The performance of the Paulson Fund during the bursting of the Internet bubble also attracted the favor of many investors. By 2005, the size of the Paulson Fund reached US$4 billion.
Although the fund size increased nearly sevenfold, Paulson still felt uncomfortable. Why? It was simple, because Paulson felt a little lost.
This is the fatal problem of hedge funds, because he is in charge of a hedge fund with a scale of 4 billion US dollars, but he does not know the direction of investment. Over time, it will inevitably cause dissatisfaction among investors.
At this time, the US economy was booming, especially the real estate market, which was extremely hot. However, Paulson was not interested in the US real estate market. He did not get involved in the mess of mortgage loans, financial derivatives and real estate. He mostly stayed out of the real estate boom. So what other goals did he have?
So, when Paulson met Pellegrini, his life was not comfortable.
But at this time, he met Pellegrini, his old friend who pointed him in a direction.
Although Pellegrini is in a state of career, his sense of smell has always been very sensitive. Especially in the past two years, the hot real estate market in the United States has made him smell something unusual.
So Pellegrini began studying the U.S. housing market. He looked at interest rates over the decades and found that they had little effect on the housing market. This meant that the Fed’s rate cuts were not the reason for the recent surge in home prices, despite the bulls’ attempts to whitewash them. But after reading academic and government documents and data, Pellegrini was frustrated: He couldn’t quantify the extent to which housing prices were overvalued, or when the bubble started. He couldn’t even prove that this price increase was different from the past.
To get a new conclusion, Pellegrini added a "trend curve" to the housing market data, which clearly shows the extent of recent price increases in the housing market. This time, Pellegrini took a step back and began to look at a longer historical period. He found real estate data for each year after 1975...
Then suddenly, the answer fell into place: From 1975 to 2000, U.S. house prices grew by only 1.4% per year after accounting for inflation. But from 2000 to 2005, U.S. house prices soared by more than 7% per year!
In other words, US house prices need to shrink by 40% to be consistent with historical trends!
This level of house price increase is unprecedented, and Pellegrini also found that every time house prices fell in history, they would fall below the trend line. In other words, if house prices really fall now, they will really plummet.
When Pellegrini told Paulson the results of his analysis, Paulson, who was naturally bold and reckless, immediately realized that this was a once-in-a-lifetime opportunity.
At the beginning of 2006, people generally believed that housing prices would never fall across the United States; mortgage experts kept advocating that the real estate market and housing mortgage market would continue to be prosperous; good news frequently appeared in major media. Most of the big names on Wall Street also held the same view. Credit rating agencies also gave AAA ratings to Wall Street's financial products.
"The experts were blinded by the booming real estate market." After receiving Pellegrini's analysis results, John Paulson decisively abandoned the rating agencies' scores. He personally led his 45-person team to track thousands of home mortgages and analyze the specific circumstances of the individual loans that could be obtained one by one.
As he dug deeper, Paulson became increasingly convinced that investors had greatly underestimated the risks in the mortgage market and that it was becoming increasingly difficult for creditors to recover their loans.
Before the subprime mortgage crisis, the relationship between CDO and CDS in the US real estate market was that the higher the risk of the CDO, the higher the value of the CDS that guaranteed it. But during the real estate boom, most people believed that CDO did not have much risk, so the price of CDS was very low.
So Paulson decisively invested $150 million in July 2006 to establish the first fund to short CDO and began to build large positions.
At the same time, he was shorting dangerous CDOs and buying up cheap CDS.
Paulson's team began to search the market for low-quality CDOs, that is, CDOs with high risks. His target was not the healthiest and most mature ones, but the ones that no one could save. Then, they bought CDS insurance contracts for these CDO shares.
"Hey, man, do you want New Century Financial's CDO?"
"Nonsense, such rubbish...Oh no, of course I want such a top-quality CDO, I'll take as many as I can get!"
“What about scam loans and interest-only loans that make up the majority?”
"Fuck, is this even necessary? Bring it over here, I want as many as you can get!"
"Hey, buddy, do you want a CDO of mortgage loans in the overheated real estate markets in California and Nevada?"
"Hey, do you have much? I want them all..."
In this way, Paulson plundered those highly risky CDOs and cheap CDSs in the hot real estate market, and his move even caused ridicule on Wall Street.
Especially in the following months, the US real estate market continued to prosper and showed no signs of sluggishness, so Paulson's fund continued to lose money - he had invested more than one billion US dollars in it.
Several times, investors hurriedly asked him whether he should stop loss. He flatly refused: "No, I want to increase my bet."
Paulson did what he said. He even took another gamble by establishing a second fund to short CDO and continued to increase his investment.
Paulson's actions caused a lot of ridicule and mockery at the time, but he still insisted on doing so, with a spirit of "everyone is drunk but I am sober, and I will go forward even if there are thousands of people against me."
But his desperate approach did not let him down. Even though he lost more than $1 billion from July 2006 to the end of 2006, he still did not back down.
In the end, his persistence brought him huge wealth!
The subprime mortgage crisis finally broke out, and Paulson, who had prepared a large number of short positions in advance, finally got the huge return he deserved in this subprime mortgage crisis - 20 billion US dollars!
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