I transcribed John Paulson's (CEO of Paulson and Co.) entire testimony before the The Financial Crisis Inquiry Commission. Paulson was one of the first people to forsee the financial crisis, shorted, and made billions. One of his funds was up 589% in 2008 according to MarketFolly. To read the full story on John Paulson's famous short, I highly recommend reading the best-seller The Greatest Trade Ever, which details how Paulson saw the crisis coming and the various methods he used to profit from it. Paulson is one of the only people who can actually claim to have foreseen the crisis and make money from it. According to Business Insider, John Paulson now runs the world's third largest hedge fund in the world, with $32 billion AUM.
CS: Ok, um, it is October 8th 2010. We are interviewing Mr. John Paulson. Mr. Paulson my name is Chris Seifert. I’m with the financial crisis inquiry commission. We were established by a statute last year; the fraud enforcement and recovery act of 2009. It tells us to figure out the cause of the financial crisis by the end of this year and deliver a report (um) documenting what we found to be the cause of the financial crisis. It tells us to look at many things, including the role of sub-prime lending, nontraditional mortgage loan securitization, etc. So we, of course, thought it would make a lot of sense to talk to you, given your success in investing in the real estate markets over the last several years. So with that, why don’t we jump right into it? And if you could maybe first tell us what did you see in the real estate market in the 2000’s that made you decide to go short? What specifically were you looking at, what kind of signals did you see, and when did you in fact start going short?
Yeah. Well the first thing that I noticed just by being a normal active person in the market that the real estate market appeared very frothy and that values had risen very rapidly from where they were several years ago. So, that led me to believe that the real estate markets were overvalued. I’ve been around; I’m 54 years old so I’ve lived in New York all my life and New York periodically goes through a real estate crisis. We went through one in ’74, we went through one in the early 80’s and then again in the early 90’s. So, I didn’t subscribe to the school that real estate only goes up. I’ve been through cyclical periods before where there were lots of foreclosures, defaults and (you know) sharp drops in value. And, I felt that I had bought both my houses in foreclosure in the early 90’s. So, I thought that relative to what my houses were worth today, I mean in 2005/2006 what I had paid for them; they are up four or five times in value. I thought that we could be in a bubble. At the same time, it appeared that the credit markets were also extremely frothy. That there was generally very little attention paid to risk and any type of borrowers sell debt securities, regardless of the financial condition. And that spreads when the premium for risk were very low. So, we generally thought that the credit markets were overvalued, the real estate markets were overvalued, and we thought if that theory is correct it could present opportunities on the short side. When we looked … since the mortgage markets are the largest credit markets in the world, even bigger than the treasury market, they’re very large liquid markets, so we initially, we looked at the mortgage markets and then divided it into prime (I guess) or mid-prime and sub-prime. And to try and find mispriced securities we immediately focused on the sub-prime sector. And when we looked at that sector, what we were initially amazed at, first was the extraordinarily low quality, low credit characteristics of the loans that the average FICO score of the borrower was very low, around 630. Around half, over half of the mortgages were cash out refinancing (so based on appraisals not based on sale values). The loan to value was very high, exceeding 80%, and in some cases 100%... in many cases 100%. The concentration of sub-prime was in California where home prices had risen, even though the nationwide home price was falling. The reason that California had risen the most. And then some shocking ratios that close to half of the mortgages were stated income, no-doc loans. And of those that reported income, the debt to income ratio was stated 40% before considering taxes and insurance. And most shocking of all was that over 80% of the loans were adjustable rate mortgages. Where typically two twenty eights where the first two year was a teaser rate of around 7%, but then they reset at (unadible) 600 which at that time would indicate a 12% rate. So, none of