If you've been reading business news the past few months, then you've probably come across the sort of story in which someone in the business world claims to have seen the approaching financial crisis. Gary Weiss has written one such article about hedge fund manager John Paulson.
It seems that Mr. Paulson can take credit for genuine prescience, since, according to Weiss's article, he bet $22 million on a credit default swap that earned him $1 billion. I'm no financial maven, but, clearly, one usually doesn't do such a thing lightly. That means that Mr. Paulson thought that he had good reasons to take such a gamble.
And it seems that his reasoning was, logically speaking, really quite simple, as this lengthy excerpt shows:
Paulson got wind of the coming storm in the credit markets through the infallible barometer of prices. By 2005, the amount of money he could make on the riskiest securities was not enough to justify the risk he was taking. Pricing, in his view, made no sense. Paulson concluded that he could do better on the short side — wagering that prices of risky securities would fall.
"We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down," he says. "We couldn't short a house, so we focused on mortgages." He began taking short positions in securities that he believed would collapse along with the housing market.
The best opportunities were in the junkiest portion of the housing market: subprime. Pricing of subprime securities "was absurd," Paulson says. "It didn't make sense." Subprime securities graded triple-B — in other words, those that the credit-rating agencies thought were just a tad better than junk — were trading for only one percentage point over risk-free Treasury bills. This absurdity appealed to Paulson as easy money.
While Paulson was hardly the only fund manager to bet against subprime, he seems to have made the most money, most consistently, from the banking industry's troubles. One reason for this is that Paulson was able to recognize and act on the unimaginable — that the banks, which took on most of the subprime risk, had no clue what they were holding or how much it was worth. Big banks like Merrill Lynch, UBS, and Citigroup held triple-A-rated securities, but these were backed by collateral that was subprime at best, making the rating of the securities almost irrelevant. "They felt," Paulson explains, "that by having 100 different tranches of triple-B bonds, they had diversification to minimize the risk of any particular bond. But all these bonds were homogeneous." It was like having 100 different pieces of the same poisoned apple pie. "They all moved down together."
What separated Paulson from the rest of the hedge fund crowd was his realization that nobody was able to value these complex securities. His advantage came when he was willing to admit that. Other traders refused to short the big banks because they couldn't believe that such huge institutions would be so unaware of their own risks. Once that fact dawned on Paulson, he bet, fast and big, that the banks would fail. "We thought that many banks and brokerages were massively overleveraged, with very risky assets, and that a small decline in the assets would wipe out the equity and impair the debt," Paulson says. He and his analysts knew that the banks were deep into subprime, and yet the prices of their debt securities hadn't fallen, indicating that the rest of the market hadn't caught on.
By the end of 2007, he started to beef up his short positions, focusing on overleveraged financial institutions — Wachovia and Washington Mutual among them.
And then there were derivatives. Since all that toxic waste on the balance sheet imperiled the survival of the banks, Paulson wanted to be sure he was prepared. So he bought credit default swaps, like the $22 million he bet against Lehman — essentially an insurance policy that paid off when Lehman's bonds defaulted.
Even though Paulson didn't actually own any Lehman bonds, he made more than $1 billion on that bet. It's as though he'd bought insurance policies on houses he didn't own along the Indian Ocean just moments before the tsunami hit.
So, apparently, it was that easy. Of course, you need the millions to buy the credit default swap in order to get the ball rolling, but it seems that the information required to make the bet the surest of sure things was readily available. Which makes me wonder about the rest of the highly paid people in the world of finance who didn't see the crisis coming. Their blindness doesn't inspire much confidence, does it?