The Greatest Trade Ever (38 page)

“I’m on my hands and knees,” one colleague, Mike Gelband, told Walker. “We are looking at an unmitigated disaster on a global scale, George.”

Walker paced the room and looked over at Fuld, who was on the phone with the Securities and Exchange Commission. Then he went to the firm’s library and placed the call. He was put on hold for minutes that seemed like hours, and then the operator came back on the line.

“I’m sorry, Mr. Walker. The president is not able to take your call at this time.”
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The government’s decision not to bail Lehman out led to a bankruptcy six times larger than any other Chapter 11 case in U.S. history. It also set off a near panic among investors and lenders worldwide that September, one that forced the United States to push through a historic rescue plan for the financial system. The government and Federal Reserve stepped in to rescue Fannie Mae and Freddie Mac, guaranteeing over $300 billion of debt. It also helped force struggling Merrill Lynch into the arms of larger Bank of America, a step taken to try to avert still more fear among investors.

The moves worked only partially. The stock market continued to plunge, tumbling more than 60 percent between the fall of 2007 and early 2009, the worst bear market since the Great Depression and one that coincided with the worst recession since World War II.

The troubles sent the value of all the protection that John Paulson had purchased soaring in value, enabling Paulson & Co. to tack on another $5 billion in profits in 2008. The firm made hundreds of millions of dollars when its CDS contracts on Lehman Brothers paid off in the fall, as the investment bank was forced to seek bankruptcy.

The hedge fund also made $1 billion by shorting British banks such as Royal Bank of Scotland, Barclays, Lloyds Banking Group, and HBOS, all of which had high exposure to British mortgages. Later, when regulatory changes forced Paulson to reveal these positions, he became something of a public enemy in corners of the United Kingdom.

“So I’m eating my cornflakes and I read that John Paulson, the New York hedge fund king, has made £270 million betting that the Royal Bank of Scotland share price would fall over the last four months,” Chris Blackhurst wrote in London’s
Evening Standard
in February 2009. “Prison isn’t good enough for the short-selling fiend! He should be paraded down Fifth Avenue, naked, and then tied to a lamp-post so we can all take out our anger and despair on the grasping monster!”

Paulson was uncomfortable shorting these stocks—not so much because of any guilt about profiting from falling shares but because there was more downside to wagering against stocks, which can soar an unlimited amount, than in owning them. That’s why he didn’t place nearly as big a bet against financial companies as he did against subprime mortgages. Paulson still scored impressive gains of 30 percent or so for most of his funds in 2008, even as the overall market tumbled 38 percent and some larger hedge-fund rivals threw in the towel and closed down, but Paulson couldn’t match 2007’s gains of 590 percent and 350 percent for his two credit funds.

For those on the other side of Paulson’s trades, and the executives running financial firms that collapsed so suddenly, 2008 was about recrimination. One Thursday morning in June 2008, the two executives who ran Bear Stearns’ hedge funds that made wrong-way bets on CDOs and other mortgage investments, Ralph Cioffi and Matthew Tannin, were hauled into a Brooklyn jail cell, to be arraigned for allegedly misleading their investors about the health of their failed funds. Their upbeat comments to the investors were at odds with the caution they shared with each other as well as their own actions, prosecutors alleged. Shackled and in shock at the turn of their fortune, Cioffi asked Tannin: “How did we end up in this spot?”
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I
N THE SPRING OF 2008
, Paulson and Pellegrini visited Harvard University, their alma mater. Pellegrini was excited about the trip and looked forward to explaining to the students how the firm had anticipated the credit crisis.

But when they got there and the class settled into their seats, Paulson
approached the dais and addressed the group by himself, while Pellegrini watched from the back of the room. Later, Pellegrini helped his boss answer some questions from students, but it stung Pellegrini that he wasn’t invited to address the class. Paulson’s shadow never seemed so huge.

“It was humiliating to me,” Pellegrini recalls.

Pellegrini spent most of the year working with Rosenberg to sell the last of the firm’s subprime insurance. Others, like Jeffrey Greene, ran into problems finding investors willing to buy the investments at prices that seemed reasonable.

But Pellegrini and Rosenberg played a waiting game—when markets were buoyant and optimism reigned, they held back; when a securities firm, bank, or hedge fund imploded, they swooped in to offer their CDS protection, usually finding a huge appetite.

By July 2008, as subprime-related investments fell to pennies on the dollar, they had exited almost every trade, cashing in the remaining chips of the remarkable trade. The two Paulson credit hedge funds invested a total of $1.2 billion of cash and racked up nearly $10 billion of gains, all in two remarkable years. Paulson’s other funds enjoyed about $10 billion of their own gains, all from obscure protection on mortgages most experts said would never get into trouble.

Pellegrini spent the rest of the year hiring specialists to refine the firm’s valuation methods for mortgages, preparing for the time when it looked safe to buy them. Over several months, Paulson sometimes pushed Pellegrini to look for cheap mortgage investments, but Pellegrini remained skeptical, and the hedge fund held off doing much buying until the fall of 2008.

By then, Pellegrini had one foot out the door.

J
EFFREY GREENE
began 2008 with a burst of confidence. He already had cashed in nearly $100 million of his investments and had decided to stop fighting his brokers with their unreliable quotes. He’d simply hold on to the rest of his CDS mortgage insurance, which he figured was worth $200 million or so. If all those home mortgages ran into problems,
as he knew they would, the insurance would pay him in a big way. He didn’t
have
to sell his holdings.

His friend in Boston, Jeffrey Libert, was panicking. He wanted to sell his own investments but also was hoping to keep them until the summer, so he would hold them for a year and could pay a lower tax rate, something Greene also was doing.

“Chill out,” Greene told his friend.

Libert eventually cashed out, settling for profits of about $5 million from his trade. It was a big score but it came with regular ribbing from his friend for not being “gutsy” enough to do the trade in a bigger way.

“I should have done more, I’m kicking myself,” Libert says. “But it just wasn’t for me.”

In the fall of 2008, when Lehman Brothers collapsed and Merrill Lynch ran into deep problems, it was Greene’s turn to sweat. He hadn’t paid enough attention to the health of his broker. Now he realized that if Merrill Lynch went under, he might not be able to gain access to his positions. He’d be just another desperate creditor lining up at bankruptcy court to lodge a claim.

“I’m thinking, ‘If Merrill goes out of business I’m out $200 million!’ ” Greene recalls.

By then, Zafran, his Merrill Lynch broker, had left to start his own firm. Greene picked up the phone to call J.P. Morgan, hoping the bank, in a safer position, would engineer a transfer of his positions from Merrill Lynch and help him sell it all. On hold, Greene waited nervously as his broker asked a few traders if they could help.

“Sorry, we’re not willing to go to market with any Merrill Lynch counterparty risk,” the J.P. Morgan contact told him. They wouldn’t help wind down any trades with Merrill Lynch on the other side.

Greene’s stress level soared. “I wanted out right away but now I only have Merrill to help me, of all places.”

Greene called up his new Merrill Lynch broker and decided to play it cool, trying to hide the fear building inside.

“Hey, it’s Jeffrey Greene,” he said, very casually, as if he was bored and looking for something to occupy his time. “I wouldn’t mind winding down some of those positions; do you mind getting me a bid or two?”

“Well, it could take us a day or two,” the broker responded.

“Oh, that’s fine, thanks.”

Greene got off the phone, beating himself up for waiting so long to sell.

What an idiot I am!

“I’m thinking if they give me fifty cents [on the dollar], I’m going to have to take it,” Greene recalls.

When the broker called back, he had an offer for Greene: “We’ll pay you $156 million” for the position.

Greene couldn’t believe it—they were willing to buy his positions at eighty-seven cents on the dollar. He had been willing to sell them for just fifty cents. Maybe his bluff was working.

He decided to push it a bit further.

“Well, let me see. I’ll think about it.”

He hung up. Merrill soon called with a new offer: ninety-three cents on the dollar.

“Do it,” Greene responded.

Greene didn’t realize it at the time, but John Thain, Merrill’s new chief, had just issued an order to his troops to get rid of any exposure to toxic mortgages, no matter the cost. Merrill Lynch was eager to get out of their trades with Greene, at any price.

Dragging his feet worked to Greene’s benefit. “I was totally lucky at the end,” he acknowledges.

After Greene hung up, though, he realized he had another issue to worry about: If Merrill Lynch went under before his trade was complete, Greene’s profits would be in danger.

He rang the Merrill Lynch broker, once again.

“Um … when does this trade settle?”

Not taking any chances, Greene had his trade transferred to Credit Suisse, a more stable Swiss bank, to ensure that it went through.

By 2009, Greene was down to just $100 million in CDS protection, a valuable memento of a trade that netted him about $500 million in profit, one of the largest gains by an individual investor in Wall Street history.

“The trade worked better for amateurs than professionals,” Greene says, noting that those not a part of the business could more clearly see
the looming problems, as well as dismiss potential obstacles to the trade. “There were so many things that could go wrong.”

D
ESPITE GREG LIPPMANN’S SUCCESS
, his superiors seemed as skeptical as ever as 2008 began. As the ABX fell further, Anshu Jain, one of the bank’s top executives, e-mailed Lippmann, pushing him to sell some of his positions.

“No, it’s going to zero,” Lippmann shot back, according to an executive who saw the e-mail. Lippmann also began warning some on Deutsche’s trading floor that the housing troubles would infect other areas of the economy.

Watching a commentator on CNBC judge the stock market’s weakness as temporary, Lippmann quickly yelled out: “In your dreams!”

Sometimes, Lippmann was so openly joyful, shouting and screaming with so much pleasure, that it rubbed some other traders the wrong way, especially those losing money.

On one particularly bad day for the market, Lippmann called over a salesman, pointing to a spreadsheet on his computer.

“Look, I’m up $400,000!”

Flashing a big smile, Lippmann explained that in his personal account he had bet against an exchange-traded fund that tracked financial companies, like banks and brokerage firms. The worse things got for Deutsche’s brethren, the more his account rose in value.

“That’s wonderful for you,” the salesman said to him, sarcasm dripping, as he shook his head.

At one point, his boss, Misra, sat Lippmann down to tell him not to be so obnoxious about his winnings.

Lippmann’s cockiness masked a growing unease as he watched a figure in the corner of his computer screen: the tumbling shares of Deutsche Bank as its own problems multiplied. Lippmann’s team was a relatively small part of a global bank; he could see the profits and losses of some others and it was an ugly picture. By the middle of the year, the bank had taken $11 billion of write-downs, dwarfing Lippmann’s gains. His bets against financial shares—approved by the bank—were a futile
attempt to limit the damage from the loads of Deutsche shares in the account. On the day his personal account rose $400,000, his Deutsche shares fell about $800,000.

Lippmann was almost right in his prediction to his bosses—the ABX index tracking the riskiest subprime mortgages eventually fell to two cents. His group would make several hundred million dollars more in 2008. In the fall, Lippmann even began recommending select subprime bonds that he thought had become attractive, bonds that began to rise in early 2009.

For all Lippmann’s success, Deutsche was dealing with so many problems by late 2008 that it could pay him only a few million dollars as a bonus, another disappointment for him. Adding salt to his wounds, his Deutsche shares had dropped more than 70 percent over the previous twelve months.

I
N SEPTEMBER 2007
, Andrew Lahde pressed his bets, raising a larger fund from newly interested investors to buy protection against commercial mortgages and another fund to wager against banks, brokerage firms, and other companies that he was sure would fall.

“Our entire banking system is a complete disaster,” he wrote in late 2007. “In my opinion, nearly every major bank would be insolvent if they marked their assets to market.”

By the end of the year, Lahde owned protection on $1 billion of subprime debt in three hedge funds and managed $100 million. But as he became increasingly worried about the fragility of the financial system, he began doing some selling.

In March, exhausted from a grueling year, he invited two young women to Miami, trying to relax. He rented a penthouse suite at the Ritz-Carlton for the women and another room nearby to ensure that he’d get some rest during the day as the women shopped. Lahde couldn’t seem to relax, however. He still held hundreds of millions of dollars of protection and increasingly was convinced that he needed to cash in his big trade before it was too late. Two weeks later, bringing a young woman with him, he left for St. Thomas to research the tax benefits
of moving to the island. The hotel was so crowded, in part due to a visit to the island by a group including President Barack Obama, that Lahde was unable to book an extra room and, frustrated, he was forced to share his suite with his traveling partner.