The Greatest Trade Ever (37 page)

“John never got to the point where he would trust me,” Pellegrini recalls. “He never gave me trading authority.”

Paulson continued to tease Pellegrini about how methodical he was. When Paulson moved another analyst to work under Hoine’s wing, to focus on the financial companies and their debt, Pellegrini was hurt. He viewed the decision as an attempt by Paulson to preserve his control of the firm, handing power to Hoine because he was younger and represented the next generation.

“I wanted an analyst to work with me to short the equities but he gave it to Andrew; John didn’t want to give me that,” Pellegrini says. “So I became disengaged.”

Pellegrini still helped manage the two big credit hedge funds, though, and they were a whopping $9 billion in size. Late in the year, Pellegrini came to Paulson with an idea: Let’s give back half the money in the fund and extend the fund’s “lockup” for another few years. That way, the firm
could cash in some of its gains while ensuring that investors wouldn’t pull all the money out when the existing lockup ended in 2009.

Pellegrini already was hearing complaints from European investors who were desperate for cash amid the market’s downturn and unhappy they couldn’t pull any of their huge gains from the hedge funds, due to the lockup agreement. Other investors grumbled that the Paulson credit funds had pocketed some cash from various sales of investments but they were not doing anything with the money. Why not give some money back and then raise money anew in 2008? Pellegrini argued to Paulson.

Paulson seemed taken aback. Maybe it was a sign that Pellegrini didn’t believe in the remaining positions. Or he was just looking to make sure he had a key role at the firm for an extended period, while he helped run those funds.

“When I hear you saying these things, it makes me question what you’ve accomplished in the last two years,” Paulson responded, tersely.

Paulson’s comment “made me feel I was no longer special,” Pellegrini recalls.

O
N THE FRIDAY BEFORE CHRISTMAS
, Paulson called an emergency meeting in the firm’s reception area. Standing in front of the group, with Pellegrini and Rosenberg nearby, Paulson opened a case of French champagne sent over by an investment bank as a thank-you for all the trading commissions of the previous year.

Paulson passed around bottles of the bubbly, poured a glass for himself, and raised it to his team. He beamed; some of his staff never had seen their boss look so happy. Paulson then toasted his employees, singling out the firm’s back-office staff and some other areas away from the limelight.

“I just want to thank everyone,” Paulson said, looking around the room, meeting the eyes of both senior and junior executives. “It was the best year ever.”

Applause rocked the office. Then the team quickly got back to work, to try to make some more money.

A few days later, Pellegrini took his wife on vacation in Anguilla. Stopping at an automated-teller machine in the hotel lobby on New Year’s Eve to withdraw some cash, she checked the balance of their checking account.

She was immediately taken aback. On the screen before her was a figure she had never seen before, at least not on an ATM. It’s not clear how many others ever had, either: $45 million, newly deposited in their joint account. It was Pellegrini’s bonus for the year, including some deferred compensation. He was still special to John Paulson, after all.

In truth, Pellegrini had withheld more from his bonus than he needed in order to pay the year’s taxes, so the figure in the bank account that day was skimpier than it could have been. Paulson paid him about $175 million for his work in 2007. Pellegrini would never again have to worry about finding a career, keeping a job, or stretching his savings.

“Wow,” his wife said quietly, still staring at the ATM.

Then they left, arm in arm, to meet a chartered boat to take them to nearby St. Barts.

Paulson did quite well for himself as well. His hedge fund got to keep 20 percent of the $15 billion or so of gains of all his funds. He also was a big investor in the credit funds. His personal tally for 2007: nearly $4 billion. It was the largest one-year payout in the history of the financial markets.

O
N FEBRUARY 20, 2008, PAULSON RECEIVED AN INVITATION FROM
Samuel Molinaro, Jr., the chief operating and financial officer at Bear Stearns, inviting him to a lunch at the investment bank’s executive dining room. A rash of hedge-fund clients had pulled money out of Bear Stearns and shifted accounts to rival brokers, worried about the firm’s health. The moves left Bear in a weak position and fed rumors that the storied firm might not survive. If Molinaro could bring the hedge funds back into the fold it would be a shot in the arm for Bear Stearns and could help right his tottering ship.

Paulson & Co. was an especially attractive catch for Molinaro. It now was among the world’s largest funds, and Paulson had remained a loyal customer of his former employer, despite the speculation about Bear Stearns’ future. But Paulson also had moved cash elsewhere, concerned about the health of the investment bank. If Molinaro could get Paulson back in Bear Stearns’ corner again, it would be an instant boon and likely would reassure others who were mulling over whether to return as clients.

After a lunch of salad, grilled chicken, and chilled string beans, Molinaro rose to address the select group of twenty or so hedge-fund bigwigs, all facing one another around a circular dining-room table. For twenty minutes, Molinaro outlined how Bear had improved its financial position, why its business was healthy, and how much cash the firm held. The press had it out for Bear Stearns, Molinaro emphasized. There really was nothing terribly wrong with the firm.

Then another Bear executive gave a speech, saying that he couldn’t
share many details, but business definitely was picking up. He appealed to the group to bring back the cash, reminding them of the long-term relationships many had with Bear and how the investment bank had helped many of their firms in times of need. Listening to it all, some of the hedgies began to feel pangs of guilt, remembering times they indeed had been aided by various Bear Stearns executives.

For another twenty minutes, Molinaro easily handled softball questions from the group. It seemed he was winning them over and a crucial victory was within sight. Maybe Bear Stearns could save itself after all.

Then John Paulson raised a hand. The executives turned to watch him, eager to hear what he might say.

“Sam, do you know what your Level Two and Level Three assets are on your balance sheet?” Paulson asked, referring to investments that could be hard to price, sometimes because they are risky.

“Not off the top of my head.”

“Do you have an idea?”

“I’d rather not guess, John. Let me give you the right number when I get back to my desk.”

“Well, I’ll tell you what the number is. It’s $220 billion. So what I’m seeing is that if you have $14 billion of equity and $220 billion of Level Two and Level Three assets, a small movement in the assets can wipe out your equity completely.”

Molinaro didn’t realize it, but Paulson had spent weeks reworking his firm’s holdings, dropping dozens of stocks and bulking up its bets against a range of financial giants, from Lehman Brothers and Washington Mutual to Wachovia and Fannie Mae. He had deep concerns about Bear Stearns, too. Investors had poured $6 billion into his firm in the previous year, and Paulson had put a good chunk of it to work wagering against banks and investment banks with flimsy balance sheets. He had done his homework.

Molinaro suddenly looked uncomfortable. He either didn’t have a good response for Paulson, was wary of publicly squabbling with a good client with a growing reputation, or didn’t want to give a faulty figure.

“I’ll have to check the number, but you may not be accounting for the fact that some of the assets are hedges.” In other words, Paulson might not be getting a true view of the firm’s risk, Molinaro argued.

His response was for naught. Paulson had pushed open the floodgates. Two other hedge-fund managers quickly followed Paulson with their own questions, adopting much harsher tones.

“How can you not know the number, Sam?!”

“Paulson’s right, you guys are in trouble!”

Paulson watched quietly as the two investors bullied Molinaro for several more minutes. The grilling got so harsh that some of the investors began to feel sorry for Molinaro. So many doubts had been raised about Bear Stearns’ health, though, that the accounts never would return to the investment bank.

As the meeting broke up, one hedge-fund executive said to a friend, “Shit, Bear’s
really
in trouble.” Chatter about the meeting began to circulate as soon as the executives returned to their firms.

It was a dagger in the staggering investment bank’s heart. Soon a rash of hedge funds pulled money out of Bear Stearns, including a $5 billion shift by hedge fund Renaissance Technologies.

Tempers flared within Bear Stearns as the investment bank’s shares plunged and its cash dwindled. The firm’s CEO, Alan Schwartz, tried to calm various executives. During one meeting, though, Michael Minikes, a sixty-five-year-old veteran, abruptly cut off his boss.

“Do you have any idea what is going on?” Minikes asked. “Our cash is flying out the door. Our clients are leaving us.”

A month later, Bear Stearns had to be rescued in an emergency sale to J.P. Morgan coordinated by the Federal Reserve and the Treasury Department at a price of just $2 per share, a figure later increased to $10 per share.

After the original sale was struck, Alan Schwartz wearily made his way to the company gym for an early-morning workout. Dressed in his business suit, he trudged into the locker room. There, Alan Mintz, a forty-six-year-old trader at the firm, in sweaty gym clothes, made a beeline for his boss.

“How could this happen to fourteen thousand employees?” Mintz demanded, getting in Schwartz’s face. “Look in my eyes, and tell me how this happened!”
¹

On the Sunday that Bear Stearns fought for its life, and while others on Wall Street were glued to their computers, worrying about the impact, Paulson watched his two daughters frolic in his home’s indoor pool. Months earlier, he had shifted almost all his firm’s cash from a Bear Stearns account to a money-market account at Fidelity Investments secured by U.S. Treasury bonds, just in case the investment bank’s health deteriorated.

It was the beginning of a year of historic troubles for leading financial companies around the globe, as the firms finally acknowledged they were sitting on deep losses due to real estate-related holdings and hadn’t adequately prepared for a downturn.

Executives at Lehman Brothers were among those most confident they could weather the storm. Richard Fuld, Lehman’s CEO, had turned down a lucrative investment from the Korea Development Bank. Fuld and his bankers also had spoken with Bank of America, MetLife, HSBC Holdings, and others, but no deal materialized. Fuld had been through crises before, and this one seemed to be just another that he and his team would maneuver around. He blamed growing weakness in the company’s shares on short sellers, many of whom were hedge funds buying CDS protection on Lehman’s debt. His complaints didn’t sit well with these funds, though, many of whom were Lehman’s own clients and were nervous enough about the health of the firm.

On September 9, after talks with the Korean investors finally fell through, Lehman’s shares dropped in half, the largest one-day plunge on record. Worries about Lehman’s $33 billion of commercial real estate holdings swept Wall Street. Lehman executives calculated that the firm needed at least $3 billion in fresh capital. A day later, though, they assured investors on a conference call that the firm needed no new capital. Wall Street rivals who viewed Lehman’s huge real estate portfolio said it was overvalued by more than $10 billion, but Lehman executives insisted that it was valued properly.
²

J.P. Morgan didn’t like what it was seeing. The big bank played
middle man between its clients and Lehman in various trades and was privy to more details of Lehman’s operations than most investors. A week earlier, J.P. Morgan had asked Lehman for $5 billion in additional collateral—easy-to-sell securities to cover money lent by J.P. Morgan’s clients to Lehman. Steven Black, co-CEO of J.P. Morgan’s investment bank, phoned Fuld, saying that in order to protect itself and its clients, J.P. Morgan needed $5 billion in additional collateral—in addition to the $5 billion J.P. Morgan demanded five days earlier, which had yet to be paid.

Lehman sent some of the money, but held off J.P. Morgan on the rest as it tried to reassure clients.

“Our balance sheet is better than ever,” Christian Lawless, a senior vice president in Lehman’s European mortgage operation, told investors seeking to pull out assets.

But so many hedge funds pulled money from their accounts at Lehman that the firm couldn’t properly process the requests, as panic grew within the firm.

Lehman tried to entice rivals to buy the firm or certain assets. But two Wall Street executives who reviewed Lehman’s real estate documents passed, saying that Lehman had placed a valuation on its real estate holdings that was 35 percent higher than it should be. Treasury Secretary Henry Paulson insisted the government wouldn’t lend financing for a purchase.

Lehman was so weakened that the 158-year-old Wall Street firm turned to the Federal Reserve and Treasury Department. Like other investment firms, Lehman had spent years enjoying outsized profits and enormous wealth from a raging real estate market. Now that housing was on its knees, however, Lehman went to the government, hat in hand.

Late one evening, standing in front of about fifteen silent members of Lehman’s executive committee, Tom Russo, Richard Fuld’s legal counsel, tried reaching Timothy Geithner, the head of the New York Fed. Russo tried Geithner in his office and on his cell phone. Nothing. He paged him, buzzed him. Still no answer.

The Lehman executives had one last chance: George Walker IV, a top investment banker at the firm who also happened to be a cousin of the
president of the United States, George W. Bush. Walker was scared and looked pale. His shirt was soaked with sweat at the thought of calling the White House. His colleagues told him they had no other choice.