John Paulson’s name has become synonymous with a trade that will make him famous for many years to come—going short U.S. subprime home loans. In 2005 and 2006, when conventional wisdom decreed that deep trouble in the housing and mortgage markets was unlikely, Paulson went against the grain and predicted that loose lending standards would herald a market crash. This bet paid off handsomely last year. His now $28 billion New York hedge fund racked up profits of $15 billion and Paulson earned an estimated $3-4 billion for himself. Paulson & Co. managed $7 billion at the start of last year, during which investors poured in another $6.5 billion.
The firm launched its Paulson Credit Opportunities Fund I and II in the middle and end of 2006, respectively, both dedicated to shorting subprime. Co-managers John Paulson and Paolo Pellegrini went short tranches of collateralized debt obligations and bought credit default swaps. When the first fund lost money initially, they increased their bet, going short the ABX index. After subprime lender New Century Financial Corp. restated its earnings in February 2007, Paulson’s two credit funds gained 60% that month. In the fall of last year, the ABX subprime index crashed and the credit default swaps Paulson owned rocketed up in value. Paulson’s Credit Opportunities Fund I and II returned 589.9% and 351.8% last year, respectively.
Paulson has taken profits on some, but not all, of his bets and remains a bear on housing.
“The correction in housing has only just started,” the hedge fund guru said at a December conference. He believes that U.S. housing prices will drop another 15-20% before they hit bottom, at which point he may start seeking long opportunities, possibly as early as 2009. He has also started betting against credit cards and auto loans. In his latest move to remain ahead of macro trends, Paulson has signed on Alan Greenspan, the former chairman of the Federal Reserve, as an adviser.
In the midst of the firm’s stellar performance run, Paulson & Co. hasn’t lost sight of the need to reach out to pension funds. It hired public fund marketing veteran Larry Pokora in early 2006 from Chartwell Investment Partners. Public funds are already a significant part of Paulson’s client base and the firm intends to build this book of business further.