Tuesday, November 03, 2009

The Greatest Trade Ever

Matthew Wuertzel on Gregory Zuckerman's eponymous book:
[John] Paulson was successful not only because he was open to letting data on subprime speak to him, but because he cultivated slightly off-center analysts like Paolo Pellegrini in his own shop who were just stubborn enough, or desperate enough, not to be sucked in by the powerful conventional wisdom -- the belief that They Must Know Because They Are Experts. The motivations here are obvious. Certainly Paulson craves the fame of besting George Soros for the biggest trade in history, but the real metric is always monetary: how much? Zuckerman doesn't make a huge deal about this, and for a very rich man Paulson can appear surprisingly modest and grounded (he takes public transportation), but this is a world, built on speculation, where levels of income and indebtedness are simply astounding.

Like the crisis itself, "The Greatest Trade Ever" is a sort of exploration of the difficulties, psychological, financial and philosophical, of prediction. Zuckerman is quite good in suggesting just how tough it was, even for those closest to real estate and the mortgage boom, to recognize the growing problem, particularly in 2004 and 2005. Even experienced real estate operators, who knew the market well failed to see it coming, and those who did often reacted to anecdotal evidence not data -- the fact that their wives wanted to plunge into real estate or that every doctor they knew was flipping houses. The sheer ubiquity of the conventional wisdom (property prices never fall broadly across the U.S.) combined with the complexity of the business and the underlying finance to mask growing problems, which extended well beyond the abuses and irrationalities of subprime. Even Paulson and Pellegrini studied the problem for months before they were able to filter out the noise and generate a single chart that showed just how dramatically real estate prices had been disengaging from long-term trends since 2000. That chart, said Paulson, suddenly revealed a bubble and gave impetus for the big trade.

The centerpiece of Paulson's giant trade was his innovative use of CDSs, which allowed him to essentially short mortgage debt in all its forms, while paying relatively small premiums and then, if prices went against him, putting up more collateral. Compared to a normal short, this was an extremely economical trade and one that could be dramatically scaled. But it was complex, and Paulson had to convince major Wall Street firms to trade CDSs on mortgages with him, then, as the situation eroded and he was making vast sums on paper, to figure out how to get out of the trade. But he went well beyond mortgages. Even as the ABX was cratering in early 2007, Paulson coolly began to realize how deeply this crisis might go. He had already put shorts on mortgage providers, but now he began to buy CDS protection against his own providers, the Wall Street firms and big dealers like American International Group Inc. (NYSE:AIG). Intellectually, the thread of the CDS trades took Paulson from the predatory mortgage hucksters at one end of the chain, through securitization and right into the leveraged-fragility of the big banks themselves at the other.

For all his skill, insight and guts, however, Paulson as portrayed by Zuckerman comes across as more empirical than omniscient. He recognized a large truth about oversold real estate. He studied it and over a number of years followed the path one step at a time. He adhered to a rough-and-ready value calculation: What was oversold and over hyped would eventually have to fall. But for all his hard-won insights he was never immodest enough (or stupid enough) to make a call on timing. Indeed, the advantage of the CDS strategy was that the cost of patience was far less than in a traditional short (though some of his less well-capitalized brethren putting on similar trades suffered more). Although Zuckerman never explicitly articulates it, Paulson is not a sterling example of how we should all have seen this coming. He was smart, open to the data, temperamentally suited and lucky. Next time he might be distracted or fixated on what had worked for him in the past, not unconventional enough, not hungry enough or not comprehensive enough in his analysis. It was never easy. Despite his triumph, the future, as Keynes always said, remains irremediably uncertain.
Paulson used the very "weapons of mass destruction" to help destroy, or at least threaten, those weapons themselves. The scourge of excess was made possible by excess and profited, by any measure, excessively. Paulson is certainly no villain, but he's not exactly a hero either, despite personal virtues Zuckerman carefully lays out. Like Soros, he recognized and profited from a gap between fantasy and reality that was certain to disappear.

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