Trader Made Billions on Subprime(online.wsj.com)
online.wsj.com
Trader Made Billions on Subprime
http://online.wsj.com/public/article/SB120036645057290423.html?mod=blog
8 comments
"Also key: Mr. Paulson didn't turn bearish too early. Some close students of the housing market did just that, investing for a downturn years ago -- only to suffer such painful losses waiting for a collapse that they finally unwound their bearish bets. Mr. Paulson, whose investment specialty lay elsewhere, turned his attention to the housing market more recently, and got bearish at just about the right time."
Interesting that this article was posted by "blackswan" -- this could be a case study in Fooled by Randomness.
Six months earlier or later, and this guy might well have busted; I don't think we would be reading about him.
Interesting that this article was posted by "blackswan" -- this could be a case study in Fooled by Randomness.
Six months earlier or later, and this guy might well have busted; I don't think we would be reading about him.
I'm not certain that Paulson could have afforded the losses if the market kept booming, so you're likely right about the six months earlier or later.
However in principle, this is exactly how Nassim Taleb (the Black Swan author) made his money during the 1987 wall street crash (iirc). At the time, people were selling options that hedged against large falls in price very cheaply. Taleb bought loads of them and profited hugely as a result of the crash.
Paulson's scheme was a little more complicated, but the formula was essentially the same - underpriced hedging instruments + crash = massive profit.
This quote from the article sums it up perfectly: Mr. Paulson became convinced investors were far underestimating the risk in the mortgage market. In betting on it to crumble, "I've never been involved in a trade that had such unlimited upside with a very limited downside," he says.
However in principle, this is exactly how Nassim Taleb (the Black Swan author) made his money during the 1987 wall street crash (iirc). At the time, people were selling options that hedged against large falls in price very cheaply. Taleb bought loads of them and profited hugely as a result of the crash.
Paulson's scheme was a little more complicated, but the formula was essentially the same - underpriced hedging instruments + crash = massive profit.
This quote from the article sums it up perfectly: Mr. Paulson became convinced investors were far underestimating the risk in the mortgage market. In betting on it to crumble, "I've never been involved in a trade that had such unlimited upside with a very limited downside," he says.
If the article is correct, and Paulson was actually short on ABX and mortgage-backed securities, the downside of his strategy was unlimited. Taleb's strategy (option trading) had a bounded loss.
It's unclear how balanced Paulson's fund was/is, but the article makes it sounds like he was playing with fire.
It's unclear how balanced Paulson's fund was/is, but the article makes it sounds like he was playing with fire.
Yeah that was half his scheme, which is unbounded as you say.
The other half of the strategy, which the quote was about, was related to purchasing credit-default swaps, which are derivatives like options. The losses on CDS contracts are bounded.
But you're right... without knowing the balance between CDS contracts and short selling, it's hard to gauge how exposed he was.
The other half of the strategy, which the quote was about, was related to purchasing credit-default swaps, which are derivatives like options. The losses on CDS contracts are bounded.
But you're right... without knowing the balance between CDS contracts and short selling, it's hard to gauge how exposed he was.
He was talking about the downside loss strategically - not in the pedantic sense you are using.
[deleted]
> he was playing with fire.
You only make $15 billion with a shit-ton of leverage.
You only make $15 billion with a shit-ton of leverage.
That's a good point. He broke one of the cardinal rules of trading:
Housing remained strong, and the fund lost money. A concerned friend called, asking Mr. Paulson if he was going to cut his losses. No, "I'm adding" to the bet, he responded...
By comparison, as Ed Seykota put it in the book Market Wizards, "The elements of good trading are cutting losses, cutting losses, and cutting losses."
Housing remained strong, and the fund lost money. A concerned friend called, asking Mr. Paulson if he was going to cut his losses. No, "I'm adding" to the bet, he responded...
By comparison, as Ed Seykota put it in the book Market Wizards, "The elements of good trading are cutting losses, cutting losses, and cutting losses."
I don't think he was 'trading'. Trading in that sense means, approximately, buying because smart people bought, and then selling to stupid people. A 'trader' of the sort Seykota (who was interviewed in, but did not write, Market Wizards -- you're thinking of Schwager) would wait for the ABX to fall, then short, then probably cover once it started to rise again.
Paulson was making a judgment that the market was wrong to price subprimes so high. Do you really think his thought process was "The market is wrong that they're worth X, when they should be at .4X. But if they move to 1.1X, they must be right!" He's thinking like a value guy in a macro trade, not like a 'trader'.
Paulson was making a judgment that the market was wrong to price subprimes so high. Do you really think his thought process was "The market is wrong that they're worth X, when they should be at .4X. But if they move to 1.1X, they must be right!" He's thinking like a value guy in a macro trade, not like a 'trader'.
I know who the author of Market Wizards is. The comment I quoted is Seykota's. The distinction is rather significant since one of the two is among the greatest traders of all time while the other is not.
Most successful traders emphasize that adding to a position that is showing you a loss, because you believe you are right and the market is wrong, is a losing strategy in the long run. That suggests that Paulson won with a losing strategy, which suggests that timr has a point.
Perhaps you are correct that there is something other than "trading" in which people routinely add to losing positions and end up making money when the market changes to confirm their judgments. It would certainly be something other than winning trading.
Most successful traders emphasize that adding to a position that is showing you a loss, because you believe you are right and the market is wrong, is a losing strategy in the long run. That suggests that Paulson won with a losing strategy, which suggests that timr has a point.
Perhaps you are correct that there is something other than "trading" in which people routinely add to losing positions and end up making money when the market changes to confirm their judgments. It would certainly be something other than winning trading.
I misunderstood you. My apologies. I was under the impression from other interviews in the book that Schwager followed the same strategy.
The thing is, trading can't be the only successful way to make money, or even more successful than other traders on average -- because trading implies buying more as the market confirms your views, and if that's profitable, it implies that traders will own all the world's assets, and every asset will either rise infinitely or collapse to zero.
If it helps, you could think of him as an arbitrageur betting that the mortgage market would converge with reality. That thesis relies on believing that the market misprices assets, so it seems that further mispricing would confirm it rather than belie it.
The thing is, trading can't be the only successful way to make money, or even more successful than other traders on average -- because trading implies buying more as the market confirms your views, and if that's profitable, it implies that traders will own all the world's assets, and every asset will either rise infinitely or collapse to zero.
If it helps, you could think of him as an arbitrageur betting that the mortgage market would converge with reality. That thesis relies on believing that the market misprices assets, so it seems that further mispricing would confirm it rather than belie it.
Warren Buffett would beg to differ with this strategy.
If you trade on value, you shouldn't really care what the market is doing. If risk is mispriced, buy more, even if the price is going down and you are losing money in the short term.
If you trade on value, you shouldn't really care what the market is doing. If risk is mispriced, buy more, even if the price is going down and you are losing money in the short term.
That presupposes you're right. But there's no way to know this for sure in advance, besides which nobody's right all the time. To do as you advocate guarantees that your losses, when they do come, will be maximal.
Whereas your trading strategy presupposes that someone else is right, but that they persistently under-react.
I find it more intellectually appealing to make my money taking a stand than to make it by saying "Me too, me too!"
I find it more intellectually appealing to make my money taking a stand than to make it by saying "Me too, me too!"
Cutting a loss is synonymous with "selling low".
I must not have understood you... let me try again. You object to Seykota on the grounds that cutting a loss entails taking a loss. That's objectionable because losses are objectionable. Did I get it?
Of course, a big loss is more objectionable than a small one.
Of course, a big loss is more objectionable than a small one.
Sure. But you can never know before which way the prices go.
Rules of thumb can be applied without thinking to control both chance of failure and chance of a crazy success.
Yes, but that's the point.
These types of risks are always brilliant when you win, and stupid when you lose. Articles like this one teach you little, other than the value of good luck, and great timing.
(also, for the record: I agree wholeheartedly with the spirit of his investments; I'm a housing bear too. But I'm also realistic enough to know that he got lucky, using a decidedly risky investment strategy. With hundreds of millions of dollars short in an admittedly irrational market, one bad month of excessively irrational market behavior could have wiped him out.)
These types of risks are always brilliant when you win, and stupid when you lose. Articles like this one teach you little, other than the value of good luck, and great timing.
(also, for the record: I agree wholeheartedly with the spirit of his investments; I'm a housing bear too. But I'm also realistic enough to know that he got lucky, using a decidedly risky investment strategy. With hundreds of millions of dollars short in an admittedly irrational market, one bad month of excessively irrational market behavior could have wiped him out.)
"He faced skepticism from other big investors. At the same time, fearing imitators, he used software that blocked fund investors from forwarding his emails."
I'm curious as to what software can prevent people from forwarding your emails...
I'm curious as to what software can prevent people from forwarding your emails...
It may be a misunderstanding from reporter. But can it be pgp? If he encrypted his emails and only receiver with the key can decrypt it. It basically prevent forwarded messages to be read.
Save for the copy and paste hack
Luckily for him, not all guys in finance are such uber-hackers.
Outlook's drm claims to do this I think. Of course, no software can do it.
It is easy to look at this guy as the bad guy, but really he just observed that the housing markets were in a massive bubble and bet against it.
It is quite hard to imagine how he's a 'bad guy'. Housing was too expensive. If you bought a house because of the hype, you overpaid. He sold short, which depressed prices, which means that people who bought after his trade are better off than if he hadn't made it.
I agree with the point you are proving. But I do not think your argument valid - for you could just use your technique to prove the opposite: People who _sold_ after his trade were worse off.
I think we need a more complex line of reasoning to justify him being the good guy.
I think we need a more complex line of reasoning to justify him being the good guy.
But people who sold after his trades made a stupid decision -- to buy overpriced mortgages. We'll live in a better world when rational financial decisions are more rewarding, and that won't happen without making folks like Paulson pretty rich. The thing is, you could make the case that a mortgage boom that went on another year would cost the country 1% of GDP in badly-allocated capital (spent on houses nobody wanted to live in and everyone bought to flip). From that perspective, he's earning a commission of less than 1%.
Ok, that sounds like a more convincing argument than the original one.
Speculators are risking their own money re-aligning badly-allocated capital in the economy and correct prices. If they are right they earn a nice commission.
Speculators are risking their own money re-aligning badly-allocated capital in the economy and correct prices. If they are right they earn a nice commission.
He better not believe he can do it again, like this guy did: http://hedgefund.blogspot.com/2006/09/amaranth-and-brian-hun...
Did any one notice that he hired Greenspan? The guy who fueled the housing bubble by lowering interest rates down to 1% the foolishness that made it possible for Paulson to make his billions.
Lots of people short, lots of people long. Nothing special about it. I made a pile of money on Countrywide a few days ago. Am I a genius?
The only distinction of a fund manager is that they slimed their way into using other people's money.
The only distinction of a fund manager is that they slimed their way into using other people's money.
All the hard-earned money people pay on mortgage interest rates ultimately goes to people like him.
Really? What path does the money take from them to him?
Arguably the bets this guy made resulted in the banks' losses on each of their sub-prime mortgage loans being greater; ultimately this will raise the cost of mortgage borrowing as banks price risk higher.
On the other hand, this guy probably helped to make the bubble burst sooner -- and thus before the banks could make even more sub-prime mortgage loans -- and that would have the effect of reducing the banks' ultimate losses (and resulting in them applying less of a risk premium to mortgages).
Trying to figure out which of these effects is larger would be pure speculation.
On the other hand, this guy probably helped to make the bubble burst sooner -- and thus before the banks could make even more sub-prime mortgage loans -- and that would have the effect of reducing the banks' ultimate losses (and resulting in them applying less of a risk premium to mortgages).
Trying to figure out which of these effects is larger would be pure speculation.
No, shorting mortgage-backed securities doesn't cause losses for mortage lenders. And it was not just banks that were issuing mortgages.
According to the article,
One concern was that even if Mr. Paulson bet right, he would find it hard to cash out his bets because many were in markets with limited trading. This hasn't been a problem, however, thanks to the wrong bet of some big banks and Wall Street firms. To hedge their holdings of mortgage securities, they've scrambled to buy debt protection, which sometimes means buying what Mr. Paulson already held.
In other words, Paulson was buying mortgage insurance contracts, driving their prices up, and now banks are buying those contracts from him (at higher prices than they would have if he hadn't been involved in the market).
One concern was that even if Mr. Paulson bet right, he would find it hard to cash out his bets because many were in markets with limited trading. This hasn't been a problem, however, thanks to the wrong bet of some big banks and Wall Street firms. To hedge their holdings of mortgage securities, they've scrambled to buy debt protection, which sometimes means buying what Mr. Paulson already held.
In other words, Paulson was buying mortgage insurance contracts, driving their prices up, and now banks are buying those contracts from him (at higher prices than they would have if he hadn't been involved in the market).
He didn't drive the prices up (at least not by much). The fact that more and more people started defaulting on their mortgage drove up the price of insurance. That's what he was betting on (and he was right). So if he didn't make the money someone else would have (whoever was holding on to those insurance contracts).
You can't buy a financial instrument without driving its price up. This applies even more if you're buying hundreds of millions of dollars worth of a financial instrument.
True in general, but when he bought them, they were priced very low. Even after he bought millions (presumably) of the swaps, other investors thought he was an idiot and didn't follow suit, so the price of the swaps probably didn't go up much. It was only after the sub-prime fiasco got into third gear that other investors began clamouring for the swaps.
By all rights, his initial foray into buying the swaps most likely had minimal effect on the price. Ultimately he felt they were incorrectly priced by the market and made a bet on them.
By all rights, his initial foray into buying the swaps most likely had minimal effect on the price. Ultimately he felt they were incorrectly priced by the market and made a bet on them.
Yes, but this still doesn't actually hurt the people that hold mortgages (the homeowners). Whether or not my bank can handle the fact that I'm about to foreclose has nothing to do with my ability to (not) pay.
Speculation provides liquidity to the market. That generally lowers the cost of financial transactions ceteris paribus.
Which raises the future cost of lending to deadbeats, because the only banks with capital will be the ones who were conservative.
I made quite a few assumptions - namely that mortgage banks are huge players in the various mortgage markets, and because Paulson extracted billions of dollars from these markets, the banks lost money as well. And the money that they would invest in these markets comes from their earnings, which is derived from interest rates.
He's short mortgages. That's what you do when you buy a home, too, except you get a home and he just keeps the cash. Paulson is actually one of the world's biggest subprime borrowers -- so however much pity you have for the average borrower, multiply it by about 20,000 or reconsider your assumptions.
Thanks for sharing that insight.
"While we never made a subprime loan and are not predatory lenders, we think a lot of homeowners have been victimized," Mr. Paulson says.
Well a lot of the money earned any which way goes to people like him. That is why they are rich.
http://online.wsj.com/article/SB120036270913390155.html?mod=...
"He bought three jets, most recently a Gulfstream. Though he paid just $2 million for an older model, "I certainly could afford" a $50 million one, he says. He adds, in a telephone interview from his 145-foot yacht: "I tend to be pretty conservative in the way I spend money.""