From Genius to Cannon Fodder in Less Than a Year

No one was able to both predict and profit from the popping of the US housing bubble better than John Paulson and his hedge fund Paulson & Co. Michael Lewis’ masterpiece The Big Short expertly recounts the way in which Paulson came to make such a large wager on the demise of mortgage related securities such as CDOs and synthetic CDOs. During late-2008 Paulson covered his bearish bets which resulted in the largest ever profits from a single trade. As if that weren’t enough, Paulson was able to see the light at the end of the tunnel. From the ashes of the late-2008 market meltdown tremendous opportunities arose to take advantage of extremely depressed valuations and bet on an economic recovery.

Paulson was able to masterfully catch the turn off the bottom in March 2009 through bullish positions in high yield debt, common & preferred equity of large cap financials, and gold & gold mining shares to name just a few of his fund’s investments. These bullish positions essentially expressed a big picture view that risk was cheap and the Federal Reserve and Treasury Department would be forced to take extraordinary measures in order to save the economy through reflating the financial system and asset prices.

Paulson and other fund managers such as Appaloosa Management’s David Tepper who were able to turn bullish in early 2009 achieved spectacular returns as the S&P 500 rose over 80% from March 2009 through April 2010. Then things got dicey in late-April 2010 as the SEC began investigating Goldman Sachs and the eurozone sovereign debt crisis became increasingly serious. However, by September 2010 the worst was over and Fed Chairman Bernanke had opened up the possibility of initiating several additional unconventional policies in order to stimulate the economic recovery and combat disinflation. I still vividly remember reading this post from Zero Hedge which summarized Paulson’s speech at the ultra-exclusive University Club in September 2010. In this speech Paulson made a strong bullish case for equities, gold, and real estate. He was also bearish on bonds and offered up the possibility of double-digit inflation by 2012 which would of course result in much higher yields on US Treasuries.

Paulson’s views from September 2010 turned out to be pretty much spot on for several months as yields rose towards the end of 2010 and into early 2011, equities rallied aggressively through mid-February 2011, and gold has been on a massive bull run with only a few minor pullbacks over the past year. Perhaps the two areas in which he has been most consistently wrong have been housing and inflation. I believe these incorrect views, particularly on housing which appears to be a consequence of his mistaken inflation forecast, laid the seeds for Paulson’s miserable performance recently. Housing has not recovered at all and is in the process of making new lows, this in turn has cast a great deal of doubt on banks’ balance sheets (see $BAC, $C, $WFC).

I recall that there was a lot of talk about BAC’s “earnings power” being north of $4 per share back in early 2010. Paulson was even quoted as making a $30/share end of 2011 prediction for BAC. Of course, this was pie in the sky talk based on a strong economy, a recovery in housing, and didn’t take into account the Countrywide legacy mortgage mess which currently has BAC exposed to billions in potential mortgage put-backs and tens of millions in legal fees. As of June 30, 2011 Paulson & Co. still owned over 60 million shares of BAC common - I wouldn’t be surprised to find out that they had sold it all over the past several weeks.

The wrong way bet on a housing recovery and inflation is understandable, however, investments in frauds such as Sino Forest and massive poorly managed value traps such as Hewlett-Packard ($HPQ) are much less understandable. Perhaps it is a problem of scale, maybe $30 billion is simply too difficult to manage effectively or perhaps he has lost his edge and hunger since becoming a multi-billionaire. Whatever it is, Paulson’s recent debacles are in stark contrast to his prior successes. I would be willing to bet that once the smoke clears and all the redemptions are over, Paulson will get his swing back similar to a Hall of Famer who has a bad season.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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