The best trades in history…

netting $4bn from subprime loans

John Paulson was born in 1955 and grew up in New York. After graduating from New York University with a degree in finance and from Harvard Business School with an MBA, he worked for Boston Consulting Group. When he got bored with that he moved into investing, working for Oppenheimer and Odyssey Partners, before switching to investment bank Bear Stearns. In 1994 he opened his own hedge fund, Paulson & Co, and despite early troubles it was by 2004 managing $3bn in assets.

What was the trade?

Between 2001 and 2006, the US housing market boomed due to low interest rates and the rise of securitisation, which allowed banks to sell off bundles of mortgages to investors. Both factors led to a drop in lending standards, resulting in many people taking out “subprime”mortgages that they couldn’t afford, in the hope that prices would keep rising. Worried about a real-estate crash, Paulson learned about credit default swaps, created to help insure against bonds defaulting, but which could also be used to bet on a default. In 2005 he started buying CDSs covering mortgage securities.

What happened?

Initially the trade lost money as CDS prices remained low. Indeed, Paulson was forced to sell his original CDS because he realised that prices would have to fall by a lot before he would profit. He continued to believe his underlying idea was sound, however, given that house prices were far above their historical trend, so he re-invested in CDS on more recent mortgages, which were more vulnerable to a smaller price fall. Over the next five years, real house prices would fall by 40%, trigging a massive wave of defaults and causing the price of CDSs to soar.

Lessons for investors

It’s estimated that Paulson’s trade, which some regard as the “best trade of all time”, made $15bn for his hedge fund in 2007 alone, with Paulson personally receiving $4bn. He also had success in 2008 betting against many of the banks. Paulson’s success shows the benefits of going against the consensus, but note that he did a lot of research to verify his analysis and was flexible enough to adjust the type of CDS he was buying after his initial setbacks.