in the US that are also a part of the S&P Nifty-50 market index:
Dr Reddy's Labs - RDY
HDFC Bank - HDB
ICICI Bank - IBN
Infosys - INFY
Satyam - SAY
Satyam Technologies - SIFY
Sterlite - SLT
Tata Communications - TCL
Tata Motors - TTM
Wipro Ltd - WIT

The list above covers industry, banking, communications and technology, but does not include any exposure to the real estate sector - except probably with the exception of HDB and IBN that have mortgage lending operations in India.

This opens up an interesting possibility - consider building a synthetic portfolio where one goes short on the entire market using IFN, IIF or INP; and simultaneously going long on a portfolio of individual stocks listed above in a way that the net exposure is only to real estate or related stocks. Unfortunately, real estate stocks currently comprise only about 4% of the Indian stock market capitalization, and as of the date of this post only Unitech is part of the Nifty-50. That makes this strategy a bit tricky to achieve but in the coming days as DLF and other Indian companies get included in the Nifty-50, it would be possible to create a portfolio that is strongly correlated (positively or negatively) to the Indian real estate sector.

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This article first appeared on Mukul Pareek's Blog