The Greatest Trade Ever

by Gregory Zuckerman

  In truth, Pellegrini had withheld more from his bonus than he needed in order to pay the year’s taxes, so the figure in the bank account that day was skimpier than it could have been. Paulson paid him about $175 million for his work in 2007. Pellegrini would never again have to worry about finding a career, keeping a job, or stretching his savings.

  “Wow,” his wife said quietly, still staring at the ATM.

  Then they left, arm in arm, to meet a chartered boat to take them to nearby St. Barts.

  Paulson did quite well for himself as well. His hedge fund got to keep 20 percent of the $15 billion or so of gains of all his funds. He also was a big investor in the credit funds. His personal tally for 2007: nearly $4 billion. It was the largest one-year payout in the history of the financial markets.

  14.

  ON FEBRUARY 20, 2008, PAULSON RECEIVED AN INVITATION FROM Samuel Molinaro, Jr., the chief operating and financial officer at Bear Stearns, inviting him to a lunch at the investment bank’s executive dining room. A rash of hedge-fund clients had pulled money out of Bear Stearns and shifted accounts to rival brokers, worried about the firm’s health. The moves left Bear in a weak position and fed rumors that the storied firm might not survive. If Molinaro could bring the hedge funds back into the fold it would be a shot in the arm for Bear Stearns and could help right his tottering ship.

  Paulson & Co. was an especially attractive catch for Molinaro. It now was among the world’s largest funds, and Paulson had remained a loyal customer of his former employer, despite the speculation about Bear Stearns’ future. But Paulson also had moved cash elsewhere, concerned about the health of the investment bank. If Molinaro could get Paulson back in Bear Stearns’ corner again, it would be an instant boon and likely would reassure others who were mulling over whether to return as clients.

  After a lunch of salad, grilled chicken, and chilled string beans, Molinaro rose to address the select group of twenty or so hedge-fund bigwigs, all facing one another around a circular dining-room table. For twenty minutes, Molinaro outlined how Bear had improved its financial position, why its business was healthy, and how much cash the firm held. The press had it out for Bear Stearns, Molinaro emphasized. There really was nothing terribly wrong with the firm.

  Then another Bear executive gave a speech, saying that he couldn’t share many details, but business definitely was picking up. He appealed to the group to bring back the cash, reminding them of the long-term relationships many had with Bear and how the investment bank had helped many of their firms in times of need. Listening to it all, some of the hedgies began to feel pangs of guilt, remembering times they indeed had been aided by various Bear Stearns executives.

  For another twenty minutes, Molinaro easily handled softball questions from the group. It seemed he was winning them over and a crucial victory was within sight. Maybe Bear Stearns could save itself after all.

  Then John Paulson raised a hand. The executives turned to watch him, eager to hear what he might say.

  “Sam, do you know what your Level Two and Level Three assets are on your balance sheet?” Paulson asked, referring to investments that could be hard to price, sometimes because they are risky.

  “Not off the top of my head.”

  “Do you have an idea?”

  “I’d rather not guess, John. Let me give you the right number when I get back to my desk.”

  “Well, I’ll tell you what the number is. It’s $220 billion. So what I’m seeing is that if you have $14 billion of equity and $220 billion of Level Two and Level Three assets, a small movement in the assets can wipe out your equity completely.”

  Molinaro didn’t realize it, but Paulson had spent weeks reworking his firm’s holdings, dropping dozens of stocks and bulking up its bets against a range of financial giants, from Lehman Brothers and Washington Mutual to Wachovia and Fannie Mae. He had deep concerns about Bear Stearns, too. Investors had poured $6 billion into his firm in the previous year, and Paulson had put a good chunk of it to work wagering against banks and investment banks with flimsy balance sheets. He had done his homework.

  Molinaro suddenly looked uncomfortable. He either didn’t have a good response for Paulson, was wary of publicly squabbling with a good client with a growing reputation, or didn’t want to give a faulty figure.

  “I’ll have to check the number, but you may not be accounting for the fact that some of the assets are hedges.” In other words, Paulson might not be getting a true view of the firm’s risk, Molinaro argued.

  His response was for naught. Paulson had pushed open the floodgates. Two other hedge-fund managers quickly followed Paulson with their own questions, adopting much harsher tones.

  “How can you not know the number, Sam?!”

  “Paulson’s right, you guys are in trouble!”

  Paulson watched quietly as the two investors bullied Molinaro for several more minutes. The grilling got so harsh that some of the investors began to feel sorry for Molinaro. So many doubts had been raised about Bear Stearns’ health, though, that the accounts never would return to the investment bank.

  As the meeting broke up, one hedge-fund executive said to a friend, “Shit, Bear’s really in trouble.” Chatter about the meeting began to circulate as soon as the executives returned to their firms.

  It was a dagger in the staggering investment bank’s heart. Soon a rash of hedge funds pulled money out of Bear Stearns, including a $5 billion shift by hedge fund Renaissance Technologies.

  Tempers flared within Bear Stearns as the investment bank’s shares plunged and its cash dwindled. The firm’s CEO, Alan Schwartz, tried to calm various executives. During one meeting, though, Michael Minikes, a sixty-five-year-old veteran, abruptly cut off his boss.

  “Do you have any idea what is going on?” Minikes asked. “Our cash is flying out the door. Our clients are leaving us.”

  A month later, Bear Stearns had to be rescued in an emergency sale to J.P. Morgan coordinated by the Federal Reserve and the Treasury Department at a price of just $2 per share, a figure later increased to $10 per share.

  After the original sale was struck, Alan Schwartz wearily made his way to the company gym for an early-morning workout. Dressed in his business suit, he trudged into the locker room. There, Alan Mintz, a forty-six-year-old trader at the firm, in sweaty gym clothes, made a beeline for his boss.

  “How could this happen to fourteen thousand employees?” Mintz demanded, getting in Schwartz’s face. “Look in my eyes, and tell me how this happened!”1

  On the Sunday that Bear Stearns fought for its life, and while others on Wall Street were glued to their computers, worrying about the impact, Paulson watched his two daughters frolic in his home’s indoor pool. Months earlier, he had shifted almost all his firm’s cash from a Bear Stearns account to a money-market account at Fidelity Investments secured by U.S. Treasury bonds, just in case the investment bank’s health deteriorated.

  It was the beginning of a year of historic troubles for leading financial companies around the globe, as the firms finally acknowledged they were sitting on deep losses due to real estate-related holdings and hadn’t adequately prepared for a downturn.

  Executives at Lehman Brothers were among those most confident they could weather the storm. Richard Fuld, Lehman’s CEO, had turned down a lucrative investment from the Korea Development Bank. Fuld and his bankers also had spoken with Bank of America, MetLife, HSBC Holdings, and others, but no deal materialized. Fuld had been through crises before, and this one seemed to be just another that he and his team would maneuver around. He blamed growing weakness in the company’s shares on short sellers, many of whom were hedge funds buying CDS protection on Lehman’s debt. His complaints didn’t sit well with these funds, though, many of whom were Lehman’s own clients and were nervous enough about the health of the firm.

  On September 9, after talks with the Korean investors finally fell through, Lehman’s shares dropped in half, the largest one-day plunge on record. Worries about Lehman’s $
33 billion of commercial real estate holdings swept Wall Street. Lehman executives calculated that the firm needed at least $3 billion in fresh capital. A day later, though, they assured investors on a conference call that the firm needed no new capital. Wall Street rivals who viewed Lehman’s huge real estate portfolio said it was overvalued by more than $10 billion, but Lehman executives insisted that it was valued properly.2

  J.P. Morgan didn’t like what it was seeing. The big bank played middle man between its clients and Lehman in various trades and was privy to more details of Lehman’s operations than most investors. A week earlier, J.P. Morgan had asked Lehman for $5 billion in additional collateral—easy-to-sell securities to cover money lent by J.P. Morgan’s clients to Lehman. Steven Black, co-CEO of J.P. Morgan’s investment bank, phoned Fuld, saying that in order to protect itself and its clients, J.P. Morgan needed $5 billion in additional collateral—in addition to the $5 billion J.P. Morgan demanded five days earlier, which had yet to be paid.

  Lehman sent some of the money, but held off J.P. Morgan on the rest as it tried to reassure clients.

  “Our balance sheet is better than ever,” Christian Lawless, a senior vice president in Lehman’s European mortgage operation, told investors seeking to pull out assets.

  But so many hedge funds pulled money from their accounts at Lehman that the firm couldn’t properly process the requests, as panic grew within the firm.

  Lehman tried to entice rivals to buy the firm or certain assets. But two Wall Street executives who reviewed Lehman’s real estate documents passed, saying that Lehman had placed a valuation on its real estate holdings that was 35 percent higher than it should be. Treasury Secretary Henry Paulson insisted the government wouldn’t lend financing for a purchase.

  Lehman was so weakened that the 158-year-old Wall Street firm turned to the Federal Reserve and Treasury Department. Like other investment firms, Lehman had spent years enjoying outsized profits and enormous wealth from a raging real estate market. Now that housing was on its knees, however, Lehman went to the government, hat in hand.

  Late one evening, standing in front of about fifteen silent members of Lehman’s executive committee, Tom Russo, Richard Fuld’s legal counsel, tried reaching Timothy Geithner, the head of the New York Fed. Russo tried Geithner in his office and on his cell phone. Nothing. He paged him, buzzed him. Still no answer.

  The Lehman executives had one last chance: George Walker IV, a top investment banker at the firm who also happened to be a cousin of the president of the United States, George W. Bush. Walker was scared and looked pale. His shirt was soaked with sweat at the thought of calling the White House. His colleagues told him they had no other choice.

  “I’m on my hands and knees,” one colleague, Mike Gelband, told Walker. “We are looking at an unmitigated disaster on a global scale, George.”

  Walker paced the room and looked over at Fuld, who was on the phone with the Securities and Exchange Commission. Then he went to the firm’s library and placed the call. He was put on hold for minutes that seemed like hours, and then the operator came back on the line.

  “I’m sorry, Mr. Walker. The president is not able to take your call at this time.”3

  The government’s decision not to bail Lehman out led to a bankruptcy six times larger than any other Chapter 11 case in U.S. history. It also set off a near panic among investors and lenders worldwide that September, one that forced the United States to push through a historic rescue plan for the financial system. The government and Federal Reserve stepped in to rescue Fannie Mae and Freddie Mac, guaranteeing over $300 billion of debt. It also helped force struggling Merrill Lynch into the arms of larger Bank of America, a step taken to try to avert still more fear among investors.

  The moves worked only partially. The stock market continued to plunge, tumbling more than 60 percent between the fall of 2007 and early 2009, the worst bear market since the Great Depression and one that coincided with the worst recession since World War II.

  The troubles sent the value of all the protection that John Paulson had purchased soaring in value, enabling Paulson & Co. to tack on another $5 billion in profits in 2008. The firm made hundreds of millions of dollars when its CDS contracts on Lehman Brothers paid off in the fall, as the investment bank was forced to seek bankruptcy.

  The hedge fund also made $1 billion by shorting British banks such as Royal Bank of Scotland, Barclays, Lloyds Banking Group, and HBOS, all of which had high exposure to British mortgages. Later, when regulatory changes forced Paulson to reveal these positions, he became something of a public enemy in corners of the United Kingdom.

  “So I’m eating my cornflakes and I read that John Paulson, the New York hedge fund king, has made £270 million betting that the Royal Bank of Scotland share price would fall over the last four months,” Chris Blackhurst wrote in London’s Evening Standard in February 2009. “Prison isn’t good enough for the short-selling fiend! He should be paraded down Fifth Avenue, naked, and then tied to a lamp-post so we can all take out our anger and despair on the grasping monster!”

  Paulson was uncomfortable shorting these stocks—not so much because of any guilt about profiting from falling shares but because there was more downside to wagering against stocks, which can soar an unlimited amount, than in owning them. That’s why he didn’t place nearly as big a bet against financial companies as he did against subprime mortgages. Paulson still scored impressive gains of 30 percent or so for most of his funds in 2008, even as the overall market tumbled 38 percent and some larger hedge-fund rivals threw in the towel and closed down, but Paulson couldn’t match 2007’s gains of 590 percent and 350 percent for his two credit funds.

  For those on the other side of Paulson’s trades, and the executives running financial firms that collapsed so suddenly, 2008 was about recrimination. One Thursday morning in June 2008, the two executives who ran Bear Stearns’ hedge funds that made wrong-way bets on CDOs and other mortgage investments, Ralph Cioffi and Matthew Tannin, were hauled into a Brooklyn jail cell, to be arraigned for allegedly misleading their investors about the health of their failed funds. Their upbeat comments to the investors were at odds with the caution they shared with each other as well as their own actions, prosecutors alleged. Shackled and in shock at the turn of their fortune, Cioffi asked Tannin: “How did we end up in this spot?”4

  IN THE SPRING OF 2008, Paulson and Pellegrini visited Harvard University, their alma mater. Pellegrini was excited about the trip and looked forward to explaining to the students how the firm had anticipated the credit crisis.

  But when they got there and the class settled into their seats, Paulson approached the dais and addressed the group by himself, while Pellegrini watched from the back of the room. Later, Pellegrini helped his boss answer some questions from students, but it stung Pellegrini that he wasn’t invited to address the class. Paulson’s shadow never seemed so huge.

  “It was humiliating to me,” Pellegrini recalls.

  Pellegrini spent most of the year working with Rosenberg to sell the last of the firm’s subprime insurance. Others, like Jeffrey Greene, ran into problems finding investors willing to buy the investments at prices that seemed reasonable.

  But Pellegrini and Rosenberg played a waiting game—when markets were buoyant and optimism reigned, they held back; when a securities firm, bank, or hedge fund imploded, they swooped in to offer their CDS protection, usually finding a huge appetite.

  By July 2008, as subprime-related investments fell to pennies on the dollar, they had exited almost every trade, cashing in the remaining chips of the remarkable trade. The two Paulson credit hedge funds invested a total of $1.2 billion of cash and racked up nearly $10 billion of gains, all in two remarkable years. Paulson’s other funds enjoyed about $10 billion of their own gains, all from obscure protection on mortgages most experts said would never get into trouble.

  Pellegrini spent the rest of the year hiring specialists to refine the firm’s valuation methods for mortgages, pre
paring for the time when it looked safe to buy them. Over several months, Paulson sometimes pushed Pellegrini to look for cheap mortgage investments, but Pellegrini remained skeptical, and the hedge fund held off doing much buying until the fall of 2008.

  By then, Pellegrini had one foot out the door.

  JEFFREY GREENE began 2008 with a burst of confidence. He already had cashed in nearly $100 million of his investments and had decided to stop fighting his brokers with their unreliable quotes. He’d simply hold on to the rest of his CDS mortgage insurance, which he figured was worth $200 million or so. If all those home mortgages ran into problems, as he knew they would, the insurance would pay him in a big way. He didn’t have to sell his holdings.

  His friend in Boston, Jeffrey Libert, was panicking. He wanted to sell his own investments but also was hoping to keep them until the summer, so he would hold them for a year and could pay a lower tax rate, something Greene also was doing.

  “Chill out,” Greene told his friend.

  Libert eventually cashed out, settling for profits of about $5 million from his trade. It was a big score but it came with regular ribbing from his friend for not being “gutsy” enough to do the trade in a bigger way.

  “I should have done more, I’m kicking myself,” Libert says. “But it just wasn’t for me.”

  In the fall of 2008, when Lehman Brothers collapsed and Merrill Lynch ran into deep problems, it was Greene’s turn to sweat. He hadn’t paid enough attention to the health of his broker. Now he realized that if Merrill Lynch went under, he might not be able to gain access to his positions. He’d be just another desperate creditor lining up at bankruptcy court to lodge a claim.

  “I’m thinking, ‘If Merrill goes out of business I’m out $200 million!’ ” Greene recalls.

  By then, Zafran, his Merrill Lynch broker, had left to start his own firm. Greene picked up the phone to call J.P. Morgan, hoping the bank, in a safer position, would engineer a transfer of his positions from Merrill Lynch and help him sell it all. On hold, Greene waited nervously as his broker asked a few traders if they could help.