In the extremely competitive world of hedge fund management, there are a handful of trades that stand out. George Soros, for instance, whose fund manages over £14 billion, is most famous for making $1.1 billion by betting on the collapse of the pound in 1992. When these contrarian strategies succeed they attract the attention of the wider public. What outsiders struggle to understand is how difficult they are to pull off.
Gregory Zuckerman's excellent new book tells the story of one such trade, made by the hedge fund manager, John Paulson, which was so successful even George Soros was left wondering how he had managed it. Paulson bet everything he had that the United States real estate market would collapse. The familiar story of what happened next - the unfolding of worst financial crisis since the Great Depression - is skilfully retraced by Zuckerman through this one, audacious trade.
Before this spectacular bet was made, Paulson was best known for being a regular fixture on the New York party circuit. He began his career as a consultant then switched to banking where he became a millionaire in his early thirties thanks to a $25,000 investment in Boston's Samuel Adams Brewery. His fortune allowed Paulson to set up a hedge fund of his own and to spend even more time at parties.
Paulson's easy living disguised an ambition to become one of the great investors. His hedge fund, however, was limited to investing in, what is known in the industry as, merger-arbitrage, a fairly common investment strategy that, in a normal year, generates between 5 and 15 per cent annual returns. Almost by accident, Paulson began looking at the mortgage industry and a type of investment called a credit default swap (CDS). His independent research showed that house prices were rising too fast and that borrowers with terrible credit histories were able to get loans they would never repay. CDSs were becoming increasingly popular as a form of insurance. The holder of a CDSs pays a small amount each year in exchange for a much larger repayment should the asset (in this case, mortgage backed securities) suddenly depreciate. Meanwhile, investment banks were busy bundling mortgages together and selling them as mortgage backed securities (MBSs). There was strong demand for the MBSs but fewer people wanted to buy the CDSs that bet against them. Paulson selected the CDSs with the lowest ratings but highest interest payments.
As the months went by in 2006 and 2007, the value of the MBSs and the real estate market continued to rise. Despite considerable resistance from both his investors and his brokers, Paulson kept buying the CDSs. One broker said he bought them so fast and in such huge quantities, it felt like a drive-by shooting. As is true of all successful trades, with hindsight it seems like an obvious move but few other funds made similar bets and none on the scale of Paulson & Co. Zuckerman's book does a terrific job at describing the months of agony Paulson went through as he tried to convince his investors to stick with him and wait for the strategy to work. As the world economy approached the precipice, Paulson's main fund was effectively going short against the entire US stock market. When the trade finally came good the results were spectacular. As the markets collapsed, Paulson's fund finished 2008 up more than 500 per cent and is now one of the largest and most respected hedge funds in the world. Paulson himself made more than $2.3 billion in two years on his trade - enough for a few more parties.