“A single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans.  All you need is a single black [one].     

                                  ” From “The Black Swan”
                                   By Nassim Taleb (2007)

The mortgage crisis meets the description of a “black swan”.  Recently, the Wall Street Journal published a description of how one trader (Mr. John Paulson) was able to profit handsomely from betting on this “black swan”.  (January 15, 2008, Trader Made Billions on Subprime).  How handsomely?  Profits of $15 billion in 2007, nearly equal to Citigroup write-offs reported in their December 31 quarterly earnings announcement. 



How did he accomplish this?

·         Seeing the opportunity, accepting that a longstanding economic assumption might be wrong
·         Thoroughly analyzing new, hybrid investment vehicles
·         Maintaining secrecy
·         Patience, waiting to invest, waiting through large losses
·         Taking on large banks, utilizing high paid public relations to maintain his strategy
·         Taking extreme risk

It is (was) a longstanding assumption that “house prices never go down on a national level”.  Since “you can’t short houses”, Mr. Paulson needed to find a tool to take an investment position opposite of Wall street banks.  This entailed researching new instruments called credit-default swaps, an arcane security holders of CDO’s (collateralized debt obligations made up of home mortgages) used as “insurance” against loan defaults.  He sold short the high risk segments of CDO’s, and purchased credit default swaps on those securities because he believed they were priced too cheaply.  In the process, he had to review the detailed information of thousands of mortgages held in individual CDO’s.  Later, Wall Street created an index fund for sub-prime mortgages, which he also sold short.

It is (was) a longstanding assumption that “house prices never go down on a national level”.Since “you can’t short houses”, Mr. Paulson needed to find a tool to take an investment position opposite of Wall street banks.This entailed researching new instruments called credit-default swaps, an arcane security holders of CDO’s (collateralized debt obligations made up of home mortgages) used as “insurance” against loan defaults.He sold short the high risk segments of CDO’s, and purchased credit default swaps on those securities because he believed they were priced too cheaply.In the process, he had to review the detailed information of thousands of mortgages held in individual CDO’s.Later, Wall Street created an index fund for sub-prime mortgages, which he also sold short.

In seeking investors, one prospect used the information to do his own trading (In Beverly Hills, A Meltdown Mogul is Living Large, Wall Street journal, January 15, 2008).  Mr. Paulson then initiated secrecy measures to limit knowledge of his strategy (like coding emails to investors so they could not be forwarded).

Other traders had tried similar schemes before, but lost their money when they invested too early and the bubble kept expanding.  Mr. Paulson waited until mid-2006; and, with about $150 million funded mostly by European investors started the first hedge fund.  He waited through heavy losses, but by the end of 2006 was up some 20%.  This enabled him to start a second fund, his firm attracting $6 billion of new investments in 2007.  (In this article, he discloses he has taken some profits, so some remain “paper” gains, which he may or may not fully realize.)

As mainstream banks began to look for a way out of their predicament, they proposed regulations that would allow them to purchase individual loans, in essence re-writing the contracts underlying the CDO’s.  Mr. Paulson hired the former head of the SEC chairman, Harvey Pitt, to publicize this tactic (thus keeping it from being implemented).           

Besides knowing the details of an historic Wall Street crash, what lessons can we take from this?

As Alan Greenspan has publically stated, hedge funds form an important “check and balance” function to keep markets honest and accountable.  It is unlikely banks will lose money again through CDO’s funded by sub-prime mortgages.

The risk and technical details of such an investment require large amounts of money and a small number of investors.

Question strategies that use the words “never” or “always” in the premise or rationale.

One relatively small investor can affect the global stock market.

This is my last post on this subject.

Jack Carney

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