Can You Explain How To Get Rich Quick?  CHOIRE SICHA  ·  JAN 15 2008

Hedge fund manager John Paulson and investor Jeff Greene both became insanely wealthy over the subprime mortgage crisis. But how? (Parsing the Wall Street Journal is hard!) So Paulson "had to think up a technical way to bet against the housing and mortgage markets." His guys bought up "collateralized debt obligation" slices, which are repackaged mortgage securities. (Kind of lost already!) His firm also bought up "credit-default swaps." Paulson then opened a hedge fund shop, taking $150-million in mostly European money to back his scheme. Then he hung on. Now "he tells investors 'it's still not too late' to bet on economic troubles." Neat! Paulson's ex-friend Greene did much the same thing, getting an investment bank's participation for assets for the swap. Then... something happened and he bought three jets and a 145-foot yacht. Finance for idiots explanations eagerly sought! (And is there any small-scale way to do such things? Or do the abilities of regular people to make money on a crisis stop at short-selling and investing in Halliburton?)

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There are 9 reader comments

Brock18 15 200812:18PM

Yes, I know what CDO's and swaps are. Explaining them in any great detail would take some time.

You can buy CDO's at the retail level, but it's not a good idea at the moment. You simply can't buy swaps at the retail level (unless you have $$$ (tens of millions) no bank will enter into one with you).

Basically all this guy did was short-selling, but since you can't actually short houses he had to create a synthetic instrument (that's the swap) that had the same financial effect as shorting houses. He also shorted the CDO (which is a debt obligation that trades on a public market, so you can short it (unlike houses themselves)). When people defaulted on their mortgages the value of the CDO fell to pennies, and he made lots and lots of money.

Unless you're a pro, stick to your short-selling and Halliburton. It works well. Very, very few investors beat the general stock market over the long term.

Adam41 15 200812:41PM

The long and short of it is that there are guys out there doing everything under the sun, investment-wise, and so there will always be someone who is perfectly positioned to benefit from an event like the sub-prime lending crisis.

But identifying those people and then asking them how they did it is not likely to be productive, because the conditions they benefited from are not likely to repeat themselves.

Say 10,000 people each flip a quarter 10 times in a row. Chances are, 9 or 10 people will get all heads. We wouldn't identify these guys as coin-flipping gurus and ask them how they did it, but that's exactly what they do on wall street.

Alex Chee58 15 200812:58PM

It's imaginary money. If you could write fiction with money instead of words.

Think Gogol's Dead Souls for the New Millennium.

Hey Choire! Glad to see you here.

greg.org13 15 2008 1:13PM

they found an arbitrage opportunity and stuck with it until it panned out. In a rational market, the price/value of the swaps should have been linked to the price/value CDO's. The swaps were insurance against the risk of CDO's losing value; higher risk should => higher price.

The holding on part of the story is not insignificant; they did their analysis of the risks and then had to wait for the rest of the market to catch on, realize how screwed they all were, and then to push the prices in the directions Paulson had anticipated.

Too bad there's not a way to short Richard Prince... because I know where those prices are heading, it's just a matter of when...

Pranav20 15 2008 2:20PM

Umm, do you really need all the !! to glorify your ignorance?

The financial markets tend to be a zero-sum game - someone's losing, someone's winning. In most market conditions, that's about 50-50 - i.e., stable economy.

When, there's a massive tilt towards one side of the see-saw, and that side loses - the few small people on the other side will score big money. Paulson & Co, is now the second largest/richest hedge fund in the country, if not the world (assuming you dis-include sovereign funds).

As for the dripping contempt/sarcasm re "bet on economic troubles". It "feels" wrong, but hey - you wanted a capitalist democracy, right!?

As for CDOs and CDSs, no you can't do them. It would take a very seasoned investor who would bet in those markets - and most of us aren't. And even if you did, and somehow lucked out and made money, it would be pretty minimal in pure, absolute dollar amount to justify the cost/time of the transaction.

As an earlier commenter said, Paulson was essentially selling short - i.e., selling something you don't own (by borrowing), betting that it falls in value, so you can buy it back for cheaper, and pocket the difference of the prices. Most retail investors (i.e., me and you) will not indulge in short selling, since the loss potential is *unlimited* (I short ABC for $50, hoping it goes to $40, and i make $10 - instead , it shoots up to $200, and I've lost $150). Also, shorts are usually induced for small periods of time, trying to gain some arbitrage profit due to a perceived mispricing - hence, for a retail investor, the commissions will heavily bite into the return you earn.

Aaron Pressman45 15 2008 5:45PM

Credit default swaps -- which are totally and utterly unavailable to ordinary folks -- are not like shorting stocks at all. It's more like buying an insurance policy against some random bad event, in this case defaults on mortgage loans. It's not that different from insurance against a flood or a terrorist strike. Paulson pays a fixed amount and profits only if the bad event happens. The worse things get with the mortgages, the more he profits. The most he can lose is the fixed amount he paid for the swap.

jmh54 15 200811:54PM

OK, here's one decent explanation of hedge-funds-for-dummies, since you asked...

http://www.brookings.edu/opinions/2007/1219_hedgefunds_young.aspx?p=1

guy49 16 2008 8:49AM

A small investor can buy put options. The are relatively inexpensive, buy greatly increase in value if the underlying security drops in value. If the underlying security (lets say a housing or real estate index) does not drop, the option expires worthless. If the market does crash, the put option becomes many times more valuable.

This thread is closed to new comments. Thanks to everyone who responded.

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