The Greatest Trade Ever (22 page)

By the spring of 2006, Greene stopped buying real estate, convinced that things had gotten out of hand. He was unsure what to do, though. Greene didn’t want to sell his properties and write a huge check to the government to pay the tax bill. But he had to protect himself from an
other real estate collapse. John Paulson’s trade seemed the best one he had heard.

After returning from New York, Greene spoke with Gary Winnick, a former top bond trader, and Fred Sands, a major local Realtor; neither had much insight into Paulson’s trade, and neither wanted to invest alongside Greene.

“I like to go in on investments with others, to give me validation,” he says. “But no one wanted to do the trade with me.”

Greene kept asking why anyone would sell insurance on iffy mortgages so cheaply. Who was on the other side of Paulson’s trades?

Greene asked Sands to call his friend Angelo Mozilo, Countrywide’s CEO, to see what he thought of the subprime trade. Sands relayed a message from Mozilo: “You’ll never make money, it’s a bad idea.… You’ll keep paying out the insurance premiums because everything will be fine.”

A broker at Goldman Sachs told Greene it was like earthquake insurance, a waste of money. “Don’t touch this stuff,” the broker said.

But articles in local newspapers and business magazines claimed few could afford to buy a home at present-day prices. Greene figured he must be missing something.

He got in touch with Jeffrey Libert, his classmate from Harvard Business School who was running a successful real estate investment firm after leaving Boston Consulting Group, where he worked with John Paulson.

“Jeffrey, I was a subprime lender in the 1980s; it’s a horrible business,” Libert told his friend.

“Well, it’s a trillion-dollar business now on Wall Street.”

“You’re kidding me!”

“We have to short it,” Greene said emphatically, hoping his friend would do the trade with him. “CDS seems to be the way.”

Greene considered giving Paulson a $20 million investment. But he wasn’t sure he was ready to tie up so much money in an idea that still seemed confusing. Perhaps he could figure out which derivatives Paulson was buying and just do the trade himself.

“Part of me is thinking I should tell him,” Greene recalls. “But who knows if I’ll even stick with it?”

He called a contact at Countrywide, trying to understand some of the aggressive loans they were making.

“So how do these ‘stated income’ loans work? How do people get loans without any verification?”

The Countrywide representative told Greene that lenders weren’t allowed to ask an employer for proof of an employee’s salary.

“So we just go to salary.com, look up a job, see what the highest salary is,” and place that on the loan application, she explained.

Greene immediately realized the implication: An architect, teacher, or accountant in Nevada or Texas might not make half the salary of someone in the same profession in New York or a few other high-income states. But on a mortgage application, they’d be able to claim the same high compensation to buy a home they couldn’t really afford.

“How else do you think they can afford these homes?” a friend in the mortgage business asked Greene, after sharing a few more secrets to getting a huge mortgage.

Greene drove to Riverside County and other areas in Southern California to meet mortgage brokers. He discovered that the only way some subprime borrowers were able to keep up with their payments was by refinancing their homes, sometimes as many as three times a year.

“It was like, ‘Aha, so that’s how it’s done!’ ” Greene recalls.

Some in the bond business warned Greene that if he agreed to pay millions a year to buy insurance on mortgages and housing held up, he’d go broke. But if most subprime borrowers refinanced their mortgages in three years or so, he realized he likely only would be on the hook for a few years of payments on the CDS insurance.

Greene was convinced Paulson was onto something with his trade. Greene had set out simply to find protection for his holdings. But he became convinced he had uncovered a superhot trade. He phoned his broker at Merrill Lynch, Alan Zafran, telling him about John Paulson’s idea. He asked Zafran to do the same trades for him.

“I gotta tell you, this isn’t bread and butter for a retail brokerage account,” Zafran told him.

Zafran had heard of John Paulson and his firm, and the idea behind the trade made some sense to him. But Zafran, who claimed some of the
largest accounts at the brokerage firm, doubted Merrill Lynch would let him make these kinds of complicated trades for an individual like Greene.

Days later, Zafran’s bosses confirmed they wouldn’t allow the trades. On paper, Greene’s net worth was several hundred million dollars, but the vast majority of it was tied up in real estate. He had $50 million in his Merrill account—a huge sum for an individual, but tiny compared with the big firms that traded credit-default swaps.

Zafran heard rumors that Paul Allen, the cofounder of Microsoft, had been turned down by his Goldman Sachs broker after requesting to do the same trade. It seemed an even longer shot that Greene would get a green light.

“You’re a two-legged individual; you’re not a hedge fund. It can’t be done,” Zafran said.

Greene hardly flinched.

“You’re a smart guy—figure out a way.”

Greene kept pushing Zafran, day after day, needling him that he might take his business elsewhere. Zafran searched for other executives at his firm who might approve the trade, but they kept turning him down. Derivative trades were too complex for most individuals, the Merrill officials said. The firm didn’t want to open itself up to a lawsuit if big losses resulted. Zafran didn’t tell Greene about all of the slammed doors at the firm, wary of how he’d react.

“You’re not trying hard enough,” Greene would tell Zafran. “Keep trying.”

In early May, Zafran finally found a few sympathetic executives at his firm who were looking for a way to help individuals buy housing protection. They said they would do their best to help Zafran as long as Greene signed a form saying his trade was an “unsolicited transaction” and a one-time event. More than a dozen Merrill Lynch executives had to sign off, but Greene was thrilled—he had become the first individual to buy CDS contracts.

Greene already had cherry-picked thirteen BBB-rated slices of mortgage bonds backed by what seemed to be especially risky mortgages, all from borrowers with poor credit history in areas such as California and Nevada. Most had low teaser rates that would climb after two years and
bought homes with no equity. The bond slices were worth $15 million each, or $195 million in total. Greene purchased CDS insurance contracts on them all at an annual cost of about 1.25 percent for each contract. His derivative investments would cost about $2.4 million a year. But if the mortgage debt ever became worthless, Greene’s insurance could be worth $195 million.

Days later, Greene got the go-ahead from Zafran to buy insurance on $75 million more BBB mortgage bond slices. By the end of May, he had purchased protection on $350 million with mortgage bonds, as well as CDS protection on another $250 million of various ABX indexes, developed by a group of banks to reflect the value of a basket of subprime mortgages made over the previous six months. Greene even bought some protection on seemingly safer A-rated mortgage slices. It was so cheap, he couldn’t say no.

He kept on buying, finding a broker at J.P. Morgan Chase also willing to sell the investments to him. After a flurry of trades, Greene agreed to pay about $12 million annually in insurance premiums for CDS contracts protecting just over $1 billion of bonds backed by subprime mortgages.

He worried that he was missing something, though. A month or so later, Greene was invited to sit with Jamie Dimon, the chief executive officer of J.P. Morgan Chase, in the bank’s private suite at the U.S. Open in New York. Greene was excited. Finally, a pro could weigh in on his moves and tell him if he was missing anything.

I’m just a beginner figuring it all out. He’s the expert!

Dimon bounded over, a warm smile on his face. This was Greene’s chance. He could hardly contain himself.

“Hey, Jamie. My biggest position is shorting subprime credit through credit-default swaps. I’ve done four hundred million with you guys.”

Dimon had a blank look on his face. “What’s that?” he asked.

Greene was taken aback. Dimon was among the most important players in the financial markets. But he didn’t seem to know much about credit-default swaps. Even the $400 million figure didn’t grab his attention. Dimon kept glancing at the tennis match below, where Roger
Federer was fending off Novak Ðjoković in the finals. Then Dimon looked around the suite, smiling at his other guests.

Greene thought maybe he just needed to explain it better. He outlined his trades to Dimon as best he could, speaking quickly and growing more excited with each detail. Greene was sure J.P. Morgan was buying the same derivatives. Or maybe the bank had discovered a hidden flaw in the trade. Greene was on pins and needles to hear Dimon’s reaction.

Dimon had little reaction, though.
He’s either bored or doesn’t understand the trades
, Greene realized.
How could that be?

Dimon soon excused himself to greet other clients.

Back in Los Angeles, Merrill Lynch’s Alan Zafran called a handful of his best customers, pitching trades similar to Greene’s. A few liked the idea and told him to go forward. But Merrill Lynch’s head of compliance put his foot down, allowing only one client to place a trade, on a much smaller scale than Greene.

Greene had gotten in just under the wire.

A
S GREENE EDUCATED HIMSELF
about the mortgage market, he continued to stay in touch with Paulson, e-mailing him insights about the market that he gleaned from conversations with various mortgage brokers. Paulson never followed up, though. Greene figured he was too busy, or just didn’t find his musings and tidbits of news that interesting.

In June, Greene made plans to sail his yacht to the Hamptons and New England. He was excited about seeing Paulson and a few other friends, as well as hosting a fortieth-birthday bash for Mike Tyson in Sag Harbor.

Before leaving, Greene sent Paulson an e-mail saying he now was interested in investing in his new fund. He mentioned that he’d done some of the trades by himself and had some questions.

Paulson fired an e-mail back.

“What trades?”

“The ones we discussed.”

“I can’t believe you did the trades; you went behind my back,” Paulson wrote. Greene, caught off-guard, could tell Paulson was fuming.

“Should I unwind it, J.P?”

“Yes, unwind it.”

Greene spent a few days thinking about whether to exit the trades. He didn’t want to anger his friend and thought he might not have done them properly.

It’s so fucking complicated, maybe I should just let him do it
.

But Greene had done so much research, and the investments were hard to unwind because they didn’t trade very frequently. So Greene decided to hold on to his trades. It was a decision that would cost him dearly.

J
OHN PAULSON WASN’T FINDING MANY INVESTORS WILLING TO TAKE A
chance on his new fund. If it was going to get off the ground, he’d have to turn to friends and family. Jeffrey Tarrant, his tennis buddy, finally convinced his partners to pony up $60 million from their investors. A few of Tarrant’s clients put several million dollars of their own into Paulson’s new fund. The parents of Andrew Hoine, one of Paulson’s executives, pitched in a few hundred thousand dollars. And Paulson drained a personal savings account at his local bank, J.P. Morgan Chase, to invest about $30 million of his own, almost all of the money he held outside his firm.

The total was just $147 million, a puny sum in an era when new funds sometimes launched with billions of dollars. Even some of those who signed up weren’t true believers. A few were real estate pros seeking to protect their holdings. Privately, they confided that they wouldn’t mind if Paulson flamed out because that would mean good things for their real estate portfolio.

Like hunters waiting on their prey, Paulson and his team eyed home prices, searching for a sign of weakness as a signal to pull the trigger on their trade.

One morning in early June, Brad Rosenberg raced into Paulson’s office clutching a news release fresh off the printer: Data from the National Association of Realtors showed that home prices had risen a paltry 1 percent over the previous twelve months. Paulson flashed a grin—this was just what he was hoping for. His team already had anticipated that if housing prices went flat the BBB-rated slices of all the mortgage bonds would start to see losses. That time seemed at hand.

It was “a defining moment,” Paulson says.

Every trader up and down Wall Street pored over the same data that morning. Paulson worried that his window of opportunity was in danger of closing. And yet he sat on his hands. His other funds had purchased mortgage insurance, but Paulson hadn’t made a single trade for his new “credit” fund dedicated to betting against housing. He realized that if he was going to swing for the fences, it was now or never. Any more delay and he risked missing it all.

The $147 million would have to be enough, he decided, at least to start. So Paulson formally launched his fund and told Rosenberg to start buying.

A short, bespectacled thirty-four-year old, Rosenberg had worked at the hedge fund for four years. He sat right outside Paulson’s office, close enough to share market intelligence throughout the day. He tended to get to work early, usually greeted Paulson around 8 a.m., and often wished him a good-night after 6 p.m.

But Rosenberg still didn’t know what made his boss tick. They exchanged few pleasantries. Paulson had never met his wife or family, and Rosenberg couldn’t remember having a single personal conversation.

That was true of most of Paulson’s staff. Rosenberg didn’t mind the lack of camaraderie, though. The son of a Long Island shoe-sales executive and a graduate of Tulane University, he was focused, serious, and bookish. The only adornment on his desk was a faux turtle made of two rocks and cardboard, a present from his young son. He didn’t wish for a high five after a successful trade—he was just as uncomfortable with that kind of celebration as Paulson.