Inside Paulson's Deal with Goldman

Just how did the deal roiling Goldman go down? Gregory Zuckerman on the tale of how hedge-fund maverick John Paulson gambled on the housing market—and why it turned toxic.

04.19.10 6:57 PM ET

Goldman reported Tuesday its first-quarter earnings doubled to $3.3 billion amid fraud charges. Just how did the deal roiling Goldman go down? Gregory Zuckerman’s book The Greatest Trade Ever tells the tale of how hedge-fund maverick John Paulson gambled on the housing market—and why it turned toxic.

For months hedge-fund maverick John Paulson had been seeking new ways to bet on the eventual failure of the housing market and collapse of subprime mortgages, and in late 2006 Paulson and his deputies reached out to investment banks like Goldman Sachs for a new vehicle for their bet. This is the story of how they did it.

John Paulson, focused on creating a huge trade, soon took a controversial step that would lead to some resentment for his role in indirectly contributing to more toxic debt for investors.

Paulson and Paolo Pellegrini were eager to find ways to expand their wager against risky mortgages; accumulating it in the market sometimes proved a slow process. So they made appointments with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create CDOs that Paulson & Co. could essentially bet against. Paulson’s team would pick a hundred or so mortgage bonds for the CDOs, the bankers would keep some of the selections and replace others, and then the bankers would take the CDOs to ratings companies to be rated. Paulson would buy insurance on the mortgage debt and the investment banks would find clients with bullish views on mortgages to take the other side of the trades. This way, Paulson could buy protection on $1 billion or so of mortgage debt in one fell swoop. Paulson and his team were open with the banks they met with to propose the idea. [Paolo Pellegrini worked at Paulson's hedge fund as the point person on this deal.]

Tina Brown: Ghouls of Wall Street Tunku Varadarajan: The Irrefutable Moral Case Against Goldman“We want to ramp it up,” Pellegrini told a group of Bear Stearns bankers, explaining his idea. Paulson and Pellegrini believed the debt backing the CDOs would blow up. But Pellegrini argued to his boss that they should offer to buy the riskiest slices of these CDOs, the so-called equity pieces that would get hit first if problems resulted. These pieces had such high yields that they could help pay the cost of buying protection on the rest of the CDOs, Pellegrini said, even though the equity slices likely would become worthless over time, as the debt backing the CDO fell in value.

And if their analysis proved wrong and the CDOs held up, at least the equity investment would lead to profits, Pellegrini said.

“We’re willing to buy the equity if you allow us to short the rest,” Pellegrini told one banker.

To try to protect themselves, the Paulson team made sure at least one of the CDOs was a “triggerless” deal, or a CDO crafted to be more protective of these equity slices by making other pieces of the CDO more likely to take early hits. Paulson’s goal was to make the equity piece a bit safer, but this step made the other parts of the triggerless CDO even more dangerous for anyone with the gumption to buy them.

He and Paulson didn’t think there was anything wrong with working with various bankers to create more toxic investments. Paulson told his own clients what he was up to and they supported him, considering it an ingenious way to grow the trade by finding more debt to short. After all, those who would buy the pieces of any CDO likely would be hedge funds, banks, pension plans, or other sophisticated investors, not mom-and-pop investors. And if these investors didn’t purchase the newly created CDOs, they’d likely buy another similar product since there were more than $350 billion of CDOs at the time.

However, at least one banker smelled trouble and rejected the idea. Paulson didn’t come out and say it, but the banker suspected that Paulson would push for combustible mortgages and debt to go into any CDO, making it more likely that it would go up in flames. Some of those likely to buy the CDO slices were endowments and pension plans, not just deep-pocketed hedge funds, adding to the wariness. Scott Eichel, a senior Bear Stearns trader, was among those at the investment bank who sat through a meeting with Paulson but later turned down the idea. He worried that Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team. Either way, he felt it would look improper.

[S]ome investors later would complain that they wouldn’t have purchased the CDO investments had they known that some of the collateral behind them was chosen by Paulson and that he would be shorting it.

“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, Eichel told a colleague; on the other, Bear Stearns would be helping Paulson wager against the deals.

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“We had three meetings with John, we were working on a trade together,” says Eichel. “He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.

“But it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side,” Eichel says.

For his part, Paulson says that investment banks like Bear Stearns didn’t need to worry about including only risky debt for the CDOs because “it was a negotiation; we threw out some names, they threw out some names, but the bankers ultimately picked the collateral. We didn’t create any securities, we never sold the securities to investors.... We always thought they were bad loans.”

Besides, every time he bought subprime-mortgage protection, someone had to be found to sell it to him, Paulson notes, so these big CDOs were no different.

Indeed, other bankers, including those at Deutsche Bank and Goldman Sachs, didn’t see anything wrong with Paulson’s request and agreed to work with his team. Paulson & Co. eventually bet against a handful of CDOs with a value of about $5 billion.

Paulson didn’t sell any of these products to investors. Some investors were even consulted as the mortgage debt was picked for the CDOs to make sure it would appeal to them. And these deals were among the easiest for an investor to analyze, if they so chose, because they were “unmanaged” CDOs, or those in which the collateral was chosen at the outset and not adjusted later on like other CDOs. It wasn’t his fault that others were willing to roll the dice.

A few other hedge funds also worked with banks to create CDOs of their own that these funds could short—so Paulson wasn’t doing anything new. Nor did Paulson’s moves create more troubled mortgages or saddle borrowers with additional losses—the deals were CDOs composed of CDS contracts, rather than actual mortgage bonds.

“We provided the collateral” for the CDOs, Paulson acknowledges.

“But the deals weren’t created for us, we just facilitated it; we proposed recent vintages of mortgages” to the banks.

But some investors later would complain that they wouldn’t have purchased the CDO investments had they known that some of the collateral behind them was chosen by Paulson and that he would be shorting it. Others argued that Paulson’s actions indirectly led to more dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the CDO slices when the market finally cratered.

In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out.

They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. “But we still didn’t know.”

Paulson & Co. had bet against about $5 billion of CDOs and made more than $4 billion from these trades—including $500 million from a single transaction—according to the firm’s investors and an employee of the firm. One of the biggest losers, however, wasn’t any investor on the other side. It was the very bank that worked with Paulson on many of the deals: Deutsche Bank. The big bank had failed to sell all of the CDO deals it constructed at Paulson’s behest and was stuck with chunks of toxic mortgages, suffering about $500 million of losses from these customized transactions, according to a senior executive of the German bank.

These were some of Paulson & Co.’s largest scores.

FROM: The Greatest Trade Ever by Greg Zuckerman; Broadway Books, Copyright @2009.

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