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John Paulson, a Wall Street legend Earning $15,000,000,000 in 2007 from the 2005 Housing Crash

In 2005, the housing market experienced a surge in investment, leading to billions of dollars in financial success. However, the wave broke, and 1 in 10 Americans couldn’t afford their mortgage, leading to nearly 10 million Americans losing their homes to foreclosure. Housing prices fell 30% from their highs, and in big cities like Miami, they dropped around 40%. This resulted in the worst global economic crisis since the Great Depression. Despite the disaster, one trader, John Paulson, predicted the housing market would collapse and bet against it even when other investors laughed him off.

Paulson started his hedge fund, Paulson & Co., with $2 million of his own money, and managed tens of millions of dollars in the 1990s. The events of 9/11 changed the trajectory of his firm, as the Federal Reserve cut interest rates to stimulate the economy, making borrowing cheaper, including for mortgages. This inadvertently laid the groundwork for the housing crisis, as banks and mortgage lenders started offering mortgages even to those with poor credit.

By 2005, 24% of all mortgages required no down payment, up from 3% in 2001. These risky loans, known as subprime mortgages, were appealing to lenders due to their higher interest rates. Banks packaged these subprime mortgages into bundles and sold them to investment banks like Lehman Brothers and Merrill Lynch, which converted these bundles into mortgage-backed securities.

Paolo Pellegrini and Paulson viewed the housing market as a house of cards, bound to collapse when housing prices fell. They proposed that they bet against risky mortgages by purchasing credit-default swaps (CDS), which acted like insurance on mortgage-backed securities. If the securities defaulted within the average timeline of CDS, they would receive $1 billion, making a skewed trade where investors lost little if the trade didn’t work but made a lot if it did.

Credit-default swaps were a significant part of the housing market in the late 2000s, with investors like Paulson and Pellegrini focusing on riskier mortgage-backed securities. Paulson’s firm bought $25 billion worth of credit-default swaps with major banks, ensuring substantial value with only a 1% annual premium. He established a new fund dedicated to betting against subprime mortgages on a large scale, but faced difficulty finding investors due to a lack of interest. Despite scoring half a billion in gains for his firm, Paulson reluctantly sold his credit-default swaps. He set up his own hedge fund and earned $100 million for his clients and $10 million for himself. Greg Lippmann at Deutsche Bank played a crucial role in facilitating credit-default swap contracts for Paulson, while Jeffrey Greene secured credit-default swap contracts on his own. Paulson’s top trader, Brad Rosenberg, summed up the wait as “getting on as many trades as possible before it was too late.” The main obstacle was the role of collateralized debt obligations (CDOs), which masked the true risks in the market. Paulson reassured his concerned wife, Jenny, that it was just a matter of waiting.

The financial crisis began in 2006 when New Century, a major subprime mortgage lender, reported a loss. In 2007, two hedge funds, Bear Sterns, and Lehman Brothers, went bankrupt, causing market chaos. The U.S. government intervened to stabilize the housing market, guaranteeing over $300 billion of debt. The crisis led to 10 million American homeowners facing foreclosure, unemployment soared, and retirement savings and investments plummeted. John Paulson, a Wall Street legend, saw an unprecedented opportunity in the turmoil and earned $15 billion in 2007, with Paulson himself making $4 billion. Paolo Pellegrini, often overshadowed by Paulson, was rewarded with $175 million in 2007. The possibility of another housing bubble is a topic of debate, and regulatory changes were made to prevent future disasters.

Written by Nouriel Gino Yazdinian

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