$4 BILLION Profit - The Greatest Trade in History | Legends of Trading

as he sat in his New York office in 2004 in a fashionable building in Manhattan John Paulson reflected on his frustrating career most people would have considered his achievements to be the height of success running his own hedge fund with two billion dollars under management and 100 million dollars to his own name but he felt like his ability was underutilized he was destined for more back in his college years at NYU his classmates nicknamed John JP a reference to JP Morgan the legendary banker and a nod to John's outstanding abilities and huge ambition following graduation and a reasonably successful career on Wall Street during which time he gained a reputation as a playboy John decided in 1994 that his days of partying were losing their appeal he knew it was time to get serious and if he wants to create substantial wealth he'd need to start his own company he decided to form porcelain Co a hedge fund focusing on merger arbitrage which was his speciality at the time John had a lot of contacts and expected to attract a lot of money for his new venture but after sending out over 500 announcements he didn't get a single response it was a humbling experience being rejected by friends having people cancel meetings at the last minute and hearing no Afton no he failed to attract any clients at all and so went ahead with two million dollars of his own money poorly earned from his Wall Street career and partly from a chance investment in a former colleagues successful brewery startup that created the beer brand Samuel Adams after a lonely first year John riddled with rejection asked his father if he was in the wrong business maybe there was something wrong with him the thing that kept motivating him was his favorite quote by Winston Churchill who said never give in never give in never never never and here he was in 2004 ten years later he had earned his two billion dollars under management the hard way and sweated for every single investor yet in terms of booming Wall Street with his super competitive traders using high-powered computer models John's soft-spoken calm demeanor and intensive research focused investing style was considered to be unspectacular at 48 years old he was in the twilight years in this fast paced industry but he's still longed for that one big trade that would prove his worth not just another forgettable money manager in an overcrowded market he was JP and he belongs amongst the elite despite having two billion dollars under management Paulsen & Co was only a small company compared to competitors it had nine members of staff one of which was a 47 year old analyst named Paolo Pellegrini after graduating from Harvard rather than moving back to his home city of Milan Italy Pellegrini starts the career in investment banking although he was highly intelligent and great with research he struggled to woo clients and found his career stagnating out of work in 2004 he applied for a job with Paulson an old friend of his to become his chief financial officer he didn't have high hopes of getting the job but he was desperate unfortunately when he spoke Paulson he found the job was already taken instead he asked if he could have a job even as an analyst this was a surprise to John as analyst is usually an entry-level job for young people fresh out of college not a 47 year old Harvard graduate with a resume featuring some of the world's top investment banks but despite this he accepted and Pellegrini stars to that paulson & Co as his last shot of making a success of his disappointing career despite putting in long hours analyzing international mergers after a year Pellegrini just wasn't making much progress his work was usable but he was often left behind from important investor meetings and other employees weren't so keen on him he was disappointed with his work and so was Paulson Pellegrini was becoming concerns about his position in the company and knew he needed to come up with something special or risk ending in failure once again I am a homeowner and that's why when financial pressures build you can call Ameriquest the company that helps you use that resource by the height of the dot-com bubble in 2000 household borrowing was up almost 60% in just the past five years this was largely thanks to the invention of securitization all the way back in the late 70s which basically involves pulling together different loans to create debt securities that could then be sold on to investors these started to really take off in the late 90s and early 2000s leading to the amount of money available to borrow increasing at an alarming rate after the dot-com bubble burst the Federal Reserve began slashing rates this low borrowing cost led to home prices starting to surge after 9/11 this began a chain of events that led to an unhealthy rise in the property market and lending that kept prices on a steep incline best summed up by a viral video from around the time of a computerized rollercoaster ride based on the property price chart that ends with an ominous rise waiting for the inevitable drop lensing companies were like crazed addicts looking for more customers to lend to the riskiness of the lows didn't matter anymore since they could use securitization to repackage the loans and shift the risk on to other investors this led to companies becoming dangerously relaxed with their lending criteria and pushing for customers regardless of their credit history or income as the Federal Reserve began to raise interest rates again in 2004 paulson started to get concerned about all of the borrowing he decided it might be the right time to start looking for some protection for his fund however it seems other investors had the same idea and put options for the S&P 500 index which would pay out if prices fell were already way too expensive he looked into shorting financial services companies but some of them had recently had takeover offers which were squeezing short sellers by sending prices higher leading to big losses he looked into alternatives to protect their portfolio but nothing seemed ideal this was Pellegrini's chance to show his worth not sure if he was stepping out of line but willing to take the risk anyway he approached Paulson in the hallway at work and suggested that the firm bought credit default swaps a credit default swap c.d.s would be like an insurance contract the firm would pay an annual premium and if the company's stock prices fell they would be Jew a big payout if they rose the only loss would be the premium that's paid out for the CTS paulsen seeing the potential miss asked Pellegrini to research how they could buy CVS contracts on financial companies since that was the area he was most concerned about so Pellegrini went ahead and arranged tutorials from different brokerage firms to learn exactly how they worked however after two months of dipping their toes in the water with CVS contracts on financial firms Paulson & Co had only incurred small losses it was clear that it would be difficult to take a position against a single financial company in 2005 the housing and debt markets were still a major concern but financial companies of big lenders like Countrywide Financial was still gaining the losses from paulson and CD s contracts were causing his returns to suffer in comparison to competitors [Music] one day as Pellegrini was discussing countrywide with paulson he suggested an idea rather than the company's why don't they figure out how to short mortgage securitization if they go bad they isn't the risk of a takeover that can increase the value like with a company instead they would stay bad the idea intrigued paulson and sparked the start of a big change in direction for paulson and co over the next few weeks they brought in experts from different brokers to teach them about the mortgage securitization market they were amazed to find that there were separate categories for subprime mortgages the riskiest lowest quality mortgages he urged Pellegrini to find ways to bet against the riskiest mortgages encouraging him over and over again dig deeper Paulo dig deeper by the end of the summer Paulson and co-owns CD s contracts protecting 100 million dollars of subprime mortgages from defaults or losses and they only paid 1 million dollars for them Paulson couldn't figure out why no one else was buying such cheap protection it soon became clear that they were too early with the trait as Paulson realized they were up against a wall of liquidity borrowing by Wall Street banks was surging do you realize these guys are leveraged 35 to 1 he said it was agreed that Pellegrini would shift to focusing on the subprime market full-time this was a sign of the first major shift in porcelain Co away from their core business in merger arbitrage investing and this change in focus for Pellegrini soon proved to be vital as a meeting with mortgage investors Pellegrini managed to speed to the CEO of new century a big lens that are offered home loans to people with bad credit he was asking him about the possibility of default on the loans if mortgage rates rose thinking that he found the fatal flaw in new century's approach however the CEO was cool about it and told him that they had just refinanced the loans if there was a risk of default they received such high fees from refinancing deals they was worth it for them so they're just keep refinancing the deal as long as the underlying properties kept increasing in value therefore no defaults homeowners want to get cash and simplify your bills ask about a combo loan from countrywide it's a refi that you could use to combine your first mortgage your second mortgage your car loan and all your high rate credit card debt into one easy loan with one low monthly payment with this news porcelain Pellegrini realized they'd made a mistake the CBS protection of ed boards wouldn't pay out because they were covering mortgages on properties that had already increased in value enough they could easily be refinanced they sold their CBS contracts and instead started buying more on recent subprime mortgages instead ones that hasn't gone up in value yet and would therefore not be able to be refinanced if mortgage rates went up but they knew things wouldn't be that easy the only way their trades would work is if the real estate market hits unsustainable price levels and began to fall leading to borrowers on a large scale being unable to refinance their loans as mortgage rates went up the problem was this didn't seem possible since everyone saw that home prices hadn't declined on a nationwide level since the Great Depression Pellegrini sensed trouble and got to work trying to figure out new ideas to solve this issue late one night he was crunching the housing data looking at annual price changes across the country he decided to add a trendline and do some regression analysis to smooth the movements in the market suddenly the answer was right there from 1975 prices after inflation had gained just 1.4 percent annually but had been shot up by an average of 7% per year in the next five years to 2005 he could see that home prices would need to drop by a massive 40% to return to the historic trendline even more encouragingly he could see that anytime the housing prices dropped in the past they actually went through the trendline this meant that any correction would be extremely severe he showed his findings to paulson finally things seemed clear they had proof the markets were in a bubble and the first key piece of research as the basis for their trades they could see that even if prices just flat lines homeowners would be under extreme of financial pressure and there would be losses of 7% for the typical pool of subprime mortgages but if home prices didn't just flatline but actually fell even just a drop of 5% would lead to losses on the mortgages of 17% they had no idea how much prices would fall but suddenly these underpriced CTS's seemed like a gold mine Paulson ramped up his buying of mortgage protection purchasing up to five hundred million dollars per day it was dirt cheap since they were only paying 1% annually for the amount being protected it almost seemed too good to be true by spring 2006 they had reached their limit of what they could handle and although trying their best to stay silent on their findings and not reveal their secret to anyone they set out to raise money for a new fund to take advantage of what they thought was the trade of the century despite many new funds raising billions of dollars horses new funds only managed to raise 147 million dollars which included 30 million of his own money it was a disappointing amount but he was afraid the opportunity was drifting away and so he decided it was now or never time to make use of the money and start buying they would mix up their trades between CVS contracts on slices of selected mortgage bonds and the entire ABX subprime mortgage index that was launched in 2006 their brokers were so shocked that anyone would want to buy the CD s contracts that they would actually speak to Paulson and his team to try to encourage them to stop since they were sure they were making mistake and wants to protect their client by late 2006 Paulson had gained a bit of a buzz and as more investors became wary of the property market they chose to invest money in portions new funds leading to the fund having seven hundred million dollars under management they immediately spent it all on mortgage protection and launched a sister fund to keep making similar traits despite the huge positions that Paulson was holding he still began to get concerned about the consequences if a crash did happen who would be liable for all the insurance he had bought he didn't know who was selling him all of this insurance but he did know that if the seller was rubble it would be a bad situation for the investment banks and maybe bring down the financial system they needed to broaden the trade and prepare for this one of the companies they shorted was new century their share price had been increasing as they announced good results quarter after quarter Paulson thought they were lying and he knew that if they weren't lying their end of year results would show it since those would have to be audited and would therefore reveal the truth immediately he got a call from a salesman cautioning him about shorting the shares explaining that David Einhorn was the largest shareholder and would have done his due diligence but Paulson stood his ground he felt that he was right and he was in February 2007 they announced their earnings for the 4th quarter of 2006 and it showed so many of their borrowers were struggling to pay their loans that the company was having to bad clones that is sold to the banks they were in trouble the next day their stock dropped 36 percent this was portance first big profit as a result of that news the ABX index also dropped five points for paulson at one point moving that ABX index was worth 250 million dollars so a five point drop meant porcelain Cove had just gained 1.25 billion dollars in just one morning a few weeks later when the fund was due to report to its investors the head of Investor Relations complained about a misprint surely the monthly gain in February couldn't be 66 percent it must be 6.6 percent right no the resolves were correct and the fund was flying [Music] over the coming months a battle ensued the big players involved in the market such as Bear Stearns battled to prop up the market and encourage buying in subprime mortgages Paulson was having some argue against his investors his team and even Pellegrini who wanted him to sell his CBS positions and avoid losing the gains that they had made which at that point stood at two billion dollars but Paulson thought the bonds would go all the way to zero so he ignored everyone and held on the trick for him would be to exit the positions just in time to actually be able to take a profit from the financial institutions that would inevitably be in trouble knowing how much trouble investment banks would be facing Paulson and his team got to work trying to estimate how exposed certain banks were the deeper they looked the more they realized just how over leveraged the banks were and how many of their assets were difficult priced and difficult to sell and would therefore cause major problems yet the c.d.s contracts to insure against investments in these companies would cheap it was just two hundred thousand dollars to insure against 100 million dollars of Bear Stearns debt Paulson began buying up CDs protection on all the major players as the inevitable collapse and financial crisis began to take hold paulson began to offload his positions the ABX index had crashed below 50 and investors around the world were moving away from risk in a panic he had ignored the complaints from his team and investors for long enough and maximized his profits but now it was time to start selling off before it was too late by July 2008 subprime investments had completely crashed and Paulson had exited almost all of his trades in the space of just two years the to credit hedge funds that Paulson had set up had invested 1.2 billion dollars and returned a profit of 10 billion dollars his other funds had also made their own gains of 10 billion dollars as well everyone had told him that his investments were worthless and that this idea wouldn't work but he stuck with his guns and went down in history for achieving the greatest trade of all time [Music] shortly after this paolo Pellegrini was on holiday in the Caribbean with his wife when she decided that she'd go to an ATM machine to withdraw some cash she checked the balance just as his bonus had hid the account she knew things that the fund had been going well but Paulo had been so secretive about their trades that she didn't know quite how well it was going she couldn't believe her eyes the balance in the account was 45 million dollars [Music] Pellegrini who joined paulsen as an analyst in desperation as a last-ditch attempt to save his failing career and improve his terrible financial position was now worth 175 million dollars after just a few years and as proportion he had finally hit the elite level that he had been dreaming of his personal cuts from this amazing success was four billion dollars the largest one-year payout in the history of the market JP had finally proven himself thanks so much for watching the video I hope you enjoyed it and found the story as inspirational as we did if you did like it then please do hit and thumbs up button and for more stories like this check out the legends of trading and investing playlist that's in the description box and don't forget to subscribe for more see you in the next one

Channel: The Duomo Initiative

Views: 252,625

Rating: 4.9289789 out of 5

Keywords: greatest trade, greatest trade ever, greatest trade in history, best trade ever, greatest trade of all time, best trade of all time, legends of trading, legends of investing, john paulson, paulson and co, subprime crisis, financial crisis, sub prime, subprime, housing market, paulson, paolo pellegrini, financial markets, legendary traders, duomo initiative, the duomo initiative, duomo method

Id: Bs3CBO_2WFE

Length: 22min 59sec (1379 seconds)

Published: Mon May 11 2020