John Paulson became a billionaire after his hedge fund effectively shorted more than $25 billion of mortgage securities at the dawn of the global financial crisis.
As he sizes up yet another frothy housing market some 15 years later, the founder of Paulson & Co. says another downturn in US home prices may be in the cards -- but the banking system is in a much better condition to handle it.
Paulson sat down with Bloomberg for a wide-ranging interview at the Union League of Philadelphia’s Business Leadership Forum on Tuesday. He also discussed how the so-called “Greatest Trade Ever” influenced his investing afterward, as well as why gold prices have been falling. Below are some of the highlights of the conversation, which have been lightly edited for clarity.
Q: You set your sights on the real-estate market about 16, 17 years ago. Basically you surmised that the US was in a housing bubble and that the huge market for mortgage securities was bound to be in trouble when prices collapsed. I’m curious if we could bring that into the present tense, because I look at how so much has changed since then: Underwriting standards have sobered up quite a bit; the banking system is much more inoculated; there are better capital requirements, a lot more regulations in place. But I look at the appreciation in home prices since the beginning of 2020 -- the Case-Shiller index is up 40-some percent -- and over the same period, mortgage rates have jumped to more than 6%. It seems like we could be in for some pain in the housing market. I wonder how well inoculated is the financial system? Compare and contrast now versus then.
A: Well the financial market, the banking system and the housing market are much different today than in ‘06 and ‘07. The underlying quality of the mortgages today is far superior. You don’t even have any subprime mortgages in the market … And the FICO scores are very, very high. The average is like 760. And the subprime, they were averaging 580-620 with no down payment. So in that period, there was no down payments, no credit checks, very high leverage. And it’s just the opposite of what’s happening today. So you don’t have the degree of poor credit quality in mortgages that you did at that time.
The other factor is the banks at that period were very highly leveraged. The average capital in your major banks was about 3%. And then they had a lot of off-balance sheet exposure as well. So, you know, it doesn’t take a lot to fail if you have, let’s say, a hundred dollars in assets, and then on the liability side you only have $3 in equity and $97 in various types of borrowing. If you’re not really careful on the asset side, all the assets have to do is fall 3% and your equity is wiped out. You go into default. So the problem, in that period of time, the banks were very speculative about what they were investing in. They had a lot of risky subprime, high yield, levered loans. And when the market started to fall, the equity quickly came under pressure.
And it caused the failure, very quickly, of major financial institutions in the US ... The banks have recovered. But as a condition going forward, they really raise the equity. Today, the average bank is probably 9% equity, the systemically important banks are 11%-12% equity. So almost between three and four times as much equity as before. So we’re not at risk of a collapse today in the financial system like we were before. Yeah, it’s true, housing may be a little frothy. So housing prices may come down or they may plateau, but not to the extent it happened.
Q: Is there anything you learned about bubbles in general? I feel like it’s one of the most-difficult things for an investor to do: It’s easy to spot a bubble, but it’s hard to sort of hit it at the right time and make the right trade to benefit from it, or at least get out of the way and cash in at the right time. Is there any lesson to be learned about bubbles or is each one unique and you have to take ‘em as they come?
A: Well, you’re absolutely right. Like crypto. Many people thought crypto was a bubble. I remember looking at Bitcoin. It was several thousand, went up to $20,000. People said, “This is ridiculous. Let’s short it.” Then it went all the way up to $65,000. So the problem with the short is there’s no way to cover the downside.
Which is what made the shorting of subprime bonds interesting, because it was an asymmetrical trade ... When you short a bond at par, say a hundred dollars, you take a hundred dollars back and then you invest that hundred dollars. So your loss is really between the rate you pay on the bond that you short and where you invest the hundred dollars. In the case of the subprime bonds, they yielded more or less 6%. They were triple-B bonds. And Treasuries at the time were 5%. So you short the bonds for a hundred, you have to pay $6, but then you take that hundred cash, you buy Treasuries, you make $5. So your net cost is only $1 per year. And if the duration of the bond is only two or three years, then you’re really risking 2%, 3%. But if the bond defaults, you can make a hundred dollars.