Rethinking Markets

I just finished reading Gregory Zuckerman’s new book The Greatest Trade Ever: The behind the scenes story of how John Paulson defied Wall Street and made financial history. The story is about how JP, a relatively staid merger expert, became intensely bearish on the housing market in 2004. He took a $2 billion in assets firm and, using credit default swaps and derivatives trades against an index of subprime housing markets, began trading against the mortgage market. When the meltdown occurred, Paulson & Co. made money – lots and lots of money. In 2007, they made $15 billion. In 2008 through early 2009, they made another $5 billion. Zuckerman estimates Paulson’s personal share at about $6 billion over two and a half years.

The book itself follows a fairly standard formula. Tell the story, punctuated with the main characters and tidbits from their upbringing, add drama, repeat. His access to Paulson appears pretty extensive, and his quite fawning, often uncritical stance towards Paulson is consistent with that. It sort of helps readers understand credit default swaps, but doesn’t give enough information to be helpful for rank beginners. I am not sure I would recommend it if it is the only thing you’re reading on the financial crisis, but as I haven’t yet read the final word on it, this may be an interesting addition to your store of knowledge.

I’d like to focus on two elements of the book that I think are wildly problematic. The first is the attitude taken towards Paulson. Zuckerman chose the one investor (or actually the 3-4 investors) who were bearish on the housing market, and spent the entire book explaining how they were so incredibly wise and persistent in the face of an industry and even a whole country’s zeitgeist pushing in the opposite direction. This is selection on the dependent variable in the worst and most glaring sense. That is, choose people who succeed and then explain why they succeeded.

Here’s the thing: imagine 10,000 people go over Niagara Falls in a barrel, and 100 survive. Then those 100 people go over the falls, and 1 survives. That person will then write a book about how to survive going over Niagara Falls in a barrel. But without knowing what these barrel-goers are doing before they all go over, there is no way to know if the survivor made it because of what they did, chance, or whatever. Likewise, despite his sideline stories of the 3-4 others who also tried shorting the housing market (and most of whom failed doing so, despite doing much the same thing as Paulson!), Paulson was the only one who made tons of dough. As they say on the webular intertubes, causality FAIL.

But let’s say you buy that Paulson & Co. were geniuses. The problem, then, is that they decided to make decisions that benefited them at the massive expense of harming society.

Now, I’m not going to talk about how Paulson & Co. worked with banks to create even more toxic collateralized debt obligations (CDOs) than even existed at the time, so that they could bet against the housing market more directly (though from the hemming and hawing on pp 179-181 it is obvious to all that it was indeed ethically dubious and that both author and Paulson are trying to explain it without shouldering too much of the blame for it).

Instead, I’d like to focus on the fact that Paulson knew that things were going to crap, and often his willingness to speak out about it was highly subordinated to his desire to keep his trades quiet enough to make a boatload of money off of the housing collapse. Of course, the environment at the time was completely over-the-top rah rah bullish. And yet. And yet. Some examples:

1.
In November 2006, Pelligrini went to a presentation to investors by Robert Cole, the CEO of New Century. There the chief executive played up the low levels of defaults in subprime. “Pelligrini was convinced that his rivals were missing it. Wait till rates reset, he thought. He resisted speaking up, though, lest they figure how bearish his firm was, and perhaps warm to the CDS protection that Paulson was becoming enamored with, pushing prices higher” (98).

2.
In early August 2007, Paulson had been purchasing billions of dollars of CDS, betting against the housing markets:

…Paulson let his friend in on a secret. A few months earlier, he had reflected on how easy it was for him to buy billions of dollars of protection on all those toxic mortgages…Paulson began to wonder, if his fund found it so easy to buy billions of dollars of protection, who was selling it all to them? And what would happen to them as housing came crashing down?

…Banks were selling subprime protection to investors like Paulson and often keeping the positions for themselves…Paulson knew that as long as [housing prices kept falling] the banks and others holding these investments would have to record deep losses because they held so much of it themselves. It was just a matter of time before the pain began.

It was no secret that banks and investment banks like Merrill Lynch, Morgan Stanley, Countrywide, and Bank of America had pushed into subprime lending. They hadn’t acknowledged any huge losses just yet, though, reassuring some investors. But as the ratings companies lowered their grades on various pools of subprime home loans, it would have to happen” [235-237]

3.
On February 20, 2008, Paulson was invited with a number of investors to a lunch with Samuel Molinaro, Jr. of Bear Stearns. At that lunch, meant to bolster confidence in Bear, Paulson finally revealed his doubts, of course after “bulking up its bets against a range of financial giants, from Lehman Brothers and Washington Mutual to Wachovia and Fannie Mae. He had deep concerns about Bear Stearns, too” (256). The meeting, apparently spearheaded by Paulson’s accurate and massively negative assessment of Bear, “was a dagger in the staggering investment bank’s heart” (257).

On March 14th, the NY Fed tried to bail out Bear Stearns with a loan, then turning to securing their debt as they were acquired by JP Morgan Chase. Oh, and providing $29 billion in financing to help a 3rd party entity eat the BS crap assets.

In each of these cases, Paulson or his adviser turned their knowledge about the dysfunctional workings of the world’s financial system into their own private advantage, at the expense of the public welfare.

I was struggling with how to make what they were doing clear, and I remembered a maddening MassMutual advertisement that irked me to no end whenever I saw it. And then it clicked:

Exactly! There’s the rub. A responsible person would not just step back from the curb and let everyone else get wet. A responsible person would say to the other people, “Hey! There’s a bus coming! You may want to step back from the puddle!” This woman makes me want to shout. She may be making a good decision, but she’s a horrible citizen.

And that’s how I feel about Paulson. He stepped back from the brink, and was highly rewarded for it. Meanwhile the rest of Wall Street got massively splashed. But the thing is, it’s the rest of us that are getting screwed over by the damages caused.