The Greatest Trade Ever

by Gregory Zuckerman

  “This guy is nuts,” he said with a chuckle, amazed that Paulson was agreeing to make so many annual insurance payments. “He’s just going to pay it all out?”

  Soon, however, the traders began to wonder when all the buying would stop. The more CDS insurance they sold Paulson, the more they were on the hook to find bullish investors willing to take the other side of the transactions. Some worried that they might be stuck with Paulson’s trades if they couldn’t find enough investors to take the contracts off their hands, a dangerous position if housing crumbled.

  Others seemed to be making the trades for their own banks’ investment vehicles, relying on mathematical models that deemed it safe to sell protection to Paulson. If he bought much more, though, the price of the insurance investments the banks were selling might go up, dealing losses to their own investment vehicles.

  Josh Birnbaum, Goldman Sachs’s top trader of CDS protection on the ABX index, kept calling Rosenberg, asking how much protection Paulson ultimately planned to buy. When Paulson and Pellegrini got wind of Birnbaum’s inquiries, they told Rosenberg to keep him in the dark. They worried that Birnbaum might raise his prices on the CDS insurance if he knew more buying was on the way.

  Birnbaum persisted, asking to come by the office. A slim thirty-four-year-old who looked several years younger despite streaks of silver in his hair, Birnbaum came alone. Sitting across from Paulson, Pellegrini, and Rosenberg in a small conference room, he quickly got to the point.

  “If you want to keep selling, I’ll keep buying,” he said. “We have a few clients who will take the other side of your trades. And I’ll join them.”

  Birnbaum was trying to tell Paulson he was making a big mistake. Not only were Birnbaum’s clients eager to wager against him, but Birnbaum was, too. He urged caution if Paulson’s team was going to stay bearish on even safer parts of the subprime market.

  “Look, we’ve done the work and we don’t see them taking losses,” Birnbaum said.

  Some on Paulson’s team couldn’t figure out what Birnbaum was up to. Was he truly looking out for them or did he want to discourage the firm from shorting more of the ABX index? Was he afraid their trading might cost Goldman?

  “It felt foolishly presumptuous to suggest we knew better than Goldman,” with its army of professionals and sterling reputation, Pellegrini recalls.

  After Birnbaum left, Rosenberg walked into Paulson’s office, a bit shaken. Birnbaum was the expert on the market—should they change their stance?

  Paulson seemed unmoved. “Keep buying, Brad,” Paulson told Rosenberg.

  Almost as soon as Birnbaum returned to Goldman’s trading floor, Rosenberg phoned him to place more bets against the ABX.

  “Really??” Birnbaum responded, apparently surprised that he hadn’t persuaded them to stop.

  Paulson invited mortgage experts from Bear Stearns to challenge his team to make sure they weren’t missing anything. The group walked into the “Park” conference room, next to Pellegrini’s office. The room featured a long set of windows looking north. In past meetings, the view sometimes proved distracting. Inside a gleaming, glass building across the street was a huge showroom with a long runway where female models sometimes gathered, wearing revealing Christian Dior swimsuits.

  This afternoon there was less to ogle. The Bear Stearns team, among the most bullish on Wall Street, began by saying that subprime-mortgage losses of more than 3 percent were highly unlikely and that BBB slices of mortgage deals wouldn’t fall much.

  “You guys are good customers and we’re concerned about you,” one Bear pro said. “You guys need to do more research on historical price appreciation.”

  “What are your models based on?” Paulson responded. “The market has changed—now you can get a loan without any documentation. Are you including that in your models?”

  “Our models are fine,” the Bear Stearns expert responded, polite but self-assured. “We’ve been doing this for twenty years.”

  Scott Eichel, a senior Bear Stearns trader, chimed in that buying a huge amount of mortgage protection on a few mortgage pools was misguided. Don’t concentrate your bets, he warned.

  Eichel was struck by the thesis of the Paulson team. It sounded too simple for a firm that he suspected had placed billions of dollars of trades. Didn’t they understand the complexities of the mortgage market?

  Pellegrini listened closely to the conversation, displaying little emotion. He became convinced that some of the executives didn’t fully believe their own arguments. They simply were aiming to stop Paulson from shorting so much and causing trouble for Bear Stearns, Pellegrini concluded. He quietly seethed.

  Two could play this game, Pellegrini eventually decided. He started to act as if he was having second thoughts about his bearish stance, pretending he was being swayed by the arguments of the guests.

  As the meeting wrapped up, Pellegrini turned to the Bear Stearns executives with a smile. “We really appreciate the help; thanks, guys.” He didn’t dare reveal what really was on his mind.

  “We said, ‘Oh, thank you for your help,’ but really we were saying ‘Fuck you,’ ” Pellegrini recalls. “We were both pretending.”

  Paulson remained poker-faced during most of the firm’s meetings with the Wall Street pros. He digested their points and made doubly sure he hadn’t missed anything, but he didn’t hint at how bearish he truly was. If he wanted to keep buying at inexpensive prices, Paulson couldn’t reveal his true appetite for the insurance.

  “They concluded that I was an inexperienced manager,” he recalls. “I had to play dumb. But I got tired of people saying I was stupid or wrong.”

  Although the new fund wasn’t large, there weren’t many others doing much buying of mortgage protection, so Paulson’s activity quickly became the buzz of the market. Over the next few months, he received checks from new clients who sensed that housing might be peaking. He put the money to work, placing even more trades. Paulson’s team soon became more fearful about rivals catching on. When some of his investors shared details of the fund’s tactics, Paulson turned furious, installing technology to prevent clients from forwarding his e-mails.

  Paulson called on Hank Greenberg, the founder of insurance giant American International Group, to see if his investment firm, C.V. Starr, wanted to invest in the Paulson fund. AIG had spent the last few years selling tens of billions of dollars of CDS contracts on subprime mortgages, and Paulson knew AIG could be at risk if housing crumbled. An investment in Paulson’s fund might be a good way to offset that position, he argued.

  Greenberg and his team didn’t know Paulson, though, so they asked an outside specialist, Anauth Crishnamurthy, to vet the idea. Visiting the firm after the close of trading one day, Crishnamurthy grilled Pellegrini and Jim Wong, Paulson’s head of investor relations, pushing for details of their moves. When Paulson dropped by the meeting, Crishnamurthy asked why C.V. Starr should pay the hedge fund to invest in the ABX index when it could do that on its own.

  “What’s your trading advantage?”

  “That doesn’t matter,” Paulson responded. “The bonds are going to zero.”

  Listening to Crishnamurthy’s detailed questions, the Paulson team worried that he might steal the trade and teach his bosses to do it themselves.

  After the meeting broke up, Pellegrini pulled aside Wong, saying, “Don’t waste your time with him.”

  Paulson pored over mortgage-servicing reports and noticed rising delinquencies among borrowers. The Fed already had raised its short-term interest rate back to 5.25 percent from 4.25 percent at the beginning of the year. Borrowers surely would come under more pressure.

  In July 2006, Paulson got more enthused. Option One Mortgage Company, a subprime lending unit of H&R Block that was accounting for about half of the profits of the tax-filing company, reported poor earnings and acknowledged problems with loans it had issued. So many customers were skipping even their first payments that the company was being forced to take mortgages back fro
m banks to which it had sold them.

  “It was one of the first signals that something was wrong with the business,” Paulson recalls.

  As Paulson’s confidence grew, he couldn’t resist bidding on a 6,800-square-foot, seven-bedroom home in Southampton with an indoor glass-enclosed pool, agreeing to a $12.75 million purchase.

  In the summer of 2006, Paulson and his wife and daughters joined Bruce Goodman and his family at the fashionable Southampton Bath and Tennis Club for lunch. After their meal, the old friends walked to the beach to watch Paulson’s daughters play on the sand. As they chatted about work, Paulson seemed cagier than usual, as if he was hiding some big secret.

  Finally, Paulson opened up: “I’m working on a situation where I’ve made a major investment of my personal funds,” Paulson confided. “Bruce, if this works out, it will be extraordinary.”

  Paulson beamed—Goodman hadn’t seen his friend this excited in years. He pushed for details of what Paulson was up to but all he got was an impish smile.

  “I’d love to tell you, Bruce, but I can’t,” Paulson said.

  Paulson’s trade started off with a thud, however, as the price of his protection slipped in August. Complicating matters, the Federal Reserve stopped raising interest rates, worried that if they got too high, home owners would feel pressure. Some investors expected the Fed to lower rates at some point, and mortgage costs fell in anticipation. It seemed that housing might survive. Paulson’s trade might be a bust.

  At home, Paulson’s wife, Jenny, expressed concerns, asking her husband if he was having second thoughts.

  “It’s just a matter of waiting,” he reassured her, before heading out to Central Park for his three-mile run.

  Friends phoned to see if Paulson was going to cut his losses and exit some of his positions.

  “How are you holding up?” Peter Soros asked. “What are you going to do?”

  “I’m adding to the bet,” he responded.

  The way Paulson saw it, it wasn’t bad news that these CDS investments remained unpopular and he was losing a bit of money. Instead, it was an “absolute gift” because it allowed him to buy even more, he told a friend.

  Peter Soros was so impressed by Paulson’s conviction that he invested in the fund, after months of sitting on the fence. Soon, Paulson’s fund was up to $700 million, and he made plans to start a second fund to make additional wagers.

  Paulson and Pellegrini soon realized that they had made a major mistake in their trade, however. Data emerged that home prices had dropped almost 2 percent in 2006. But most of the subprime mortgages that the firm had bet against were handed out before 2006, and were for homes that already had appreciated in value. These borrowers were unlikely to run into problems because they easily could refinance their mortgages. Paulson had taken aim at the wrong target.

  “We were too early,” Pellegrini acknowledges. “Even though home prices were down over the previous year, people in the market didn’t care.”

  Paulson walked out of his office toward Rosenberg’s desk, a new plan in hand. “We’ve got to roll everything,” he told his trader. “We need protection on the latest vintages”—in other words, on houses that had not enjoyed any appreciation; those owners would not be able to refinance because they had no equity in their homes.

  Quietly, Rosenberg traded the firm’s CDS protection for similar insurance on more recent mortgages. Once again, Paulson and Pellegrini chose the riskiest subprime bonds to insure. Not only were they made to borrowers with sketchy histories but they were made at a time when home prices no longer were rising.

  Rosenberg called every contact he had to get his hands on more mortgage protection.

  “What do you have, what do you have?” Rosenberg asked trader after trader. He made himself something of a pest. On Fridays in the summer, when some senior traders took their time getting back to him, hoping to push off the transaction to Monday and get an early jump on the weekend, Rosenberg kept after them, prodding them with repeated calls.

  Luckily for Paulson & Co., the exchange for insurance on the latest mortgages proved relatively painless because the ABX index tracking the most recent mortgages remained around 100, close to the level where it began trading, reflecting continuing enthusiasm for housing. Because the index was so high, the cost of the CDS contracts on the mortgages remained cheap. Paulson had dodged a bullet.

  OUT ON THE WEST COAST, Jeff Greene was experiencing more serious setbacks. He had placed his own trades a few months before Paulson launched his fund. As the market continued to rally in the summer of 2006 and the cost of mortgage protection fell further, it caused Greene deeper losses than Paulson was experiencing. By the summer, Greene was down about $5 million.

  He ached to reach out to his old friend, to discuss the market and ask whether he should hold on to his trades. And Greene still remained interested in Paulson’s fund. But Greene’s account was down so much, he was even less eager to exit his trades and lock in the losses. He knew he had to confess to Paulson that he had kept his investments, despite Paulson’s demand that he sell them.

  Sitting in his Malibu home, the wind chimes playing a gentle tune, Greene booted up his computer and wrote a new e-mail to Paulson. When he had finished, he took a deep breath and pressed the send button. In his e-mail, Greene had written that he was looking forward to getting together when he was back on the East Coast. He asked if he could still invest in Paulson’s fund. Then Greene casually mentioned that he still held his own subprime trades.

  Greene quickly got a sense of Paulson’s reaction: He was livid.

  “I don’t want you in my fund,” Paulson fired back in an e-mail. “You’re not an honorable person.”

  Paulson stormed out of his office to alert his staff not to have anything more to do with Greene.

  A few days later, Paulson called Jeffrey Tarrant, sounding hurt: “You build a relationship with someone and this is what happens?”

  “We really could have used Greene’s money at the time,” Paulson said later, explaining why he felt so betrayed. “And he said he unwound the trade after I asked him to and he didn’t.”

  Greene felt some regret over his actions, and his friend’s reaction. But a part of him also wondered what the big deal was. Paulson had given him dozens of investment tips over the years. He had acted on most of them. And Paulson had told dozens of investors about the trade; he already owned billions of insurance protection. Surely the word was out. It’s not like it’s a secret, he thought to himself.

  “He never told me ‘Don’t do it,’ ” Greene says.

  For Greene, the dustup was a downer, especially since few of his other friends managed to find brokers willing to place the trades for them.

  “It was lonely,” Greene says.

  Greene never did see Paulson on his trip back east. Well after midnight on a warm Saturday night, he anchored off Sag Harbor to check out another party. There, at the back of a room crowded with people, Greene met an attractive woman, Mei Sze Chan, a Chinese refugee from Malaysia who had grown up in Australia. Like Greene, Chan was in the real estate business and was a fixture in the late-night scene, sometimes attending a half-dozen parties a night in the Hamptons or New York. The thirty-two-year-old also had begun to wonder whether she would ever find Mr. Right.

  Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.1

  A few months later they were engaged.

  Greene was less successful with his short trade, however, and his frustrations began to boil over. Every day at 11 a.m., soon after rolling out of bed, he called his broker, Alan Zafran, to ask, “What’s the pricing today?”

  Most mornings Zafran came back with data showing that Greene’s protection was worth less than the day before. Demand for subprime mortgages was growing, not shrinking, Zafran told him.

  “It doesn’t make any sense to me,” Greene responded one morning. “It just doesn’t
make any sense.”

  Zafran visited Greene’s Hollywood Hills home to go over the results of the trade, and they pored over a giant spreadsheet of figures together.

  Soon Greene’s calls to Zafran became more heated. Greene couldn’t even get a quote on his investments without asking a bond dealer for an estimate, feeding his frustrations. He also couldn’t figure out why the insurance wasn’t rising in price, even as housing seemed to falter. The Merrill traders seemed reluctant to lower the value on all those subprime mortgages, he decided.

  “How can you justify this price?!” Greene asked at a rapid-fire clip, his voice rising with anger. “It doesn’t make any sense to me. Does it make sense to you!? Call me back!”

  After Greene read a newspaper article about growing difficulties at Countrywide Financial, he called Zafran, who patched in a Merrill executive in New York, Cliff Lanier.

  “I have to be in the money, right?” Greene said, bitterly.

  Lanier retrieved a fresh quote for Greene from a trader, along with an update on the market: The ABX index tracking subprime mortgages indeed was falling. But Greene held insurance on a range of mortgage bonds, not just the ABX, and those positions showed even more losses for Greene.

  “Come on!!” Greene responded. “Countrywide’s on the front page of the paper. I don’t understand it!”

  With each call, he noticed that the quotes were getting a little better. That pleased him, but it also sowed suspicions about how Merrill was coming up with its quotes. The Merrill team said it was merely passing along the latest quotes.

  Greene had spent millions investing in an obscure, opaque market. Now, as housing was slipping, his mortgage insurance wasn’t budging. He couldn’t even be sure what they were worth.

  “I don’t understand it, Alan. Explain it to me,” Greene pleaded to Zafran.

  MICHAEL BURRY was under even more pressure. He’d become bearish on housing a full year ahead of Paulson & Co., buying protection against mortgage securities and financial firms when no one else wanted it. But by mid-2006, his investments, too, were falling in value. And unlike the previous year, Burry couldn’t find many winners with his stock picks to offset the losses. His trade was dealing his fund its worst setback ever.