He earned almost $6b betting against houses and banks.
The credit crisis spelled disaster for many, but it catapulted John Paulson into the top league of hedge-fund managers.
Background and early career
John Paulson was born in Queens, New York, in 1955. Knowing his way around a balance sheet may have been in his genes, as his father was an accountant at a public relations company, while his maternal grandfather was a banker who reportedly did well during the Great Depression of the 1930s.
It was this grandfather who encouraged the young Paulson to buy sweets in bulk and sell them in the school playground. His interest in commerce then led him to graduate top of his class -- 'Valedictorian', to use the American term -- with a BS in Finance from New York University’s College of Business and Public Administration, in 1978.
From there he went to Harvard Business School, from which he graduated with an MBA as a Baker Scholar, the school's highest academic honour.
Initially going into management consulting with Boston Consulting, he migrated into investment banking with Odyssey Partners before joining Bear Stearns as an investment-banking associate at the age of 28. Four years later he became a general partner of Gruss Partners, a hedge fund, eventually setting up on his own in 1994 with $2m of his own money.
Paulson & Co.
Paulson focused initially on merger arbitrage, taking advantage of pricing anomalies that arose when mergers and acquisitions were announced. And he built up an enviable track record in this area, reportedly losing money in only one year since his company was founded -- 1998, year of the Asian crisis.
As a result, money flowed in from investors, and he was able to expand his team.
Credit crisis, or opportunity
In 2005 Paulson became more concerned that the economy was heading for a fall, and asked his people to find a bubble to short. “We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down. We couldn't short a house, so we focused on mortgages.”
The infamous mortgage-backed securities (MBS) he was referring to were packages of debt consisting of mortgages, but divided up into many different tranches, each with different priorities in the pecking order. The top grades would receive their payout in all but the most disastrous situations, but receive a lower return for this relative lack of risk, while higher rates were paid to those who would bear the brunt of any defaults.
"In the case of sub-prime securities, we targeted the triple-B bonds, which are the lowest tranches in the subprime securitisation". Paulson calculated that a loss of just 5% would see these securities in trouble, while a loss of 6% would wipe them out completely. And the higher yield for taking that risk wasn't actually very high, just 1% above LIBOR. “For me, it was so obvious that these securities were overvalued.” It was time to start shorting.
From 2006 Paulson started taking short positions on these securities, betting that the market would eventually see sense and start pricing both housing, and the securities based on it, in a rational manner. It's easy with hindsight to see that he was right, but remember that at that time the banks, whose job it is to evaluate risk, were loading up with this stuff. His position was highly contrarian.
We all know what happened from 2007 onwards -- house prices collapsed, bringing down with them the securities that depended on them, and the banks that owned them. And the fact that these MBSs contained the fragments of many separate mortgages offered no real protection, as they all fell together.
Paulson didn't confine himself to the US either, taking significant bets against Barclays (LSE: BARC), Royal Bank of Scotland (LSE: RBS) and Lloyds TSB.
The result: his funds profited massively. His Credit Opportunities fund alone was up 590% in one year. Personally, Paulson had the biggest pay-day in the history of Wall Street, earning $3.7bn in 2007. But he didn't lose his nerve, and maintained his shorting strategy through 2008, picking up another $2bn while others were buying the 'dips'.
Current positions
In recent months, Paulson has reversed his position on the banks, proving that he is not just a shorter. In particular, he has been buying Citigroup, Bank of America and Goldman Sachs.
He has also been bullish on the outlook for gold, buying into producers such as Anglogold Ashanti, Kinross Gold Corporation and Gold Fields. Some might view this as a bet against currencies in general, considering the fears of inflation as governments try to prevent a deeper recession.
Having rapidly accumulated a personal fortune of $6bn, making him 76th richest man in the world according to Forbes, and with $27bn assets under management, all eyes are on John Paulson to see if he can stay ahead of the curve.
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