John Paulson's Interview With The Financial Crisis Inquiry Commission
Courtesy of zerohedge.com
 John Paulson, of the eponymous uber-hedge fund did an hour-long interview with the Financial Crisis Inquiry Commission. I listened to it (thanks to NYT Dealbook, although not sure where they got it from), and really, I got a kick out of it even though I think my carpal-tunnel is really flaring up now. Anyway, without further ado, here's what the man behind the Greatest Trade Ever has to say about the Financial Crisis…  When asked what he saw, when, and why he decided to get short, he said "First thing we noticed was that real estate market appeared very frothy, values rose very rapidly, which led me to believe real estate markets were over valued." That's pretty simple/straightforward, no? I think it's pretty interesting that he said the 3 homes he's bought were all out of foreclosure, and they'd increased in value 4-5x over a 2-3 year period through ~'2005. Apparently the impetus for the research that led to The Trade was literally staring him in the face every time he got home from work!He explained his approach, and the way he put it makes me really think the guys who didn't leave their trading desks & "never saw the bubble/crash coming" really had their heads buried in the sand deeper than I previously thought. As Paulson said, "Credit markets were very frothy, very little attention paid to risk, spreads were very low, we thought when those securities correct, it could present opportunities on short side." Their research approach was pretty straight-forward: Focus on subprime, where they were amazed at how low quality the underwriting was, and how low the credit characteristics were on the loans. They found the average FICO was around 630, and over half of the loans were for cash-out refi's, which were based on appraised, not sales prices (so "value" could be manipulated). For many of these loans, LTV was very, very high, 80, 90, 100% with many of them concentrated in California (no surprise there). Close to have of the mortgages they looked at were of the stated-income, no-doc variety. Those who did report incomes had D/I ratios of > 40% before taxes and insurance. 80% of them were ARMs, so-called 2/28's with teaser rates around 6-7% for those first 2 years, but after they reset, the rates were L+ 600bps which at the point would have doubled the interest rate on these loans, and Paulson & Co thought there was very little - if any - chance borrowers would be able to afford the higher payments. Once the rates reset, the only thing these borrowers could do would be to sell, refinance, or default. These were people spending > 40% of their gross income on their mortgages already, once the rate jumped up after the teaser period, they expected that many borrowers would simply default, and the price of the RMBS into which these loans were securitized would fall drastically, while the price of the protection (CDS, etc) Paulson bought on them would skyrocket. Paulson & co also went much further in their analysis, well-beyond what many of those on Wall Street were doing. In May, 2006, they researched growth of 100 MSA's and found that there was a correlation between growth and the performance of subprime loans originated within them. As growth rates slowed, defaults rose. From 2000-2005, they found that with 0% growth, there'd be losses of around 7% in the mortgage pools. When they looked at the structure of the RMBS they found the average securitization had 18 separate tranches and that the BBB level only had 5.6% subordination, essentially, once losses surpassed that point, the tranches would become impaired, and if they reached 7% losses (what Paulson thought would happen once home price appreciation only slowed to 0%), the entire tranch would get wiped-out entirely. By mid-2006, home prices not only had slowed to 0% but were actually decreasing, albeit slowly, only about 1%. Even still, demand from institutional investors was so great, spreads tightened to 100bps. Why? Because as Paulson went on to explain, institutional investors were buying up the BBB tranches (the lowest investment grade ones) in hoards. While he didn't say it, I will (for the umpteenth time!): This is what happens when institutions effectively outsource credit research to the Ratings Agencies, even though many had/have internal credit analysis groups (ahem IKB ahem). They buy the highest-yielding security you can find that meets your investment guidelines, which meant that for many, they could only buy securities deemed by the brain trusts at the Ratings Agencies as "Investment Grade." Paulson started their credit fund in June, 2006, and as he explained, it wasn't really as simple as it may seem. Historically - going back to about WWII - the average loss on subprime securities was 60bps, nowhere near what Paulson & Co expected was about to happen. As he said "according to the mortgage people, there'd never been a default on an investment grade (IG) mortgage security." These same people were also of the mindset that they'll NEVER get to the levels where the BBB tranches are impaired let alone wiped out completely. These were also the same people who said that not since the Great Depression there hadn't been a single period where home prices declined nation-wide. These same people thought, worst case, home price growth would drop to 0% temporarily and then return to growth, just like before. |
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