“On the screen before her was a figure she had never seen before, at least not on an ATM…$45 million, newly deposited in their joint account. It was Pellegrini’s bonus for the year….”
Paolo Pellegrini’s wife Henrietta could hardly believe their good fortune.
A few short years ago, Paolo had been living in a tiny one bedroom apartment. Now, they were set for life.
Pellegrini was John Paulson’s right hand man. Together, they made the trade of a lifetime — shorting the housing market.
Wall Street Journal reporter Gregory Zuckerman tells the fascinating story of their bet in his book The Greatest Trade Ever.
A Dangerously Overheated Market
By the mid 2000’s, the housing market was dangerously overheated:
“By 2005, 24 percent of all mortgages were done without any down payments at all, up from 3 percent in 2001. More than 40 percent of loans had limited documentation, up from 27 percent. A full 12 percent of mortgages had no down payments and limited documentation, up from 1 percent in 2001.”
Lax mortgage standards drove rapid increases in housing prices.
After having barely grown at all in real terms from 1975 to 2000, prices were suddenly climbing 7% a year. Pellegrini showed Paulson that housing prices would have to fall by 40% just to get back to their historical average.
“‘This is our bubble! This is proof,’ said Paulson.”
Convinced a housing crisis was coming, Paulson and Pellegrini placed a massive bet against subprime mortgages.
Placing the Bet
Paulson bought insurance on subprime mortgage bonds as a way to short the market. Should the housing market falter, that insurance would become much more valuable.
When they started buying, the coverage cost next to nothing. Paulson and Pellegrini were almost alone in thinking the housing market would crash.
“Could it be that no other investors had caught on?”
The pair snapped up insurance on billions of dollars worth of mortgage bonds. If the housing market came apart, their gains would be historic.
Conviction Is Everything
At first, Paulson’s trade seemed like a dud.
By mid-2006, their investments were falling in value. Everyone from Goldman Sachs to Fed chair Ben Bernanke said the housing market was solid — even as lenders churned out bad loans faster than ever.
Even once a few lenders began to fail later in the year, Paulson’s positions barely budged.
At this point, it would’ve been easy for them to conclude that the market was rigged. Many traders would’ve just dumped their positions and moved on.
But not Paulson and Pellegrini. Stubbornly, they held on.
Paulson and Pellegrini had conviction. That conviction would ultimately make them billions.
Wrap-Up
Would you have joined Paulson and Pellegrini’s trade? Why or why not?
Leave a comment and let us know!
Tomorrow, we’ll see what happens when the housing market begins to crack…
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