The Greatest Trade Ever

gteOver the weekend I read Gregory Zuckerman’s The Greatest Trade Ever. The book details the story of John Paulson’s gutsy, ingenious (at the time) trade against the housing debt bubble. Paulson and co-manager Paolo Pellegrini not only identified the correlations between home price appreciation and mortgage defaults, but more importantly identified a way to manufacture huge profits if their thesis was correct. They purchased billions of dollars worth of CDS (credit default swap) insurance on a variety of subprime MBS debt related securities. This enabled them to limit their exposure to the annual premiums if the housing bubble continued, and earn many multiples on their return when the debt bubble popped. In the end, the Paulson hedge funds made tens of billions on their investments and pulled off the greatest trade in Wall Street history. The book also includes tales of a few others who were able to place the same trade, but focuses on the personalities of Paolo and John. (if you read The Big Short by Michael Lewis many of the same characters appear)

What I enjoyed about this book most is that it focused not only on identifying the housing bubble – which many did – but on the more difficult task of developing and implementing an investment portfolio to earn outsized gains based on this view. This was not easy as most investors were not well versed in CDS and did not have the ability to trade them. It required ‘rolling’ the CDS to ensure the subprime MBS in your investments were the most recent – and most risky – created. And at the time, most on Wall Street thought your were crazy to bet on a national housing price decline – something that had not occurred since the Great Depression.

What did Paulson do with the proceeds of his great trade? He catapulted them into another massive winning trade purchasing CDS on the investment banks that were on the hook for paying him his CDS payouts. Bear Stearns, Lehman Brothers, Merrill. Just an amazing run … and a fun read for investors everywhere.

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