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Greg Zuckerman's 'The Greatest Trade Ever'

by Robert Teitelman  |  Published August 4, 2010 at 4:50 PM
he Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
by Greg Zuckerman
Greg Zuckerman, The Wall Street Journal's hedge fund reporter, adds another volume to to the growing stack of tomes on the financial crisis -- a phenomenon that's beginning to resemble its own bubble. The worst thing I can say about it is that the title -- "The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson  Defied Wall Street and Made Financial History" -- is very long, if par for the course these days: We live in an age of book titles that have heads and decks like magazine articles. The book (which was excerpted in Saturday's WSJ) itself is compact, focused and illuminating about the roots of the crisis. It doesn't feel rushed; it doesn't feel undefined; if not Shakespearian in its prose, it's written professionally and packed with information. Zuckerman has a story to tell, a thread to follow, and it just happens to turn out that by following the saga of John Paulson, Zuckerman reveals all kinds of fascinating perspectives on complex finance, the real estate bubble and Wall Street and Washington's difficulties in putting the two together.

Zuckerman focuses on hedge funder Paulson, who with a small band of colleagues, recognized the subprime crisis to come, developed sophisticated techniques using credit default swaps to short it and made the biggest trading killing in history. Paulson, whose background is in merger arbitrage not real estate, was not alone in recognizing the looming disaster. Zuckerman touches on a handful of others who detected the signs and fumbled their way to a similar strategy. The inherent drama here arises from the difficulties that lie in their path: mastering the intricacies of CDSs, CDOs and mortgages; putting on trades then hanging on while the ABX mortgage index either moves in the wrong direction or fails to mirror what appears to be the accumulating evidence of underlying deterioration; and resisting the wall of skepticism, some legitimate and some deeply self-interested.

At a minimum, "The Greatest Trade Ever" is a reminder how relatively little is reported on the actual mechanics of finance -- how hedge funds and Wall Street trading desks interact, the role of analysts and models, the fundraising and client handholding, the mechanics of buying and selling. 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.

Still, for all the difficulties of understanding what was really happening, Zuckerman also notes how talk of real estate bubbles was hardly absent in the media. Writes Zuckerman,

Between 2000 and 2003, there were 1,387 mentions of the phrase "housing bubble" in articles in U.S. publications. Over the next three years, there were 5,535 mentions of the phrase, including prominent stories in most major newspapers, some of which sparked nervousness among major real estate investors.

The two realities -- the sense of a growing problem and the difficulty of dealing with it -- are not mutually exclusive: A bubble arises because contrarian views never gain traction.

Why were so many experts wrong? For all its size, real estate was viewed as an esoteric specialty, particularly the realm of mortgage-backed securities. Paulson and Pellegrini were often condescended to, and even warned, about a business they were supposedly not equipped to understand. On Wall Street, real estate was the province of quantitatively oriented analysts and traders who lived off their MBS models and believed deeply in the power of securitization, in all its fantastically abstract forms, to diffuse and redefine risk -- even that of the crummiest, most predatory mortgages. What was happening on the ground in places like California was irrelevant; the abstraction had disengaged from any underlying reality. And there was, of course, self-interest, though it's remarkable how long it took to shift from blithe confidence to snarling defensiveness. As the market began to crumble, and Wall Street firms began to sense the shape and scale of Paulson's big trade, the firms, stuffed with mortgage-backed CDOs and CDSs insuring those deteriorating tranches of mortgages, began to react in their own self-interest, though rarely in an organized way. Zuckerman leaves it hanging, but all the parties who had put on trades like Paulson's suffered from a strange stickiness in the ABX index and yawning disparities between the data, the ABX and the valuations, calculated by firm trading desks, on certain subprime tranches. It was, at best, suspicious.

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. A thousand John Paulson's or Nouriel Roubini's will leave us not any more certain about the future than the two we have today.

And, in fact, it's a volatile and irony-filled game. Zuckerman mentions several times how David Einhorn, the widely regarded short at Greenlight Capital, had joined the board of mortgage peddler New Century Financial -- a piece of data widely disseminated to suggest how solid that operation was. New Century soon folded. Einhorn then went on to famously short Lehman Brothers Inc., which folded. Josh Birnbaum, a young Goldman, Sachs & Co. (NYSE:GS) asset-backed trader, pays a visit to Paulson to warn him that he was making a big mistake in 2006, then, recognizing that Paulson was right about subprime, leads Goldman's replication of Paulson's shorting strategy in 2007. And yet, Zuckerman is also clear how confidence bordering on lunacy drove the ragtag collection of traders who put on the mortgage short. Contrary to every sane voice, they refused to give in -- and eventually triumphed, at least monetarily.

A final point, which Zuckerman touches on as the market falls and the triumph of the CDS short becomes apparent: How should we view someone like Paulson et al. (or Einhorn or Goldman Sachs for that matter) who made a killing on the collapse of a market that hurt millions of Americans? True, Paulson neither created the situation nor made it much worse, though his winnings against Wall Street firms certainly didn't help them. Paulson at his worst is clinical and slightly chilly about these matters; at his best, he's warm and accommodating. Paulson would argue that his big trade brought reality to an unsustainable situation that, if it had continued, would have sucked in more Americans, though it's a tossup whether the reality showed up first and Paulson profited from it, or whether he actually hastened its arrival. What's clearer is that this big trade was made possible by torrents of liquidity and leverage that also made subprime, CDOs and CDSs possible. 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. What Paulson does with his winnings after being on the right side of the greatest trade in history may well be a whole other story.

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