The Alpha Masters

Maneet Ahuja

HEDGE FUND MANAGER JOHN PAULSON HAD TRAVELED from New York to Capitol Hill to address the Committee on Oversight and Government Reform on November 13, 2008. A series of well-executed complex trades at the height of the financial crisis had made Paulson a very rich man at a time when many banks and institutions were on the brink of collapse. Among these was a trade that has been widely hailed as far and away the greatest trade in financial history, one that earned his firm a record $15 billion by the end of 2007. Now Congress wanted to hear what he had to say about the systemic risks that hedge funds posed to financial markets, and to listen to proposals for regulatory and tax reforms.

Paulson was not the only hedge fund manager who had been summoned by the Committee that day, although he was certainly the best performing over the past year. Joining him was fellow subprime winner Phil Falcone, as well as George Soros, the head of Soros Fund Management, Jim Simons of Renaissance Capital, and Ken Griffin of Citadel, all industry legends and billionaires in their own right. Each of these industry titans would have his turn to address the Committee, but right now the floor was Paulson’s. The entire room, indeed, the entire financial world, wanted to hear what this man had to say; his remarks were running live on CNBC, Bloomberg, and, of course, C-SPAN.

“Chairman Waxman,” he began, calm and unruffled, peering through his dark-rimmed glasses at Henry Waxman, the liberal Democratic congressman from California who was presiding over the hearing, “the problem in the U.S. financial system is one of solvency. In general, financial institutions are undercapitalized and have insufficient tangible common equity to support their overlevered and deteriorating balance sheets.” Perfectly silent, the room hung on his every word. “Remarkably, the average tangible common equity to total tangible assets for the 10 largest U.S. banks is only 3.4 percent, or 30 percent leverage. The solution to solve the problem is to strengthen their balance sheets by raising equity both privately and publicly.”

Addressing Congress was an uneasy moment for Paulson. He didn’t like being called onto the carpet, so to speak, to justify his successes. He’d been in the business for over 15 years focusing on event-driven transactions, and the financial crisis of 2008 happened to be the biggest event-driven trade since the Great Depression.

Paulson began his testimony with a synopsis of his background— graduating summa cum laude from New York University (NYU) in 1978, attending Harvard Business School as a Baker Scholar in 1980, and working as a managing director of mergers and acquisitions at Bear Stearns. He opened his hedge fund in 1994, and by 2008, it was the fourth-largest such fund in the world. He then explained how it happened that his firm managed to pull off a $15 billion trade. He explained that, in 2005, he and his team had become concerned about weak credit underwriting standards and excessive leverage among financial institutions believing that credit was fundamentally mispriced. “To protect our investors against the risk in the financial markets, we purchased protection through credit default swaps on debt securities we thought would decline in value due to weak credit underwriting. As credit spreads widened and the value of these securities fell, we realized substantial gains for our investors.”

Paulson explained this as if it were just that simple. The funny thing is, to Paulson, it was that simple.

He concluded his testimony with some recommendations for steps the government could take to relieve the credit crisis. The top idea, one that he had just offered in a Wall Street Journal op-ed article, was for the U.S. government to “purchase senior preferred stock in selected financial institutions, which provides for maximum taxpayer protection.” Following his op-ed, the Troubled Asset Recovery Program (TARP) was reoriented to focus on the purchase of preferred stock. When John Paulson speaks, people listen.

One of the unique skills that Paulson had developed through his career was in shorting bonds. He first practiced this strategy while at Gruss Partners in the early 1990’s when it shorted the bonds of bank holding companies that were at risk of a downgrade or of failing. The holding companies’ bonds were particularly vulnerable to a decline. Unlike the operating company bonds, which had direct access to the assets as collateral, the holding company’s primary asset was the equity in the operating company, which would almost always be wiped out in the event of insolvency.

The attraction of shorting bonds is the asymmetrical nature of the returns. If you could short a bond at par or close to par at a tight spread to Treasuries, then the downside would be limited if you were wrong, but the upside could be substantial if the company defaulted. The trick, though, was in finding mispriced credit that traded at par, which could default. This is no easy task. In addition to banks with two-tiered capital structures, Paulson also found opportunities in other financial companies with a holding company structure, such as insurance companies, and in leveraged buyouts. Almost all investors hated shorting bonds because most of the time the bonds paid out, and the negative carry from paying the interest on the short bond was a drag on performance.

Paulson had not been dissuaded from this challenge. He liked the asymmetrical risk/return potential, and continued to pursue this area as an investment strategy with periodic success over time.

By the spring of 2005, Paulson became increasingly alarmed by weak credit underwriting standards and excessive leverage being used by financial institutions. Credit quality had deteriorated to the point where the worst-performing companies could readily raise financing. And banks had fostered this trend by adding vast quantities of credit assets to their balance sheets and by increasing their leverage. When measured against common equity, the largest banks had leverage ratios of 30 to 403 and in some cases 503. With that type of leverage, it wouldn’t take much for a loss to wipe out the equity, and with the credit quality deteriorating as it was, this appeared increasingly likely.

At the same time, as credit markets were spinning out of control, Paulson also felt the residential real estate market could be in a bubble. Prices had gone up rapidly and continuously for an extended period, and almost everyone was euphoric about the easy money to be made in housing. Paulson’s own home in Southampton, purchased at a bankruptcy auction in the last real estate downturn in 1994, had appreciated six times in value by 2005, well in excess of the long-term growth rate on home prices. Furthermore, John didn’t adhere to the theory that residential real estate prices only went up, having experienced previous real estate downturns.

The bubble nature of the real estate market, the frothiness of the credit market, and Paulson’s focus
on shorting bonds led Paulson to investigate short opportunities in the mortgage market. While Paulson had no previous experience in the mortgage market, he knew it was the largest credit market in the world, larger at the time than the U.S. Treasury market. He asked Paolo Pellegrini and Andrew Hoine, two analysts at the firm, to take a look at the structure of the mortgage market.

Paolo quickly came back and said there were prime, midprime, and subprime segments. “Since we were interested in shorting, we decided to focus on the subprime segment,” explains Paulson. “Although the smallest of the mortgage segments, the market was so large that there was over a trillion dollars of subprime securities outstanding. When we dived deeper into the residential real estate market, the subprime market, and the securitization market, we began to believe that this area could implode.”

At that point, Paulson asked Paolo to focus exclusively on subprime securities. Paulson began to suspect that shorting credit could be the strategy that could give him the outsized performance he was looking for without taking excessive risk. Slowly, Paulson and his team were able to piece together how housing prices, and the trillion-dollar market built around them, were doomed to collapse like a house of cards. This gave Paulson the green light to begin purchasing protection through credit default swaps on debt securities he felt would decline in value due to weak credit underwriting.

The subprime mortgage securitization market was uniquely suited to buying credit protection. The typical subprime securitization was divided into 18 tranches, ranging from “AAA” to “BB,” with each lower tranche subordinate to the one above. The “BBB” tranche traded at par with a yield of about 100 basis points more than U.S. Treasuries. On average, they had only 5 percent  subordination and were only 1 percent thick, meaning a loss of 6 percent in the pool would wipe out the “BBB” tranche. “In other words, by risking a 1 percent negative carry, we could make 100 percent if the bond defaulted,” says Paulson. “That was the precise asymmetrical investment we were looking for. We would lose very little if we were wrong, but could make a 100:1 return if we were right. And given the low quality of subprime loans and the deteriorating collateral performance, we thought the probability of success was very high. Yet, the credit markets at the time were in such a state of exuberance and the global demand for ‘BBB’ subprime securities was so strong that we could buy protection on virtually unlimited quantities of the securities.”

In the end, Paulson bought protection across his funds on about $25 billion of subprime securities. As spreads widened, and the value of those securities fell, Paulson and his team cashed in at an increasingly accelerated pace. Paulson & Co. had amassed $15 billion in profits off these trades by the end of 2007 with the Paulson Credit Fund up 600 percent that year. The firm’s assets under management grew from a respectable $6.5 billion in 2006 to a monstrous $28 billion by year-end 2007.

Paulson’s credit fund returned 20 percent, 30 percent, and 20 percent in 2008, 2009, and 2010, respectively. Paulson liked the neighborhood. “I think I always wanted to be in the top bracket,” he says. “I never imagined we’d get this big but I always liked and aspired to be successful. You can have a goal. You can try. But, you know, at the end of the day unplanned things can happen, too. I had a broad tool kit in the event area: mergers, bankruptcy, distressed, restructurings, which we could apply from either a long or short perspective. I had a great deal of experience working with a lot of brilliant people—Leon Levy, Ace Greenberg, and Marty Gruss— and had seen a lot of great investments including 100-to-1 investments.”

In its year-end 2010 investor letter, Paulson & Co. acknowledged that the fund participated as the lead or one of the lead investors in 10 of the top 14 bankruptcies, highlighting that because of its size and expertise, it was invited by numerous corporate management teams to provide capital on favorable terms to repay debt, strengthen equity, and/or restructure their balance sheets.

While most of the deals Paulson & Co. take on are intricate enough to warrant outsized returns, some stand-alone event-arbitrage investments are so treacherously complex, they brought the firm high prestige and enormous profits in their own right.

Excerpted from with permission from John Wiley & Sons. Copyright© 2012 by Maneet Ahuja.

Maneet Ahuja is CNBC’s hedge fund specialist and a producer on Squawk Box. In 2011, she co-created and developed the network’s “Delivering Alpha” hedge fund summit in conjunction with Institutional Investor and was awarded CNBC’s prestigious Enterprise Award in 2009 for her coverage of the industry.
Maneet is one of Forbes magazine’s 30 under 30 (Jan 2012), has been featured in Elle magazine’s annual Genius issue (April 2011), and in 2010 was nominated for Crain’s New York Business Forty Under 40 Rising Stars. Follow Maneet on twitter @WallStManeet and visit her book’s website at