In 2005, financial institutions flourished amidst a booming housing market, yet they faced a major downturn as the market collapsed, leading to the worst economic crisis since the Great Depression. Amidst this turmoil, John Paulson distinguished himself by predicting the market downfall and making a fortune for his firm. His success centered on betting against subprime mortgages when others dismissed his foresight.

John Paulson's transformation from a relatively minor player to a Wall Street icon demonstrates his keen analytical skills and willingness to take significant risks. Initially struggling with skepticism from others, Paulson leveraged credit-default swaps on a massive scale, ultimately achieving what many call "the greatest trade ever" by profiting massively when the market crashed.

Main takeaways from the video:

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Key Vocabularies and Common Phrases:

1. euphoric [juːˈfɔːrɪk] - (adjective) - Intensely happy or confident. - Synonyms: (elated, joyful, ecstatic)

In 2005, investors were euphoric about the booming housing market.

2. foreclosure [fɔːrˈkloʊʒər] - (noun) - The legal process by which an owner's right to a property is terminated, usually due to default on payments. - Synonyms: (repossession, sequestration, taking)

Nearly 10 million Americans lost their homes to foreclosure.

3. collapse [kəˈlæps] - (verb / noun) - To fall down or fail suddenly and completely. - Synonyms: (crash, breakdown, ruin)

John Paulson predicted the housing market would collapse.

4. triumphed [ˈtraɪəmft] - (verb) - To achieve a victory or success. - Synonyms: (succeeded, prevailed, won)

Yet despite the disaster, one trader triumphed.

5. acquisitions [ˌækwɪˈzɪʃənz] - (noun) - The act of obtaining something; typically refers to gaining control of another company. - Synonyms: (purchase, gain, procurement)

He was an expert in mergers and acquisitions.

6. trajector [trəˈdʒɛktəri] - (noun) - The path followed by a projectile flying or an object moving under the action of given forces. - Synonyms: (course, path, route)

But the events of nine eleven would change the trajectory of his firm.

7. subprime [ˌsʌbˈpraɪm] - (adjective) - Referring to loans given to borrowers with a poor credit history. - Synonyms: (second-rate, lesser, below standard)

These risky loans, known as subprime mortgages, were appealing to lenders due to their higher interest rates.

8. domino effect [ˈdɒmɪnoʊ ɪˈfɛkt] - (noun) - A situation where one event causes a series of other events to happen. - Synonyms: (chain reaction, cascade, spillover)

...leading to widespread defaults, it triggered a domino effect through the financial system.

9. Collateralized Debt Obligations (Cdos) [kəˈlætrəlaɪzd dɛbt ˌɒblɪˈgeɪʃənz] - (noun) - Complex financial products that pool together and re-slice different debt sources. - Synonyms: (financial instruments, securities, derivatives)

Collateralized Debt Obligations (CDOs).... We’re like the sturdier lower blocks of a tower about to fall over, delaying the inevitable collapse.

10. Credit-Default Swaps (Cds) [ˈkrɛdɪt-dɪˈfɔːlt swɒps] - (noun) - Financial derivative that allows an investor to swap their credit risk with that of another investor. - Synonyms: (insurance policies, risk swaps, financial swaps)

Pellegrini proposed that they bet against risky mortgages by purchasing credit-default swaps.

The Greatest Trade The Rise of John Paulson's Insight

In 2005, investors were euphoric about the booming housing market. Financial institutions raked in billions of dollars financing real estate ventures. Riding the wave of financial success. But then, the wave broke, and it all came crashing down. 1 in 10 Americans couldn’t afford their mortgage. Nearly 10 million Americans lost their homes to foreclosure. Housing prices fell 30% from their highs, and in big cities like Miami, they dropped around 40%. The result was the worst global economic crisis since the Great Depression. Yet despite the disaster, one trader triumphed. John Paulson predicted the housing market would collapse. He bet against it even when other investors laughed him off.

And here’s the thing - Paulson didn’t know a thing about real estate. He was an expert in mergers and acquisitions. Yet during the market meltdown, when other firms lost billions of dollars, he made $20 billion for his firm and his clients. That's why it's called the greatest trade ever. This is the story of how an outsider pulled off the greatest trade of all time. Before the crisis unfolded, John Paulson was a small fish in a big pond. In 2005, his funds only gained 5%, below the average of 9% at other hedge funds.

At age 49, he was also older than many of his peers who were in their 20s and 30s. He had catching up to do because after attending NYU and Harvard Business School, he went into consulting first. But he soon realized he’d rather make money for himself than advise others on how to make money. So, he got a job at investment bank Bear Stearns and then Gruss where he gained valuable experience and also partied hard after hours. Despite rising through the ranks, he sensed that greater opportunities lay ahead. In 1994, he started his own hedge fund, Paulson & Co. Trouble is, the phone didn’t ring. No one wanted to invest with him.

As Paulson recounted to Gregory Zuckerman in his book, “The Greatest Trade Ever,“ “It was hard to be rejected; it was a lonely period. After a while I said, this is too much. He lifted my spirits.” Referring to his dad. Paulson also clung to Winston Churchill’s famous “never give up” commencement speech. Since no one took a chance on him, he decided to take a chance on himself. He started his firm with $2 million of his own money. It took him a full year to find his first client. He barely had enough resources to hire employees, though he did hire an assistant, Jenny Zaharia, who would later become his wife. In the 1990s, his firm managed tens of millions of dollars, whereas the big hedge funds managed hundreds of millions.

But the events of nine eleven would change the trajectory of his firm. In response to the shock and uncertainty, the Federal Reserve cut interest rates to try to stimulate the economy. This made borrowing cheaper, including for mortgages, allowing more people to afford homes. Yet this inadvertently laid the groundwork for the housing crisis. Banks and other mortgage lenders started loosening their standards, offering mortgages even to those with poor credit. “If you were a borrower and you had no credit, you had a horrible credit rating, you had a history of never paying your money back and you had no cash to put down to buy the house, they would still lend you 110% of the purchase price of the house. So you can actually buy the house with no money down and get 10% of the purchase price in your pocket, as crazy as that may sound.

By 2005, 24% of all mortgages required no down payment, up from 3% in 2001. These risky loans, known as subprime mortgages, were appealing to lenders due to their higher interest rates. Banks packaged these subprime mortgages into bundles and sold them to investment banks like Lehman Brothers and Merrill Lynch which converted these bundles into mortgage-backed securities, selling them to a range of investors worldwide, from Japanese pension funds to Swiss banks. When an increasing number of homeowners couldn’t afford their mortgage payments, leading to widespread defaults, it triggered a domino effect through the financial system, which experts failed to foresee.

According to Moody’s and S&P, there had never been a default of an investment-grade mortgage-backed security. Never being I guess post-WWII or post-1950. And we said, ‘Oh well, they did default in the Great Depression.’ They said, ‘Well, unless you think we’re gonna have a Great Depression, we don’t think mortgage securities are gonna default.’ And they laughed. But Paulson didn’t think the past would predict the future given the risky mortgages being issued. The only thing that kept these mortgages afloat was that housing prices were rising rapidly.

If you couldn’t pay your mortgage and defaulted, the lender would take back the house, but would still profit as the property value went up. But what would happen if housing prices started to fall? Paolo Pellegrini wondered the same. He had asked Paulson for a job after his career had derailed, convinced that his Italian accent had hurt him. Pellegrini poured over mountains of housing data and noticed a troubling trend: Home prices had increased an average of 1.4% between 1975 to 2000 factoring in inflation but afterward, soared 7% a year on average from 2000 to 2005, hinting at a bubble. His analysis also showed that when housing prices fell in the past, they dropped below the trend line, suggesting when the housing market corrected, it would be brutal.

He and Paulson viewed the housing market as a house of cards, bound to collapse when housing prices fell. It was kind of a very simple physics problem. If home prices kept falling and went negative and delinquencies kept rising, at some point the mortgage market would collapse and then these mortgages would sustain losses. It became very obvious to us but the problem is, the machinery, the factories that were just geared up to buy mortgages, securitizing and selling them, they just were oblivious to what was going on. They couldn’t stop the machine.” Pellegrini proposed that they bet against risky mortgages by purchasing credit-default swaps.

Credit-default swaps - or CDS - acted like insurance on mortgage-backed securities. It’s like buying insurance for a house. If the house catches on fire (which can be compared to default on the mortgage-backed security), the insurance company, or the seller of the credit-default swap, compensates the buyer. The cost of insurance was only around 1% of the amount being protected. For example, it cost $10 million annually to ensure $1 billion of mortgage-backed securities. If their bet didn’t go well, they’d lose $10 million. But if the securities defaulted, they’d get $1 billion. In essence we risked 1% in order to make 100% if they defaulted within the average timeline of these CDS which was about two years.

So it was a very skewed trade where you lost little if the trade didn’t work but you made a lot if it did work. Understanding credit-default swaps required specialized knowledge. Pellegrini educated himself through tutorials provided by Bear Stearns brokers and also at industry conferences. Their strategy involved targeting the riskier mortgage-backed securities. Mortgage-backed securities are divided into different layers or slices, known as tranches. Each tranche has a different level of risk. The top tranches like AAA are considered the safest, the bottom ones the riskiest. Paulson strategically targeted BBB slices, believing that a housing collapse would impact BBB-rated tranches more than the “safer” A ones.

His firm bought $25 billion worth of credit-default swaps with all the major banks. The total value insured was substantial even with only a 1% annual premium. Paulson established a new fund dedicated to betting against subprime mortgages on a large scale. However, finding investors was difficult because few believed in his strategy. As described in Zuckerman’s book, Jeffrey Tarrant of the hedge fund Protégé Partners said, “People on trading desks warned, ‘He (Paulson) doesn’t have expertise in the area,’ or ‘He doesn’t know what he’s doing’.” A Bear Sterns expert said: “You guys need to do more research on historical price appreciation.” - page When Paulson asked, “What are your models based on?” The expert replied: “Our models are fine. We’ve been doing this for 20 years.”

Paulson found himself bewildered by the lack of interest in his fund. He lamented, “I don’t know why they don’t get it…this is the trade of a lifetime.” He ended up scrounging together $147 million for his new fund, mostly from friends. There were other traders who foresaw a collapse, but they weren’t as determined as Paulson and didn’t invest nearly as much. Unlike Paulson, Michael Burry failed to convince investors to support a dedicated fund for betting against subprime mortgages. When investors started withdrawing money from his firm, he reluctantly began to sell his credit-default swaps.

Despite scoring half a billion in gains for his firm, he wondered what might have been if he hadn't been forced to sell some of his positions early. Andrew Lahde’s boss was furious at his bearish housing bets and fired him. So he set up his own hedge fund and earned $100 million for his clients, and $10 million for himself. When he retired, he wrote a letter sticking it to those who failed to see the warning signs of a crash: "I was in this for the money. The low-hanging fruit, i.e., idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking." Greg Lippmann at Deutsche Bank played a crucial role in facilitating credit-default swap contracts for Paulson.

Lippmann's own bets against housing were successful, but the troubles at his bank meant he was only given a few million as a bonus. Paulson had encouraged his friend, real-estate millionaire Jeffrey Greene to invest in his fund, but Greene decided to secure credit-default swap contracts on his own, which Paulson viewed as a stab in the back. Greene pocketed $500 million on his bets. Although all of these investors walked away very wealthy, none matched the scale of Paulson’s earnings. Paulson went all in, certain everything would collapse. In addition to shorting mortgage-backed securities, his team also shorted banks that had large quantities of subprime mortgages: New Century, Fannie Mae, Freddie Mac, Citibank, Washington Mutual, IndyMac, Bear Stearns, Lehman Brothers.

Paulson’s top trader, Brad Rosenberg, summed it up this way: “We had to get on as many trades as possible before it was too late.” The wait, however, seemed endless. By late 2006, the housing market was slowing down, yet the widespread mortgage defaults they anticipated hadn’t yet occurred. The main obstacle was the role of Collateralized Debt Obligations (CDOs). These complex financial products which bundled various types of debt including mortgage-backed securities masked the true risks in the market. They were like the sturdier lower blocks of a tower about to fall over, delaying the inevitable collapse.

Paulson reassured his concerned wife, Jenny, saying, “It’s just a matter of waiting.” The collapse began in late 2006 when New Century, one of the largest subprime mortgage lenders, reported an unexpected loss as its borrowers struggled to pay their loans. In 2007, two big hedge funds run by Bear Sterns that were heavily invested in subprime mortgage-backed securities imploded, triggering market chaos. The heads of Citigroup and Merril Lynch were ousted. And then, in September 2008, Lehman Brothers went under, the largest bankruptcy in U.S. history that sent shockwaves through the financial system.

The U.S. government stepped in to rescue the government-sponsored enterprises, Fannie Mae and Freddie Mac, guaranteeing over $300 billion of debt, motivated by a desire to stabilize the housing market. The fallout from the financial crisis was devastating: 10 million American homeowners faced foreclosure, unemployment soared, and retirement savings and investments plummeted as the stock market fell 60%. (from fall 2007 to early 2009) And yet, in the turmoil, Paulson saw an unprecedented opportunity, and it changed his life. Paulson & Co. earned $15 billion in 2007, with Paulson himself making $4 billion. Over the next two years, his firm added another $5 billion, with Paulson taking home $2 billion.

He was no longer a mediocre player but a Wall Street legend. Paolo Pellegrini, who was often overshadowed by Paulson, was rewarded with $175 million in 2007. The possibility that we’re in another housing bubble is a topic of debate. The financial crisis led to significant regulatory changes like stricter lending standards to try to avert another disaster. Yet, despite these measures, future bubbles can’t be ruled out. Financial markets are complex and influenced by a wide range of factors, including economic policies, market conditions, and investor behavior. John Paulson’s story is a powerful reminder of the value of in-depth analysis and independent thinking, even when few believed him. Sometimes, the most insightful decisions are those that go against the grain.

Investment, Economics, Finance, John Paulson, Credit Default Swap, 2008 Financial Crisis