It’s fitting that Hedge Fund speculator John Paulson gave his $400 million donation to Harvard’s School of Engineering and Applied Sciences (SEAS). The largest in the history of the school, it was described as an act of “stunning generosity” by President Faust. That’s her name. You can’t make this up. Paulson of course is known for his role in engineering with Goldman Sachs the infamous Abacus trade, a financial atom bomb designed to deceive while inflicting maximum damage on the market and society. And for what end? Personal enrichment. It would later require Goldman Sachs CEO Blankfein to attempt a lame — embarrassing really — defense of his firm’s “client comes first” reputation in front of Congress. Goldman would soon settle accusations of financial fraud with the Securities and Exchange Commission for $550 million. All the attention on “love to hate” Goldman deflected it away from Paulson, the principal behind the trade. In fairness, Paulson wanted to make a speculative bet that the systematically fraudulent subprime market built on “liars’ loans” would soon collapse. That judgment was correct. But simply shorting mortgage bonds was expensive, and the timing of the collapse was unknown so the costs could mount. Not a “great trade.” This is where the twisted genius of Paulsen and his co-conspirators came into play. The (too) clever feat of “applied financial engineering” was unprecedented, even in a world of financial engineering run amok. It was also an act of sheer frontal violence on a few, such as German Bank IDK. A rescue ensued, sending ripples beyond Germany. Whether bond insurer ACA Financial Guarantee Corporation was a victim or a co-conspirator all to eager to gorge at the fee trough next to Goldman remains a question in my mind. The lives of millions of unsuspecting innocent citizens were harmed or wrecked — some by suicide — by the financial crisis, which was no doubt made more extreme by the fallout from this synthetic atom bomb inserted into the system. Indeed, the Abacus trade and a series of Magnetar trades executed by JPMorgan and others, created leveraged and amplified losses on the stock of bad loans, willfully, with great attention to detail. It is difficult to fathom the workings of a mind capable of first masterminding and then actually pulling the trigger on a deal like Abacus. Merely profiting on others’ misery pales in comparison. These are harsh words. But the complexity of modern finance has shielded the public from seeing the full truth. And the financiers who do understand (including the ones on Harvard’s Board it would appear) prefer the legend that Paulson was simply a prescient, even brilliant trader in a game played by big boys where winning is what counts and whining is not welcome. I’m now going to speculate, but here’s how I think it went down: The Set Up The sub-prime mortgage market was known to be a cesspool of fraud, with many homeowner’s in houses they could not afford, thanks to low-life mortgage hucksters, poor regulatory oversight, and well-intended but imprudent public policy support for housing via the mortgage agencies. As a reported $15 million donor to the Center for Responsible Lending (some suggest CRL was a contributor to the problem by pushing lax mortgage underwriting standards), Paulson knew this better than most. While hard to imagine, some even consider that $15 million a strategic donation to dramatically expand CLR’s well intended but ill-conceived efforts, a premeditated, sinister dimension of the trade set up. That’s dark. Paulson understood that many borrowers were exposed to and unable to cope with even the slightest rise in interest rates if and when they should come. And they came in response to the price of oil going from $20 in 2002 to $80 in 2006 (on its way to $140). And the subprime market is linked to the $10 trillion mortgage market (keep this in mind for later). The investment banks had hoodwinked the (not-so-clever) rating agencies into using their own models to assign credit ratings to structured mortgage bonds, handing much control in the hen house over to the foxes. For money of course. The resulting boom in “structured finance” complex mortgage origination was mind-boggling, some of it with no economic purpose. Wall Street balance sheets were also recklessly bloated with risk, warehousing a lot of the “less risky” securities to pad their profits (and bonuses) with net interest income without disclosing the true risk to their blissfully ignorant management. Paulson knew these “weak hands” would be forced to sell in a panic if and when the market turned, accelerating the fall. The Trade Concept The boys at Paulson sensed an opportunity to “short” this ticking time bomb. But how to deal with the excessive cost of carry, particularly for the riskier junior tranches of sub-prime mortgages that would vaporize when the chickens came home to roost? This is where the twisted genius comes in. Paulson knew that Goldman would do pretty much whatever a profitable client like him wanted. He also knew that if he brought them this trade idea, they would likely front-run him on it, because that’s what they do. But he figured there was room for both of them, and Goldman’s need to get out of their own exposure to mortgages might just accelerate the anticipated avalanche itself, a beautiful self-fulfilling prophecy. The security selection for Paulson’s trade was based on his information advantage on pools of mortgage loans (legally/ethically attained or not I don’t know). The package was designed to create seemingly “low risk” senior securities that would in fact behave like very risky junior securities in default because of the deadly waterfall construction directing the priority of cash flows (this is the feature making it a financial atom bomb). Normally a bond rated say AA is not expected to drop in price more than 5% due to a credit problem. Worst case might be 20%. These bonds were purposely designed to go to zero (which they did), but because Goldman and Paulson colluded to fool the rating agencies, they still had the AA label. And the AA label made them very cheap to short (via purchasing insurance on them in the credit default swap market – another victim, probably AIG). Ingenious. Never mind that if and when these AA-rated securities went to zero (unheard of), it would trigger a panic first in the entire subprime market, which would then bleed into the $10 trillion mortgage market. Lost confidence coupled with massive scale and absurd complexity is a deadly mix, as Paulson knew devilishly well. This was the nuclear fallout feature of Paulson’s trade. Not only would his direct bet pay off, but the structural leverage in the sinister engineering of the deal itself would perhaps trigger or at least accelerate and accentuate a market panic, doubling or more Paulson’s profits. It would also lead, at least in part, directly to the collapse of Bear Stearns, Lehman Brothers, AIG, Merrill Lynch, RBS, Iceland, and Greece, and the worst financial crisis since the Great Depression, with all of the real world consequences still playing out to this day. Any concern Paulson may have had for the millions foreclosed out of their houses, some while serving in Iraq defending his freedom, and the many lives ruined in the process (the nuclear fallout) faded into the sweetness of a billion-dollar pay-day for himself. That takes a level of callousness that caused even my hardened high-yield trader friend to grimace at the time, “I don’t know how that guy can live with himself.” Well live with himself (and his art collection, he likes Calder) he is doing. And his plan to restore his reputation has worked well. Wait eight years until the memories fade a bit. Propose the largest gift (by the smallest increment that is respectable) in the history of Harvard, ensuring a hero’s embrace from the one institution with the best reputation cred on offer (no one ever said he was not shrewd with his money). For Harvard President Faust, it was quite a bargain! “Nature magically suits a man to his fortunes, by making them the fruit of his character.” –Ralph Waldo Emerson
CORRECTION: In response to my blog post above, I received a thoughtful and edifying note from David Beck at Self-Help Credit Union. David referred to the negative reference to their policy affiliate, Center for Responsible Lending, in my post. Here is the relevant paragraph in its entirety:
The sub-prime mortgage market was known to be a cesspool of fraud, with many homeowner’s in houses they could not afford, thanks to low-life mortgage hucksters, poor regulatory oversight, and well-intended but imprudent public policy support for housing via the mortgage agencies. As a reported $15 million donor to the Center for Responsible Lending (some suggest CRL was a contributor to the problem by pushing lax mortgage underwriting standards), Paulson knew this better than most. While hard to imagine, some even consider that $15 million a strategic donation to dramatically expand CLR’s well intended but ill-conceived efforts, a premeditated, sinister dimension of the trade set up. That’s dark.David set me straight on the facts with respect to Paulson’s $15M donation to CRL. It occurred after the crash, so could not have been the “premeditated, sinister dimension of the trade set up” as suggested by the Center for Consumer Freedom (CCF), whose article I cited. In fact, David explained that “CCF is a front-group set up by PR strategist Rick Berman to represent payday lenders and other corporate interests opposing public advocacy groups. See here. After reading David’s note, I actually remembered reading back at the time that Paulson had indeed made a donation to a housing advocacy group after he made his killing. I now recall thinking at the time, “he blows up all these unsuspecting people whose lives will never be the same, puts $1B in his pocket, and drops a $15M tax deductible donation on the table to assuage his guilt?” Sure wish he had given the $400M to support those hurt by the housing bust and for policy advocacy to ensure it doesn’t happen again, rather than giving it to Harvard! Thanks David for clarifying the facts and refreshing my memory!