"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." - John Maynard Keynes.
If "The Big Short" theme was that Wall Street bond traders were corrupt and stupid and it was inevitable that they would blow up, "Greatest Trade Ever" covers the same ground but instead argues that it is nearly impossible to profit from a wildly out of consensus trade. Lewis opens his book with a quote by Tolstoy, which emphasizes that the experts could not be convinced because they know too much. Zuckerman instead opens with the Keynes quote above which explains why there are so few independent thinkers on Wall Street. The amazing thing about the subprime debacle was not that a few smart contrarians figured it out, but rather that so few did, and perhaps most amazing of all, the pain they endured during the process. (Although their massive, deserved riches may be a salve for those wounds).
The Greatest Trade Ever is mis-named. It is not really a story about a trade, but about the fascinating few people that were able to make this trade. Zuckerman, in vivid detail, helps us to understand what drove these men to bet everything they had against the rest of the world. The book succeeds on several levels. It explains the actual mechanics of how traders spotted and profited from the subprime meltdown. On a very subtle level, it gives serious investors some amazing insights in successful investing, but it is no "how-to" book. Most important, it tells the stories of these fascinating people who rode the wave.
The author compares these contrarian investors to people who climb K2 or surf Pipeline in Hawaii. In the investing world, there is no more treacherous challenge than betting against a mania. History is full of legendary investors who rode financial waves to their ruin, putting on gutsy financial trades against the crowd, only to suffer humiliating losses that sometimes haunted them for years.
The author gives many examples of investors that bet against the herd and failed:
Sir Isaac Newton went broke in shares of the South Sea Company, and said, "I can calculate the motions of the heavenly bodies, but not the madness of people." Legendary Value Investor Ben Graham lost 2/3 of his investments' value during the crash of 1929. Famed trader Jesse Livermore anticipated the 1929 crash and scored $100 million in profits by shorting shares. However, by 1934, he was bankrupt and six years later shot himself in the bar of the Sherry-Netherland hotel.
Hedge-fund maven Michael Steinhardt, who made millions betting against overpriced stocks in the 1960s, bet against the market in the early 1990s, losing most of his clients. His bonds eventually rallied and he made $600 million for his fund. He said: "Betting against a bubble is dangerous, but it's one of the most rewarding things, it's truly a pleasure. In your mind you're going to be right ultimately; there's a certain virtue in being alone" he said afterward.
A mania even beat the legendary Soros, who lost 20% in a few months on dot-com stocks. He said "the understanding of a bubble doesn't help you as an investor. Those that reach historic proportions go further than you would think." Even Peter Schiff who correctly predicted housing would stumble didn't make money because he played it wrong - underscoring the fact that an awareness of an investment bubble is only valuable when you know how to profit from it.
The subprime bubble was very hard to short. Even Bill Gross bought a little CDS protection in 2006, which led to his fund trailing the rest of the pack. This made him so miserable that he had to take an unplanned 9-day vacation midway through the year, sitting around the house, sulking to his wife. "I couldn't turn on business television, I couldn't pick up the paper; it was just devastating. I couldn't sleep at night," he said. And this is the so-called King of Bonds, a billionaire bond investor.
What was the "Greatest Trade Ever?"
The greatest trade ever was shorting subprime using CDS contracts on mortgage bonds. They were essentially insurance contracts on other bonds. If the bonds defaulted, you were paid. If not, you had to keep paying for the insurance, year after year.
The cost was cheap relative to the upside, at only 1-2% of principal per year. But that money went out the door constantly. The amazing beauty of the trade was the way Paulson played it. He had the nerve to have $300 million a year going out the door, effectively a $14 billion bet against the rest of the world. There was a kind of divine sickness to this trade. What kind of person can do this, and do it with such overwhelming passion and greed?
As if that first coup wasn't enough, when the CDS started paying off, Paulson made massive short bets against Fannie Mae, Freddie Mac, the mortgage insurers, and even the Wall Street banks. It was the greatest trade ever followed by the second greatest ever, all in the space of 3 years. Meanwhile the rest of the world was against him - all of Wall Street, the Fed, and finally the US government.
Wall Street always ultimately rips off clients in one way or another, treating them like rubes that they usually are. This just further shows the genius and sheer willpower of this trade. The client never comes out ahead when betting against Wall Street. They change the rules, make pricing opaque, take the skim, or do something to soak the clients. Yet in this amazing trade, a medium sized hedge fund with a lackluster record bet big against the crooked house playing with loaded dice and won anyway. The elegance, magnitude, sheer beauty of this coup is hard to overestimate. Even with the government taking billions from taxpayers to feather the nests of Wall Street, they were still insolvent. They were wrong, Paulson was right, and he won.
The author interweaves the stories of the people that put on this trade, but he focuses most of his time on John Paulson.
John Paulson.
Paulson was out to earn money, even as a young kid. He used to buy packs of candy, break them up and sell the pieces individually at school for 5 cents each. Buffett did this with gum.
An expert showed Paulson early in his career that adjusted for inflation, annual gains for housing were only 1.5%.
Paulson had a hard time getting his fund started. "A salesman's job starts when the customer says no," he was told. He reached out to everyone he knew, even mailing more than 500 mailers about his fund's launch. He didn't get a single response, even after waiving the $1 million minimum investment. Even bankers at Bear Stearns that he had worked with said no. A few didn't even return his calls. Others set up meetings, only to cancel them. Even his old mentor wouldn't invest. He had no luck with his successful business school peers either.
"I had lots of contacts and I thought money would pour in. Some people said they would give me money, but only if they got a piece of my business. It was humbling," he said.
Instead, Paulson started his firm with $2 million of his own money. It took a full year to find his first client, an old friend from Bear Stearns, who gave him $500,000. The firm was just him and an assistant in a tiny office in a Park Avenue building owned by Bear Stearns and shared with other small hedge-fund clients.
At times, Paulson became discouraged, because despite good (but uneven) investment performance, he still had few clients. He clung to a quote by Winston Churchill: "Never give up. Never give up."
By late 1996, he still had only $16 million of assets, tiny in the hedge fund world. By the end of 1997, he had about $100 million. He lost 4% in 1998, and lost about half of his client assets, down to about $50 million by year-end.
As his performance got better, investors discovered his firm. Assets surged to $3 billion in 2004. Meanwhile, Paulson turned more conservative, with plain suits, less profanity, eating healthier, gaining control over his emotions and temper.
Despite his growing success, Paulson was not initially able to raise money for a new fund to short subprime. Zuckerman writes: "John Paulson's perspective was so vastly different from that of most others on Wall Street that it was as if he had landed from a different planet." Paulson complained: "I don't know why they don't get it... this is the trade of a lifetime. They concluded that I was an inexperienced manager. I had to play dumb. But I got tired of people saying I was stupid or wrong."
Paulson's wife even felt the strain, asking him if he was having second thoughts. "It's just a matter of waiting" he reassured her.
The trade didn't work for months, even after subprime started collapsing, because the firms would not mark the CDS properly. They were protecting their own books. Finally, it started working and working big! His credit fund climbed 66% in one month. Investors were incredulous and some thought it was a misprint, that it should have been 6.6%.
At one point, during a meeting with two executives that wanted to buy a piece of Paulson & Company, Paulson was fidgety, like he was waiting for news. An hour into the meeting his trader Rosenberg knocked on the door, interrupting the group. He leaned into Paulson's ear, whispering something. Then Paulson immediately rose, apologized and stepped out of the meeting. Ten minutes later, he returned, upbeat. He finally blurted out what was on his mind: "We just got our marks for the day. We made a billion dollars today."
Paulson kept the trade on, because he knew it could go much further, despite almost doubling the money in the early part of the year.
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