The days aren’t so bright and cheery for John Paulson, what with his hedge fund down nearly 40%. They’re certainly not as cheery as they were five years ago, when he made his famous bet against subprime mortgages and made billions of dollars. I just finished reading Sebastian Mallaby’s awesome book, “More Money Than God”, about history of hedge funds, and Paulson features towards the end of the book.
It’s a brilliant read, touching on all the major hedge funds and their various strategies. What jumped out though was John Paulson putting on his big bet via the subprime mortgage index the ABX – here’s the passage from the book. I love the line the trader uses, ‘Tell us your picture’.
The challenge was how to do the trades in the size that he now wanted. Paulson could bet against mortgage bonds by borrowing them and selling them short, a cumbersome operation. Or he could buy an insurance policy – a credit default swap from a bank – but that depended upon finding a bank that was interested in selling.
To Paulson’s great good fortune, in July 2006 Wall Street’s top investment banks created an easier option: Hoping to earn themselves a stream of trading commissions, they launched a subprime mortgage index, known as the ABX. Paulson now found that, on any given day, it was easy to buy insurance on, say $10 million of subprime paper. Then, a week or two later, he took a call from one of the big banks. The man on the line was an ABX trader.
“What’s your picture?” the trader demanded. He was willing to deal with Paulson in size. How many millions’ worth of subprime bonds did he want to buy insurance on?
Paulson considered. He didn’t want to scare the trader off. If the ugy knew ho much insurance Paulson really wanted, he surely would not be stupid enough to sell without first moving the price against him.
“Five hundred million,” Paulson ventured.
“Done,” the trader responded.
“Another five hundred million,” Paulson said.
“Done,” the man repeated. He wasn’t flinching in the least. Then he said again, “Tell us your total picture.”
“Call me again tomorrow,” Paulson said, and the next day he bought insurance on another $1 billion of subprime bonds. In the first half of the year, he had hustled to lay his hands on $500 million of this stuff. Now, in just two days, he had bought four times that quantity.
“Tell us your picture,” the trader said again.
Paulson thought to himself, this is the holy grail. He remembered Soros’s words: Go for the jugular.
“I’ll do another $3 billion,” he said. At this, there was a silence on the line. The trader agreed to another billion, then balked at doing any more.