The Man Who Made Too Much

The one bad bet

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.

Though the financial crisis has rewarded Paulson handsomely, he continues to search for investment opportunities. On October 2, he walked into a breakfast meeting at the J.P. Morgan Chase Tower, right across the street from his hedge fund’s old office on Park Avenue, to make a presentation to potential investors about a new fund he had started to trade distressed debt. Its name: the Paulson Recovery Fund. As usual, Paulson was calm and quiet. His associates described how Paulson & Co.’s funds had thrived during even the very worst declines in the market, with an annual growth rate of 17 percent since inception.

Slides in Paulson’s presentation declared that the U.S. had slipped into its deepest recession since World War II. His charts displayed the usual parade of bad tidings: a steep decline in home prices, soaring mortgage delinquencies, credit contracting, and hemorrhaging in the financial sector. The 14th chart showed his strategy. It read, “How do we benefit near-term?”

Paulson’s answer came in four bullet points: Cut leverage and build cash, eliminate exposure to the equity markets, maintain only short-term securities, and prepare for bargains in debt securities of distressed companies—a “$10 trillion opportunity,” another chart pointed out.

Paulson has also taken steps that may help him avoid being tagged as a robber baron, donating $15 million to the Center for Responsible Lending to support a program designed to help homeowners avoid foreclosure. His congressional testimony on November 13 included his thoughts on how the government could help the banks get back on their feet—something that will of course benefit everyone, not just the holders of those distressed securities that Paulson is eager to buy.

But it’s hard to see how any financier who made a fortune from market turbulence can improve his public image when the economy is in such serious trouble. George Soros, even with his massive philanthropic efforts to promote democracy in Eastern Europe, will probably go down in history as the man who broke the Bank of England. Traders like Paulson will probably never be popular. They might as well get used to it.

Paulson himself remains unrepentant. At a recent lunch for investors at the Metropolitan Club in Manhattan, his clients dined on Colorado rack of lamb and sipped champagne, the recession be damned.

Paulson, his wife, and their children still live in their home on East 86th Street, in a mansion that at one time was a men’s club.

They also have a seven-bedroom, seven-and-a-half-bath estate with an indoor pool on Ox Pasture Road in Southampton, New York; he bought the house in 2006 for $12.75 million. This past April, Paulson apparently wanted a place that was larger than a mere bungalow for his growing family, so he listed the property for $19.5 million.

At last look, it was still for sale; its asking price, which had been lowered at least twice, was down to $13.9 million. Evidently, John Paulson had bought at the top of the market.