The Man Who Made Too Much

by Gary Weiss in Portfolio.com February 2009 Issue

Hedge fund manager John Paulson has profited more than anyone else from the financial crisis. His $3.7 billion payday in 2007 broke every record, and he made it all by betting against homeowners, shareholders, and the rest of us. Now he’s paying the price.

Two young men, traders on John ­Paulson’s staff, come into his hedge fund’s office seeking advice on whether to buy a certain debt security. Sitting just a few feet away, I have no idea what Paulson tells them. His slightly high-pitched voice is so soft that on the rare occasions he is forced to speak in public, he’s easily drowned out by the rustling of papers or the clearing of throats. When he appeared before a U.S. House committee in November to try to explain how he had lavishly profited while countless others had suffered, Paulson spoke so gently, even when inches from the microphone, that representatives repeatedly, and with growing irritation, had to ask him to speak up.

Paulson is smart enough to know that at this particular moment in history, the less he’s heard from, the better. The simple reason: He is not suffering. In an era in which losers are universal and making a profit seems somehow shady, Paulson is the most conspicuous of Wall Street’s winners. Paulson & Co.’s funds (with an estimated $36 billion under management and growing by the day) were up a staggering $15 billion as the markets teetered in 2007; one fund gained 590 percent, another 353 percent. All this reportedly garnered him a personal payday of $3.7 billion, among the biggest in history. In 2008, his funds didn’t climb nearly as much but were still successful enough to put him at the very top of his profession. By scoring returns of this magnitude, Paulson has dwarfed the success of George Soros, whose currency trades in the 1990s made him so much money that he has spent much of the rest of his career atoning for them.

Paulson makes no apologies. During our conversation in his conference room, he describes in detail how he pulled off the greatest financial coup in recent history—a two-year bet that the calamity we are now experiencing would take place. It was a megatrade involving dozens of financial instruments, along with prescient wagers that banks like Lehman Brothers would eventually go under. (View a graphic showing how much John Paulson has outperformed other indices.)

Left unexamined is the uncomfortable moral dimension of Paulson’s achievement. If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down? Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?

The question has long dogged that most hated species of Wall Street trader, the short-seller who profits by trading borrowed stock. Because of his recent success, Paulson is now their designated king. So it’s no surprise that he is finding himself the object of finger-pointing about who caused the mess we’re in.

On November 13, Paulson and four other titans of the hedge fund world—Soros, Philip Falcone of Harbinger Capital Partners, Ken Griffin of Citadel Investment Group, and James Simons of Renaissance Technologies—were forced to answer questions in the glare of TV lights before the House Oversight Committee, chaired by Henry Waxman, a Democrat from California, the same man who dog-and-ponied tobacco executives into claiming under oath that cigarettes aren’t addictive. The five were selected because they were the highest-paid fund managers in 2007, as ranked by Alpha magazine, an industry trade publication.

There has never really been a time when short-sellers have been feted. They had a brief moment in the sun following the corporate scandals of the early 2000s, when hedge fund manager Jim Chanos, among others, was credited with uncovering Enron’s fraud. Even though short-sellers red-flagged the dangers of subprime lending years before the crisis—Gradient Analytics, a research firm, issued private warnings as far back as 2002—they have received few brownie points since the housing bust began. “Everybody’s too busy looking out for themselves to come to the defense of people who are perceived as profiting from the misery of others,” Chanos says.

In the view of many C.E.O.’s, short-sellers do more than just profit from corporate misfortune; they inflame it. C.E.O. Dick Fuld of Lehman Brothers and Alan Schwartz, former C.E.O. of Bear Stearns, in their own recent appearances before congressional panels, blamed rumormongers and short-­sellers for the demise of their firms.

“The shorts and rumormongers succeeded in bringing down Bear Stearns,” Fuld ­asserted. “And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers.” Schwartz gave similar testimony when he appeared before the Senate Banking Committee in April, saying that there was a run on the bank despite a “capital cushion well above what was required to meet regulatory standards.” He testified that “market forces continued to drive and accelerate our precipitous liquidity decline.” Banking Committee chairman Christopher Dodd chimed in that “this goes beyond rumors. This is about collusion.”

But was it? Chanos, for one, is tired of the blame-the-shorts litany, and he recalls a conversation with Bear Stearns’ Schwartz to make his point.

The day before the Fed’s rescue of Bear Stearns, Chanos says he was walking to the Post House restaurant in New York City, when, at 6:15 p.m., his cell phone rang. He saw the Bear Stearns exchange come up on his caller I.D. and took the call.

“Jim, hi, it’s Alan Schwartz.”

“Hi, Alan.”

“Well, Jim, we really appreciate your business and your staying with us. I’d like you to think about going on CNBC tomorrow morning, on Squawk Box, and telling everybody you still are a client, you have money on deposit, and everything’s fine.”

“Alan, how do I know everything’s fine? Is everything fine?”

“Jim, we’re going to report record earnings on Monday morning.” 

“Alan, you just made me an insider. I didn’t ask for that information, and I don’t think that’s going to be relevant anyway. Based on what I understand, people are reducing their margin balances with you, and that’s resulting in a funding squeeze.”

“Well, yes, to some extent, but we should be fine.”

“This is now 6:15 on Thursday night, the night before the collapse,” Chanos says. “It was after a meeting with Molinaro”—Bear Stearns C.F.O. Sam Molinaro—“who basically told him at that meeting, ‘We’re done. We’re gone. We need money overnight we don’t have.’  So here he is, calling one of his biggest clients to go on CNBC the next morning to say everything’s fine when clearly it’s not. And he knew it wasn’t.”

Chanos refused to go on CNBC. By 6:30 the next morning, word was out that the Fed was engineering the rescue of Bear Stearns. Chanos realized that he could have been on CNBC while that was ­announced. “I thought, That fucker was going to throw me under the bus no matter what.”

“So here it is,” Chanos says. “Alan Schwartz takes the position ‘Short-sellers were our problem,’ and who did he try to get to vouch for him on the morning of the collapse? The largest short-seller in the world. You want to talk about ethics and who’s telling the truth on these things? It’s unbelievable.”

Schwartz, not surprisingly, has a different version of events. “I did not make the statements attributed to me by Mr. Chanos,” he says through a spokesperson. According to someone who has spoken to Schwartz, the ex-C.E.O.’s side of the story is that the conversation took place on Wednesday, not Thursday, and that it was entirely different from what was related by Chanos. His contentions are that the call was an effort to obtain a public statement from Chanos that “a group of short-sellers out there are trying to take Bear Stearns down” and that no information on Bear’s financial strength was conveyed to Chanos.

Paulson is in his mid-fifties, hair thinning at the top just a bit, with a slight paunch that he fights by jogging in Central Park, a half-block from the 28,000-square-foot Upper East Side townhouse that he bought a few years ago. He is of medium height, medium build, medium disposition. He favors old-fashioned tortoiseshell bifocals and dark-gray suits—none of the forced informality that you find in some hedge fund offices. He speaks fluidly and candidly and is unmoved by critics of his chosen profession. This, after all, is a man whose mind has been set on making vast, historic amounts of money since he was a kid, when he bought candy in bulk and sold individual pieces to his buddies at a profit.

At the beginning of 2008, he says, the general thinking was, No, we’re not going to have a recession; we’re going to have a slowdown. “Then there would be a pickup in the second half of the year. When the second half started looking as bad as the first, the general feeling became, We’re not going to have a pickup; we’ll have a slowdown.”

Paulson is astounded that some optimists continue to expect that somehow the formerly unsinkable economy will remain afloat, at least long enough for the government’s rescue boats to arrive. “Now that we’re in a recession, they’re probably admitting, ‘Okay, we’re in a recession, but it will probably last just two to three quarters.’ So they’re always underestimating the severity of the magnitude,” he says.

Paulson’s own view of the current situation is much darker. He predicts that the recession will last well into 2010 and that unemployment will reach 9 percent, a sharp increase from its current perch just below 7 percent. “We have a long way to go before we reach the bottom,” he says.

Paulson has become a lightning rod not simply because he made money in an awful market, but because of the way he made it. He wagered against subprime securities while everyone else was piling in. He bet that in addition to Lehman Brothers, other banks like Washington Mutual and ­Wachovia were due for a fall.

Long before the financial crisis hit, Paulson, according to one person briefed on the trade, invested $22 million in a credit default swap that eventually paid $1 billion when the federal government opted not to rescue Lehman Brothers. That amounts to a staggering $45.45 for each dollar invested.

John Paulson was born in 1955 in Queens, New York, in a pleasant and somewhat obscure middle-class neighborhood called Beechhurst. His father, Alfred, an accountant who came from a Norwegian family that had settled in Ecuador, rose to become C.F.O. of Ruder & Finn, a public relations agency. But John’s investment-­banking genes seemed to have come from his mother’s father, Arthur Boklan, who, during the crash of 1929, was a banker at a long-since-vanished Wall Street firm. In an interesting parallel with his grandson, he apparently prospered even as the Great Depression dragged the country into misery. In 1930, according to census records, he was able to afford a $220-a-month apartment in the Turin, a stately building that still stands at 93rd Street and Central Park West in Manhattan.

Boklan saw to it that his grandson had an early appreciation for the principles of capitalism. When John was a small child, Boklan was the one who encouraged him to buy Charms candy in bulk at the supermarket and then sell the individual candies to kids in the schoolyard at a substantial markup. His profits grew, as did his appreciation for economies of scale and the tendency of certain commodities to become mispriced through ignorance or carelessness. It was also the point at which he would become transfixed by the process of turning pennies into dollars. Paulson would spend much of the rest of his career under the tutelage of older Wall Street role models, seeking to replicate those days with his grandfather.

Following high school in Brooklyn, Paulson moved on to New York University, which in the 1970s offered a popular seminar taught by John Whitehead, then a senior partner at Goldman Sachs. Paulson listened, fascinated, as Robert Rubin, later secretary of the Treasury under Bill Clinton and now an unofficial adviser to Barack Obama—talked about the mysterious and new (to Paulson, anyway) world of risk arbitrage. At the time, the scholarly, soft-spoken Rubin was viewed, at least by Paulson’s professor, as the smartest partner at Goldman Sachs; he was certainly the richest. Paulson graduated first in the class of 1978, with visions of arbitrage in his future.

Harvard Business School followed. There, Paulson came under the spell of another established star in finance, the leveraged-buyout titan Jerry Kohlberg. “I had never heard of Jerry Kohlberg,” Paulson recalls, “but one of my friends told me, ‘Forget about investment banking. You’ve got to hear Jerry Kohlberg. These guys make more money than anybody on Wall Street.’ ” According to Paulson, Kohlberg described how he engineered the L.B.O. of a company by putting up just $500,000 in equity and then obtaining a $20 million bank loan secured by the company’s assets. The company was turned around and sold at a profit of $17 million in two years’ time.

Paulson received his M.B.A. and then spent his time in pursuit of as much money as he could earn. In 1980, the hottest jobs were not in investment banking but in management consulting. So when Paulson finished at Harvard that year, he joined one of the leading lights in the field, the Boston Consulting Group. Though the starting salaries were far higher than those in investment banking, he realized that even the partners didn’t manage to pull in the kind of money he was hoping for. Thus, following a chance social encounter with Kohlberg, Paulson moved to Wall Street, where he was introduced to Leon Levy of Oppenheimer & Co. Paulson was soon hired by Levy’s new venture, Odyssey Partners.

After a couple of years at Odyssey, Paulson realized he was not getting the training he needed to climb the ­investment-banking money tree. So in 1984, just as the bull market was beginning, the 28-year-old joined Bear Stearns as an investment-banking associate. Four years later, he was promoted to managing director but soon opted to strike out on his own. After dabbling in real estate and beer—Paulson was an early investor in what would become the Boston Beer Co.—he joined the great, long march of former investment bankers and traders into the hedge fund business in 1994, going where he thought the money was.

Paulson began with about $2 million of his own money, just a blip in the hedge fund world, even then. The firm consisted of just Paulson and an assistant. He shared office space in a Park Avenue building with other small hedge funds.

At first, growth was slow. Paulson, who lived in an apartment in Lower Manhattan above what is now a discount shoe outlet, shepherded his money carefully and began to establish a track record. In keeping with the norms of the time, he charged a fee of 20 percent of profits and 1 percent of assets—a comfortable sum when the size of his fund was $20 million but nothing like what he has made recently.

Then, in the late 1990s, came the tech bubble, and more important for Paulson, who was shorting stocks and betting big on corporate mergers, its bursting in 2001. When the market crashed after stocks lost steam that year, Paulson’s funds climbed 5 percent and rose the same amount in 2002, demonstrating his uncanny ability to avoid losing his investors’ cash as the rest of the market cratered. (Indeed, Paulson has had only one down year out of the past 15: His funds recorded a 4.9 percent decline in 1998, the year of the debacle in the Asian markets.) Money continued to pour in. By 2003, his funds had $600 million under management; two years later, their value was upwards of $4 billion.

Paulson began branching out, moving away from betting on mergers and into the financial instruments of firms in bankruptcy. He was still as obscure as he could be, keeping his name and that of his wife, Jenny, out of the papers, though they did begin to accumulate the usual symbols of hedge fund wealth. He left his apartment on Broadway for the palatial quarters of a mansion on East 86th Street and bought an opulent, though not extravagant, house in the Hamptons, outside of New York City.

Paulson got wind of the coming storm in the credit markets through the infallible barometer of prices. By 2005, the amount of money he could make on the riskiest securities was not enough to justify the risk he was taking. Pricing, in his view, made no sense. Paulson concluded that he could do better on the short side—wagering that prices of risky securities would fall.

“We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down,” he says. “We couldn’t short a house, so we focused on mortgages.” He began taking short positions in securities that he believed would collapse along with the housing market.

The best opportunities were in the junkiest portion of the housing market: subprime. Pricing of subprime securities “was absurd,” Paulson says. “It didn’t make sense.” Subprime securities graded triple-B—in other words, those that the credit-rating agencies thought were just a tad better than junk—were trading for only one percentage point over risk-free Treasury bills. This absurdity appealed to Paulson as easy money.

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.