The Man Who Made Too Much: The Other Paulson

Portfolio.com's February 2009 issue profiles John Paulson, the now legendary hedge fund manager whose record payday in 2007-'08 came as a result of doing what can only be described in its entirety as "shorting Subprime." What's remarkable about his feat is that there was no simple way to do so at the time 2 years ago. No subprime instruments existed that one could short, and no representative futures or other derivatives were available to make this a strategy that others, no less, Paulson, could employ in order to facilitate his gigantic bet against subprime mortgages and housing.

This is this weeks must-read piece. Here are a few excerpts to whet your appetite:

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.

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.

The article also features an eye-opening conversation between Jim Chanos and Bear Stearns' Alan Schwartz:

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 f*cker was going to throw me under the bus no matter what.”

Then, Paulson's outlook:

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.

About his recent presentation:

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

/Read on