Sunday, April 5, 2015

Learning From The Greatest Trade Ever

It's slightly surprising that it's taken me this long to get to it, but I finally read Gregory Zuckerman's "The Greatest Trade Ever", which documents John Paulson's multi-billion dollar score in the real estate crisis of 2007-2009. Zuckerman puts Paulson & Co.'s winnings at $15b in 2007 (with astonishing gains of 590% and 350% in its two credit funds), and a further $5b in 2008 and early 2009. I'm actually glad I waited a few years to read this, because it affords some historical perspective on the trade itself and Paulson's results since then.

A quick review of the book is in order before I launch into some lessons learned. It's a scintillating read, and captures the boom and bust in real estate and associated securities, as well as prior episodes of market mania. It is certainly a difficult task to write a page-turner about credit derivatives, but Zuckerman succeeds admirably. In addition, he seems balanced and even-handed in his treatment of the colourful array of characters, offering wonderful snapshots of the mania that pervaded investment management, and the ensuing collapse.

Now, on to some of the many things I learned from the book:

1) Macro matters. It won't surprise you if you've read other posts of mine, but yes, macro matters. This was essentially a macro bet. Contrary to some views that decried Paulson as a "tourist" from the merger arb space, he had proven to be "gutsier, playing the merger game differently than his peers. He began to short companies set to be acquired when he deduced that their merger agreements might collapse." This penchant for a more creative approach led Paulson to his most famous set of trades. 

Zuckerman lays out the (not always totally correct) macro framework that guided Paulson's thinking:
- In 2004, Paulson became concerned about who would be exposed when the Fed began raising interest rates.
- In early 2005, as Paolo Pellegrini suggested shorting mortgage securitizations, Paulson decided the Fed wouldn't want to lower rates to help borrowers because it might weaken the dollar further and stoke inflation.
- In late 2005, Paulson "trimmed holdings that seemed especially sensitive to the economy and shorted the bonds of others".
- By late 2007, Paulson recognized the impact a real estate and credit collapse would have, shorting shares of banks with significant exposure to the credit card business and those making commercial real estate, construction, and other risky loans. He also shorted Fannie and Freddie on the same premise.

2) Luck matters. There's no doubting the brilliance of the trade, and the nerve that it took to pull it off, but luck played a healthy role too. Paulson was early enough to have time to refine his trade, and late enough not to suffer excessively while the housing market stood firm. It's remarkable that Paulson started from knowing nothing about CDS in Oct 2004, and had time to revise his trade several times. In November 2005, "the Paulson team's original thesis, that a spike in interest rates would cause problems for home owners, seemed dead wrong." Paulson sold his original CDS protection after concluding that it covered mortgages on homes that already had enjoyed so much appreciation that refinancing would be easy. This seemed to happen again in 2006, but they were able to roll protection into the latest vintages. As Zuckerman writes, "Paulson had dodged a bullet." The trade also evolved as the team's views on housing matured. Incredibly, until early 2006, "Paulson's team hadn't put much thought or research into whether housing prices were bound to tumble

But, fortunately for him, he wasn't too early. Zuckerman notes that, "Paulson also had good fortune on his side: By the time he determined that the housing market was in a bubble in the spring of 2006, prices had begun to flatten out, making it the perfect time to bet against the market. Others who had come to a similar determination much earlier were licking their wounds because they had placed wagers against real estate too early and suffered as it climbed further."

Finally, Paulson was lucky to be an outsider. "It was fortuitous that Paulson was a merger pro, and not a veteran of the mortgage, housing, or bond markets. He wasn't deterred by the dismal track record of those who already had bet against housing, and wasn't fully aware that his bearishness wasn't especially unique."

That said, I don't want to overstate this element. It obviously took a tremendous amount of work to get up to speed on an arcane market. Other prominent managers demurred at taking such an outsized bet. "Paul Singer of Elliott Management Corp. and Seth Klarman of Baupost Group bought some CDS insurance contracts on risky mortgages but chose to buy small portions of it and not go overboard." "Buying so much was a reputational risk," Klarman says, "It wasn't a no-brainer." Zuckerman also details how Paulson avoided getting cold feet in 2007 when the trade seemed to have worked partially. Furthermore, he successfully played both sides of the trade, profiting on the long side by 2009. Others, like John Devaney, faced serious losses by re-entering the market too early. All in all, this was the confluence of luck and skill, with Paulson correctly reading macro forces, real estate-specific drivers and investor sentiment.

3) Lucky or not, being an outsider helps sometimes. Zuckerman quotes Bertrand Russell: "The fact that an opinion has been widely held is no evidence whatsoever that it is not utterly absurd; indeed, in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible." One stunning example Zuckerman cites is the "discovery" by Deutsche Bank analyst Eugene Xu that "home prices had been key to loan problems for more than a decade, including during the mini-downturn in real estate in the early 1990s." If you're scratching your head that this should be a revelation, Zuckerman goes on to say that "at the time it was quite a radical viewpoint. Most economists and traders figured that a range of factors, including interest rates, economic growth, and employment, determine the level of mortgage defaults." I found it interesting that two outsiders, Paulson and Greg Lippmann, were communicating and helping to reassure one another. Sometimes this is the path to breaking through dogma; sometimes it results in an unhealthy echo chamber. It's hard to know which is which. In a world where things seem to be getting ever more complicated and specialized, we rely on gatekeepers more than ever. Perhaps the skills most needed are common sense and critical thinking.

4) There are ethical grey areas in investing. Zuckerman duly notes the ethical grey area of Paulson working with bankers to create risky investments. But we shouldn't allow hindsight bias to excessively colour our judgement. "In truth, Paulson and Pellegrini still were unsure of their growing trade would ever pan out." Furthermore, Paulson was betting against supposedly sophisticated investors. 

Similarly, Jeff Libert reveals the ethical quagmire he found himself in as he "discovered an odd impulse: He found himself rooting for a rash of home owners to run into problems paying off their mortgages."

5) The emotional strain of a great trade may not be for everyone. Zuckerman vividly describes the strain the trade took on Michael Burry, Jeffrey Greene, Pellegrini and Paulson. Some examples:
- "[Jeff Greene's] very reputation and sense of self-worth seemed tied up with the trade." "If [the trade] doesn't work, I'm cooked", he confided to Jeff Libert.
- Despite a gain of 150% in 2007, Michael Burry was deeply exhausted. "Burry couldn't enjoy his belated success...still weary from the battles with investors and too sensitive to ignore their unhappiness."

Those with lavish lifestyles, such as Pellegrini and Jeff Greene, placed some self-imposed stress on themselves. Perhaps Paulson's earlier decisions to alter his lifestyle provided him with the equanimity to see the trade through.

Most of us will never experience the nerve-wracking strain of a trade like this, and perhaps that's for the best. One of the funniest paragraphs in the book describes Greene meeting his future wife, Mei Sze Chan. Zuckerman writes, "Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.

A few months later they were engaged."

Most of us will have to be content with matrimonial bliss, rather than Paulson's stupendous financial gains. Given the strain he and others underwent in their pursuit of profit, it is a gentle reminder that some of the greatest trades we make happen outside the financial arena. 

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