Trader Made Billions on Subprime
online.wsj.com
online.wsj.com
http://online.wsj.com/article/SB120036270913390155.html?mod=...
"He bought three jets, most recently a Gulfstream. Though he paid just $2 million for an older model, "I certainly could afford" a $50 million one, he says. He adds, in a telephone interview from his 145-foot yacht: "I tend to be pretty conservative in the way I spend money.""
Interesting that this article was posted by "blackswan" -- this could be a case study in Fooled by Randomness.
Six months earlier or later, and this guy might well have busted; I don't think we would be reading about him.
Housing remained strong, and the fund lost money. A concerned friend called, asking Mr. Paulson if he was going to cut his losses. No, "I'm adding" to the bet, he responded...
By comparison, as Ed Seykota put it in the book Market Wizards, "The elements of good trading are cutting losses, cutting losses, and cutting losses."
These types of risks are always brilliant when you win, and stupid when you lose. Articles like this one teach you little, other than the value of good luck, and great timing.
(also, for the record: I agree wholeheartedly with the spirit of his investments; I'm a housing bear too. But I'm also realistic enough to know that he got lucky, using a decidedly risky investment strategy. With hundreds of millions of dollars short in an admittedly irrational market, one bad month of excessively irrational market behavior could have wiped him out.)
Of course, a big loss is more objectionable than a small one.
Paulson was making a judgment that the market was wrong to price subprimes so high. Do you really think his thought process was "The market is wrong that they're worth X, when they should be at .4X. But if they move to 1.1X, they must be right!" He's thinking like a value guy in a macro trade, not like a 'trader'.
Most successful traders emphasize that adding to a position that is showing you a loss, because you believe you are right and the market is wrong, is a losing strategy in the long run. That suggests that Paulson won with a losing strategy, which suggests that timr has a point.
Perhaps you are correct that there is something other than "trading" in which people routinely add to losing positions and end up making money when the market changes to confirm their judgments. It would certainly be something other than winning trading.
If you trade on value, you shouldn't really care what the market is doing. If risk is mispriced, buy more, even if the price is going down and you are losing money in the short term.
I find it more intellectually appealing to make my money taking a stand than to make it by saying "Me too, me too!"
The thing is, trading can't be the only successful way to make money, or even more successful than other traders on average -- because trading implies buying more as the market confirms your views, and if that's profitable, it implies that traders will own all the world's assets, and every asset will either rise infinitely or collapse to zero.
If it helps, you could think of him as an arbitrageur betting that the mortgage market would converge with reality. That thesis relies on believing that the market misprices assets, so it seems that further mispricing would confirm it rather than belie it.
However in principle, this is exactly how Nassim Taleb (the Black Swan author) made his money during the 1987 wall street crash (iirc). At the time, people were selling options that hedged against large falls in price very cheaply. Taleb bought loads of them and profited hugely as a result of the crash.
Paulson's scheme was a little more complicated, but the formula was essentially the same - underpriced hedging instruments + crash = massive profit.
This quote from the article sums it up perfectly: Mr. Paulson became convinced investors were far underestimating the risk in the mortgage market. In betting on it to crumble, "I've never been involved in a trade that had such unlimited upside with a very limited downside," he says.
It's unclear how balanced Paulson's fund was/is, but the article makes it sounds like he was playing with fire.
The other half of the strategy, which the quote was about, was related to purchasing credit-default swaps, which are derivatives like options. The losses on CDS contracts are bounded.
But you're right... without knowing the balance between CDS contracts and short selling, it's hard to gauge how exposed he was.
You only make $15 billion with a shit-ton of leverage.
I'm curious as to what software can prevent people from forwarding your emails...
I think we need a more complex line of reasoning to justify him being the good guy.
Speculators are risking their own money re-aligning badly-allocated capital in the economy and correct prices. If they are right they earn a nice commission.
The only distinction of a fund manager is that they slimed their way into using other people's money.
On the other hand, this guy probably helped to make the bubble burst sooner -- and thus before the banks could make even more sub-prime mortgage loans -- and that would have the effect of reducing the banks' ultimate losses (and resulting in them applying less of a risk premium to mortgages).
Trying to figure out which of these effects is larger would be pure speculation.
One concern was that even if Mr. Paulson bet right, he would find it hard to cash out his bets because many were in markets with limited trading. This hasn't been a problem, however, thanks to the wrong bet of some big banks and Wall Street firms. To hedge their holdings of mortgage securities, they've scrambled to buy debt protection, which sometimes means buying what Mr. Paulson already held.
In other words, Paulson was buying mortgage insurance contracts, driving their prices up, and now banks are buying those contracts from him (at higher prices than they would have if he hadn't been involved in the market).
By all rights, his initial foray into buying the swaps most likely had minimal effect on the price. Ultimately he felt they were incorrectly priced by the market and made a bet on them.