Reading about the German government’s abrupt decision to restrict sovereign credit default swaps, I was reminded of July 2009 when I met John Paulson at the New York offices of his eponymous hedge fund. I was prepared to be impressed. It isn’t every day that you meet a man who has just made six billion dollars from betting against subprime mortgages and the banks that created them.
Paulson was jumpy. Although I didn’t know it at the time, I was interviewing him at the precise same moment that the SEC was investigating his fund’s role in the now notorious Abacus deal, gathering the information that would later be deployed against Goldman.
The question I am now asking myself is: Is the six billion really his money after all? Did he actually deserve it? During my conversation with him last year, he verbally acknowledged the failures in regulation that he exploited, and at the end of the interview, he called for tougher regulation of derivatives ““ regulation that would have dramatically diminished his outsized profits.
To his admirers, Paulson is the leader among a cast of Wall Street outsiders, whose scepticism and independent thought allowed them to see through a real estate bubble which carried everyone else before it. There is another view of Paulson, however. He was simply a player who happened to be in the right place at the right time.
As Paulson himself would concede, it was not enough to have a hunch about subprime. He needed a tool that enabled him to execute it, namely the default swap linked to subprime mortgage bonds. The inventors of this tool were bankers such as Greg Lippmann, until recently a trader at Deutsche Bank, and Goldman’s former head of mortgages Dan Sparks.
Without these specialised default swaps, subprime would never have permeated the global financial system to the extent that it did. The inventors of these derivatives bypass what now seems like a very sensible bottleneck: you can’t invest in more mortgages than have actually been issued. With derivatives you can, with the only bottleneck being the need for somebody to bet against the synthetic mortgages you create.
Enter Paulson, who told me that he couldn’t believe his luck at being approached by bankers offering such long odds on the bets he wanted to make. Why were the odds so long? Because the game was rigged in the form of triple-A rated synthetic collateralised debt obligations (CDOs) designed to exploit loopholes in capital requirements and credit ratings.
Regulations gave European banks like IKB or Royal Bank of Scotland (RBS) an overwhelming incentive to invest in these synthetic CDOs even though they only earned a pittance for the risk they were taking. These apparently ‘sophisticated’ investors were lured by regulatory capital arbitrage to walk into a trap where genuine sophisticates like Paulson relieved them of their capital. In this environment that only lawyers would argue was a fair market, firms like Goldman and Deutsche directed and profited from the surrealist movie in which Paulson featured.
Unwittingly bankrolling the movie were governments that were forced to pump in taxpayer funds to rescue the banks that Paulson and others had pillaged as a consequence of inept regulation. Financial innovation and regulation made the crap shoot possible. The snowballing backlash against derivatives, hedge funds and banks ““ now that governments themselves are in the firing line ““ should come as no surprise.
Note: I haven’t updated my website over the past two months since I’ve been working on the second draft of my book (which has now entered the final editing stage). I have written a couple of Breakingviews articles recently which you can read here and here.
