Felix Salmon

John Paulson’s high-risk hubris

By Felix Salmon
January 14, 2010

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.

10 comments so far | RSS Comments RSS

John Paulson had to take on the risk the way he did. I run a fund that was massively short the market but did not use derivatives to express my view. It was the biggest mistake I made. I give him all the credit in the world for not only having his view but expressing it the way he did. He is a man guided by conviction and if he lost their money that is part pf the game. You make the type of money that he made by having conviction. By the way the money that he made was the most money ever made in such a short amount of time. Also, I regret not following my own conviction with more action like Paulson did..

Posted by blackswanmiami | Report as abusive

Very lucky guy with strong convictions? The bookies are laughin’. Oh how they’re laughin’.

Posted by Uncle_Billy | Report as abusive

It is an important distinction that has largely disappeared with financial deregulation between investing, as described in the closing paragraphs where wins are wins for both the investor and the overall economy, and playing the market which is gambling and a zero sum game.

Added value and value creation have evaporated from finance as it has transformed itself into rent seeking (and now with proposed Cap and Trade rules tax farming) and the rent seeking ethos is blind to value creation because it does involve real economy risk.

Posted by jnewman | Report as abusive

“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.”

It is equally reasonable to conclude otherwise. (see Shiller). Felix, please check your embedded bias. You deserve a prosperous retirement.

Posted by maynardGkeynes | Report as abusive

Investors in his Credit Opps Funds knew the investment thesis, the cost and the elevated risk. This was reflected in the Credit Fund (liquidity) terms which were very different than his other Funds. Investors in his “unspectacular” Merger Arb Funds had minimal exposure to the trade but were aware of it nonetheless. From Zuckerman’s book it seems to me that all of his investors were aware of the “trade,” and while some chose to walk away, others stayed and are quite happy today.

Posted by Morgan_03 | Report as abusive

“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?”

You’re misrepresenting what he did here. He didn’t bet the entire fund on this trade, he took a small part of the fund and made a bet at long odds.

I buy options and expect payoffs of 100-400%, but I use only small proportions of my portfolio and try to include some hedging.

I didn’t find the returns of Taleb’s fund at all impressive, given that this was the ultimate black swan event. No one had 100% of their money in the fund, he himself says the vast majority of his wealth is in Treasuries.

Posted by Bob_in_MA | Report as abusive

That’s why I typically don’t short. It is very difficult to time your trades, and shorts, because of the negative carry, must time a peak fairly precisely. I also once worked for a bearish hedge fund — that was a consistent difficulty — it would be for anyone in the same trade.

The closest I have come to an answer on this is the following:

http://alephblog.com/2009/12/23/on-contr arianism/

Posted by DavidMerkel | Report as abusive

“The fact is that Paulson did take bold risks, on factors which were entirely out of his control: When would the bubble burst?”

“Out of his control” in this context is meaningless. Only investments where you have some executive control escape this description, and then only marginally. Otherwise, all trades and investments are essentially passive probability plays. As for “bold risks”, I don’t see how a finely judged and strictly limited risk bet qualifies for that moniker, not unless you want that phrase to become meaningless as well.

“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.”

Hyperbole, Felix, sheer hyperbole. Seems to me Paulson was just doing what traders are meant to do, namely trying to strike a decent balance between risk and reward.

In this case, he certainly wasn’t alone in thinking it an unusually sweet opportunity.

Posted by Basho | Report as abusive

“Otherwise, all trades and investments are essentially passive probability plays.”

This absurd. Surely you realize that one is not balancing risk and rewared unless he holds a well-diversified portfolio of long positions in stocks. Hedge funds do not diversify and as such seek high returns, but of course with high risk. In addition, there is also substantial liquidity risk with hedge fund investments. Hedge fund investments cannot be sold as easily as a public US stock. As a result, investors clearly demand compensation for this excess risk.

In addition, realize that derivatives and short positions are fundamentally different from long stock positions. In fact, buying an option (like a CDS contract) is equivalent to using leverage to make a long stock investment. As such, options are without question incredibly risky, not just from a purely financial perspective, but also from the perspective of investor utility functions, as discussed in this article. Investors get hurt much worse by large losses than they benefit by large gains. Would you bet your entire net worth right now on a coin-toss? Of course you wouldn’t.

There is no question Paulson took an incredible amount of risk with such large positions in CDS contracts.

Think of this way: say you play the hard-eight bet on a craps table: it will pay off 8 to 1 while the odds of you losing the bet are not good at 8.5 to 1. Say you lose your first $400 million bet, but you hit your second one, winning $3.2 billion. You just made $2.8 billion profit. Surely you wouldn’t consider that a great investment.

Posted by stevenstevo | Report as abusive

I thought I’d weigh in on Salmon’s interesting piece, given that it concerns John Paulson, and my recent book, The Greatest Trade Ever.

Were there risks to Paulson’s trade? For sure. Losses of 8% a year for a few years certainly add up. Then there was the reputation risk—if the trade hadn’t worked, Paulson would have been know as the guy who bet foolishly against mortgages after the experts warned him not to. Paulson likely wouldn’t have been able to try anything similar ever again. Further, when the trade finally started to pay off in early 2007 and Paulson piled up billions, he held on to most of his positions rather than cash out, transforming the trade, in my view, into a riskier one. He suddenly sat on huge profits that easily could have evaporated (as some of them did when the subprime market rallied in the summer of 2007).

But the dangers to Paulson’s trade weren’t outsized and it’s fair to say that he wasn’t acting an “extremely risky” fashion. So I disagree with the thrust of the Salmon piece.

Paulson was using credit-default swaps, which have a much more limited downside than a short position on equities or many other negative bets. The embrace of CDS was a sign that Paulson was indeed risk-averse. And it is unlikely that Paulson ever would have faced 8% annual losses for an extended period. If he was wrong on his trade and housing held up or kept rising, most of those who took out risky mortgages would have refinanced their loans (most of which had 2-year teaser rates), ending his CDS trade.

Just as important, Paulson was smart enough — and risk-averse enough — to place most of his subprime bets in a separate fund and lock his investors up for two years in that fund. That way, if he was wrong, it wouldn’t cripple his entire firm. That was good business sense, but also another sign of watching the downside

It’s a misunderstanding to say that Paulson “simply had to pray that it would happen before his investors deserted him.” As I note, they were locked up for two years, at least those in Paulson’s credit funds. And they were well aware of the potential downside, it was all spelled out and quite obvious, since they were buying CDS contracts with set payments. I’m not sure betting billions on the health of the rail industry, a la Buffett, is less risky — or suggests less “hubris” — than entering into CDS contracts with set costs to buy insurance on toxic mortgages.

And to say there’s a “Ponzi aspect” to what Paulson was doing is a bit silly. It’s sort of like saying Pimco is running a huge Ponzi scheme because it takes in money from investors each day, and – get this — uses it to buy investments that the firm likes. Even if new money came it, the returns to Paulson’s investors would have been based on their initial investment and when it was made.

Oh, and Andrew Lahde did complain about his back, and the stresses of his job as a hedge-fund manager. But that’s not why he quit the business. He simply enjoys spending time on the beach with beautiful women. Thanks for taking the time to read my book and for the interesting discussion! Greg Zuckerman

Posted by GZuckerman | Report as abusive

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