“Sub-prime king” John Paulson – The Rise and Fall of a Legend

John Paulson is probably one of the most well-known hedge fund managers in the world due to his infamous call on shorting US Sub-prime mortgages through a complex instrument called CDO’s (basically out of the money put options on the value of these bonds). He racked up a stellar performance in2007 and 2008 as the world was falling apart, having correctly anticipated the collapse of the US sub prime mortgage market and which took several banks down with it including Lehman Bros.

Paulson’s clever bets turned him into a billionaire almost overnight with a net worth that amounted to a stunning $16 billion in 2010. Unfortunately, it seems that what goes up, also goes down and Paulson has now been left with a few less billion as his funds have done poorly in 2011 and 2012 – succumbing to the immutable law of the markets that nobody performs forever (as Julian Robertson, Greg Coffey, Victor Neiderhoff et al will pay testimony to!) Indeed, it seems somewhat ironic that just as he made his billions as all around were losing theirs, he is now losing his billions as the markets are rising once more for the masses. I am not sure if he sees the irony in that…?

2012 YTD Return of worst performing hedge funds

Paolo Pellegrini – the real brains?

Paulson started his own hedge fund business with not more than £2 million in the mid 90’s and was largely involved in what is called “risk arbitrage” – making very conservative bets on company mergers & acquisitions. He would buy shares of companies that were a target for a merger while selling the acquirer’s shares. In generic terms this is the most conservative approach a fund can have. And he was quite successful at it. Cent by cent, he was able to grow steadily and in 2007, prompted in large part by someone deemed by many to be the real architect of the “subprime” trade – Paolo Pellegrini (who also closed his own fund last year due to the inability to make money in the current market environment!) – he took the best opportunity of his life.

At a time that seems another lifetime ago now, a background in which banks were happy to lend money to everybody with only the scantest of credit checks and the crooks on Wall Street were only too eager to package these as mortgage backed securities and sell them onto investors, Paulson, along with a few other lone dissenters, bet against the prevailing wisdom. He took a position against the subprime mortgages and made $3.7 billion personally, in 2007 alone. As his assets under management grew on the back of his fame he continued to add to his fortune and in so became a legend on Wall Street. At their peak in 2010 his funds assets topped some $30 billion.

Icarus’ fall from grace

In late 2010 the wheels of his strategy began to come off however. Some argue he became greedy and was nuts to risk his billions for more that he was unlikely to ever be able to spend… I suppose hubris became him. His bet on a Eurozone break up went awry as politicians in Europe closed ranks behind the Euro, and similarly his call on the U.S. recovery stalled in 2011 aswell as other failed macro-event trades.

With the leverage his funds have, his bets were very nearly ruinous. Ugly bets and too much leverage will sink any trader – no matter how good. Paulson’s Advantage and Advantage Plus funds lost 36% and 52% in 2011 respectively, an underperformance that is almost intolerable for a hedge fund. It seems the concept of risk management went out of the window with all the billions in the coffers and Pauson no doubt believed he was “bigger” than the market.

In 2012, the underperformance continued with the Advantage and Advantage Plus funds down 20% and 15% respectively at the end of October. Somewhere in 2011, when already severely beaten, Paulson it seems changed his views and opened up another heavily leveraged position, this time in gold and gold related assets. You can guess what happened since then to gold and in particular gold related shares – yup, moribund performance.

However, it is in fact his hedging of the underlying positions into gold that has actually stopped his performance being even worse, certainly in the so called “gold class” shares which have not underperformed as much as the unhedged classes. Some people suspect that he has in fact been offloading his straight gold exposure in recent months and this is one of the factors weighing on the gold price. It seems the only way to get gold up is for Paulson to get out!!

On being “right”

Paulson it seems wants to be “right” – the most dangerous characteristic possible for a leveraged trader. After being “so right” on the sub-prime bet, it seems he cannot accept he is wrong and, following Pellegrini’s departure, seemingly wants to prove that it was in fact he that was the brains behind the infamous short trade and not Pellegrini.

The reason we believe Paulson thinks he is “bigger” than the market is if we look back to the start of his story in the 90’s when he was carrying out very conservative strategies and even in 2007 the risks he was taking were relatively low as he paid “peanuts” for the CDO options. The one thing that we will say in favour of Paulson is that the majority of the monies in his funds are in fact his and his employees, although again, without outside investors to “answer” to that probably kept him in his losing positions for too long.

The morals of this story? One good trade does not maketh the trader, a cracking trade can in fact be dangerous if you believe you are “bigger” than the market when sat with your swag and for spread betters and all leveraged traders – my old chestnut – CONTROL YOUR LEVERAGE!