Saturday, April 17, 2010

How it looked to Paulson

Why did Paulson and Magnetar need to participate in the creation of new CDOs? Apparently Paulson had trouble finding counterparties at the time willing to take direct billion dollar bets on CDS indices. If I had had a decent way to short subprime in 2005 or 2006 I would have done it too -- see post1 and post2 from 2004!

Regarding the SEC charges against Goldman: the buyers of synthetic CDOs should have realized that there must have been short interest on the other side of the deal, and at the time Paulson wasn't a prominent figure. His short strategy was very contrarian and took enormous guts. I think this is going to be a very tricky case for the SEC.

Here's a revealing excerpt from WSJ reporter Gregory Zuckerman's book The Greatest Trade Ever. Read the whole excerpt!

WSJ: ... Mr. Paulson traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard's endowment. Mr. Taborsky was wary. Mr. Paulson's fund was willing to lose 8% a year to buy the mortgage insurance, which seemed like a lot. Mr. Taborsky also thought Mr. Paulson might be excessively gloomy about the housing market. Mr. Taborsky turned him down, too.

Even some investors who agreed with Mr. Paulson's view that housing prices would tumble doubted he would make much money because there was relatively little trading in the investments he was buying. He might have a hard time selling his investments without sending prices tumbling, shrinking any profits, they said.

"It looked like a dangerous game, taking one single bet that might be difficult to unwind," said Jack Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said no to Mr. Paulson's fund.

Mr. Paulson's growing fixation on housing began to spark doubts about his business. One long-time client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr. Paulson was "straying" from his longtime focus, and that the bank should pull its money from Paulson & Co., fast. The bank stuck with Mr. Paulson but turned down his new fund.

... By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg, Mr. Birnbaum got to the point.

Not only were Mr. Birnbaum's clients eager to buy some of the mortgages that Paulson & Co. was betting against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as securities, to hold their value. "We've done the work and we don't see them taking losses," Mr. Birnbaum said.

After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson's office, a bit shaken. Mr. Paulson seemed unmoved. "Keep buying, Brad," Mr. Paulson told Mr. Rosenberg.

[Yes, in hindsight everyone knows that subprime loans were "toxic waste" -- but at the time lots of smart money didn't think so. Mr. Market needs a little help sometimes ... Steve]

Months into their new fund, Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon found a creative and controversial way to enlarge their trade.

They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

The investment banks would sell the CDOs to clients who believed the value of the mortgages would hold up. Mr. Paulson would buy CDS insurance on the CDO mortgage investments—a bet that they would fall in value. This way, Mr. Paulson could wager against $1 billion or so of mortgage debt in one fell swoop.

Paulson & Co. wasn't doing anything new. A few other hedge funds also worked with banks to short CDOs the banks were creating. Hundreds of other CDOs were being created at the time. Other bankers, including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Mr. Paulson's request and agreed to work with his team.

At Bear Stearns, however, Scott Eichel, a senior trader, and others met with Mr. Paulson and later turned him down. Mr. Eichel said he felt it would look improper for his firm. "On the one hand, we'd be selling the deals" to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Mr. Eichel told a colleague; on the other hand, Bear Stearns would be helping Mr. Paulson wager against the deals.

Some investors later would argue that Mr. Paulson's actions indirectly led to the creation of additional dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the CDO slices.

At the time, though, Mr. Paulson still wasn't sure his trade would work. He simply was buying protection, he said. "We didn't create any securities, we never sold the securities to investors," Mr. Paulson said. "We always thought they were bad loans."


Madhu said...

As you say, Paulson does not seem to have a problem here. But why do you call it a tricky case for SEC ? The case is primarily against Goldman which acted in bad faith by failing to disclose material information (that the counterparty was Paulson himself) to ACA and ABN Amro.

One thing's for sure - I am going to scour your pages for tips from now on !!

steve hsu said...

This is a synthetic CDO -- no real mortgage interest flowing through it, just bets "referencing" existing CDOs. That means there's somebody on the short side of the trade for sure. So what if they had disclosed it was Paulson? Who knew who Paulson was in 2007?

See the excerpt -- plenty of people told him to his face he was crazy; would disclosing his involvement really have scared away the buyers? Anybody long a synthetic CDO is thinking they are taking money from some overly pessimistic guy on the other side.

ziel said...

I think the point is not that somebody would shorting it or who that would be, but that the instrument itself was effectively designed by the shorting counterparty.

steve hsu said...

> I think the point is not that somebody would shorting it or who that would be, but that the instrument itself was effectively designed by the shorting counterparty.

Sure, that looks bad. But it's more of a problem for ACA, the CDO managers, not GS. ACA did the (supposed) diligence on each of the proposed reference CDOs -- they even rejected many of P's suggestions. The question is whether the specific information "IT WAS PAULSON" (as opposed to some *other* short interest) involved in the structure was actually material and should have been disclosed. If I understand correctly, ACA lost a lot of money on the deal, so it's hard to believe they built it to fail. My excerpt is meant to show that in 2006-2007 most people -- even the "smart money" -- thought Paulson was crazy and that the AAA tranches were pretty safe.

donthelibertariandemocrat said...

I don't see a problem for Paulson in the Goldman deal, but his views are not quite as presented. I first became a fan of his because he believes that there was predatory lending, lowered standards, and misrepresentation going on after 2005. In other words, he believed that people were fudging books and cutting corners, without reporting that. In picking a middleman, I wonder if it matters that your client might think that the people he's shorting are cooking the books. It seems fine to be neutral in a normal deal, but what if one client suspects malfeasance? That's my problem. Of course, Paulson could have been wrong. But illegality, either civil or criminal, where suspected, I feel needs to be disclosed, even if you're not sure. I've no idea if this is illegal. But I sure wouldn't deal with anyone who wouldn't let me know about possible illegality.

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