John Paulson’s high-risk hubris
Malcom Gladwell is no particular expert on financial markets. But he has said, according to Moe Tkacik, that of all the people he has interviewed, he most identifies with Nassim Nicholas Taleb — in a 7,800-word profile which explains just how hard it is to invest in markets when your strategy involves losing money every day and waiting for a tail event.
With a few notable exceptions, like the few days when the market reopened after September 11th — Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. “It’s like you’re playing the piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and the only thing you have to keep you going is the belief that one day you’ll wake up and play like Rachmaninoff.”
So I was very puzzled to pick up this week’s New Yorker to find Gladwell write about John Paulson in very different terms. (The story is behind a firewall; it’s not particularly worth paying for, although the magazine as a whole is a fantastic value.)
Gladwell in this essay characterizes Paulson as “The most successful entrepreneur on Wall Street — certainly of the past decade and perhaps even of the postwar era”. I think this involves a very narrow criterion of what makes successful entrepreneur. Later in the essay Gladwell talks about how “people who work for themselves are far happier than the rest of us”, and in my experience hedge-fund managers — who do after all work primarily for their clients — are not in fact particularly happy people. They might not have a single boss telling them what to do, but the pressures of managing other people’s money are immense.
What’s more, any hedge fund manager playing a version of the negative-carry trade has it much worse than most of his peers. Warren Buffett says that the first rule of running other people’s money is don’t lose it; the second rule is “don’t forget the first rule”. One of the reasons Taleb gave for giving up running money day-to-day was precisely the incredible toll it takes when you’re losing money almost every day. Andrew Lahde, another huge winner from the subprime crisis, also quit the business, citing the way in which the stress of the job destroyed his health. Gladwell himself talks about how successful entrepreneurs will deliberately harm their own reputation if it means improving their risk-adjusted returns. That’s not a route to happiness.
And in any event, although success is often measured in dollars on Wall Street, even Wall Streeters don’t end the analysis there. Is Paulson really a more successful entrepreneur than, say, Charles Schwab, just because he arguably has more money? For that matter, Mike Bloomberg has not only founded a hugely successful company which can run very well without his presence; has also made more money than Paulson. Even if Paulson does count as an entrepreneur, it’s not at all obvious how he counts as being more successful than Bloomberg.
But I digress. The point is that Paulson, like Taleb, is a negative-carry kind of guy. Positive-carry investing can take you a very long way, and indeed it’s the foundation of the entire global banking industry, but it’s negative-carry trades which have the ability to score enormous home runs like Paulson’s. Many big hedge-fund managers avoid negative-carry trades, because they feel too much like a gambling habit: you pay out money every day in the hope of scoring a huge jackpot. That’s not the kind of strategy most investors in hedge funds particularly like, and indeed the likes of Taleb take great care to sell their funds as hedging devices — a place to put a small amount of your net worth for insurance purposes — much more than as absolute-return vehicles.
Paulson is no Taleb: his clients are pretty typical hedge-fund investors, including rich individuals who really hate losing money. Which means that his negative-carry trade — buying credit default swaps which obligated him to pay out millions of dollars in annual premiums, with no income attached at all — was extremely risky, from a business point of view. Gladwell quotes Greg Zuckerman explaining that “the most an investor could lose would be 8 percent a year”, while the upside (as we saw) turned out to be astronomical. But it doesn’t take many years of 8% losses — or any losses at all, for that matter — for clients to pull all their money out of your hedge fund.
Paulson was not actively trying to burst the bubble, in the way that George Soros pushed the pound out of the European exchange-rate mechanism with his legendary 1992 negative-carry trade. Instead, he was just the biggest of a long line of investors who saw that there was a housing bubble and tried to find a way to go short. Those who were right but too early disappeared into the footnotes of finance — if they were lucky to get even that. They learned the hard way that “the market can stay irrational longer than you can stay solvent”. Paulson was like them: he felt certain that the bubble was going to burst, but he didn’t — couldn’t — know when, and he simply had to pray that it would happen before his investors deserted him.
What’s more, there was no guarantee that even if the housing bubble did burst, that Paulson was going to make lots of money. To be sure, he had a lovely model, put together by his colleague Paolo Pellegrini, showing that if house prices stopped rising, subprime mortgages were going to suffer enormous losses. But on the other hand, all the banks and credit-rating agencies also had models, showing that the bonds that Paulson was betting against had almost no chance of defaulting. When your model shows one thing, and everybody else’s models show something else entirely, there’s a very good chance that your model is flawed.
Gladwell’s thesis, in this essay, is that Paulson is actually very risk-averse, rather than being a big risk-taker. “Would we so revere risk-taking,” he asks right before introducing Paulson as Exhibit A, “if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?”
The fact is that Paulson did take bold risks, on factors which were entirely out of his control: When would the bubble burst? How long could he hold out before his investors deserted him? Indeed, Paulson’s strategy had a Ponzi aspect to it, where he would try to make up losses with new investments: “He bought CDS contracts by the truckload,” Gladwell writes, “and, when he ran out of money, he found new investors, raising billions of new dollars so he could buy even more.”
Warren Buffett has described his most recent mega-acquisition, that of Burlington Northern, as a huge bet on the long-term health of the US economy. That kind of bet has made him more billions than even Paulson can dream of, and it’s a bet made in the positive-sum game of the equity markets. Stocks can and do rise over time, and a well diversified stock-market investor has been able to reasonably expect to see some kind of profit over the long term.
Paulson, by contrast, was playing in the zero-sum derivatives markets. In order for him to make any money at all, somebody else had to lose. If I bought a random basket of derivatives contracts and held them over the long term, my expectation would be that I would end up with less money than when I started.
The amount of sheer hubris involved in Paulson’s trade, then, is enormous. He had to have an unshakeable faith in the infallibility of his own models, in a world where no model is infallible. He had to have entirely irrational confidence that the bubble would burst before he ran out of cash. And he had to do all of this with other people’s money: while he was already personally set for life when he entered into the bet, he couldn’t say the same thing about all of his clients, who didn’t necessarily share his shoot-for-the-moon risk profile.
After all, Paulson’s clients had invested their money with a manager whose returns, Gladwell quotes Zuckerman as saying, were solid, careful, and decidedly unspectacular. Did Paulson decide to put them into a risky derivatives trade with a negative carry just because he’d already made lots of money and was now aiming for posterity? I’m sure all those clients are very happy with Paulson today. But if you’d told them about his strategy while the bubble was still inflating, they might have had a very different opinion indeed.
Update: Zuckerman responds, in the comments.