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 this made any sense, it’s completely different than anything I have been involved in before. When I purchased my home, it was very strict underwriting standards; I had to provide two pay stubs, two years of tax returns, three months of bank statements, all sorts of credit card information. And, you know I got three mortgages in my life, so it never changed. And all of a sudden I saw the lowest quality margins with basically no underwriting standards at all. Most importantly there were two twenty eights which means if the average borrower was now spending over 40% of their gross income on debt service based on the teaser rate, that meant once the loan reset and the cost of the loan would go up by 50%, that they would either default, refinance the loan, or sell. But, if they couldn’t refinance or sell, they would have to default. It would be impossible for them to spend 60% of their income on debt service. So we thought that these were extraordinarily low quality mortgages that were very correlated to home price appreciation. And then if we were in a bubble and home prices would have fallen, these mortgages would likely default. And then after doing that analysis of the mortgages, and we did further analysis of the trends in the underwriting, the percent that were under percent, the combined loan to value ratio, and basically there would have been a steady deterioration in the credit quality. And then we looked at the structure of the mortgages. I should say we did one key piece of research which correlates, I mean based on the structure, you know I can say that these things need home prices to go up or they default. But then we did some research based on historical performance of the subprime mortgage securities and I think we analyzed a hundred MSAs and the performance of subprime loans based on growth rates in those MSAs, you’ll find a very strong correlation that when growth was very high default rates were very low but when growth slowed, default rates rose. And that … We didn’t find any periods that had negative growth from 2000 to 2005 but we found some at 0% growth. And at 0% growth, the data showed losses of around 7% in these pools.
(Unknown Female Voice): Excuse me, Mr. Paulson, when did you do that research?
JP: Let’s say in 2005 and in early 2006.
(Female): Thank you.
JP: And then we looked at the structure of the subprime loans and again were made to see that these were basically originated and then sold as securities and the securities were structured where the securities were tranched into an average 18 separate tranches ranging from various tranches of AAA, AA, to BBB, to BB. And at the … there was tremendous demand for the BBB as the lowest rated investment rate security. But that security only had 5.6% subordination. Which meant that if losses were greater than 5.6% this tranche would be impaired. On average these tranches were about 1.5% thick, so losses of 7%, these tranches would be extinguished. And then, we also had shown that at 0% growth losses in the data we analyzed could reach 7%. So, we basically felt if home prices declined to 0% of less, that losses in these pools would exceed 7%; wiping out the BBB. And, even though … then we started to look at home pricing and sure enough, home prices began peaking in ’05. The year over year change continued to decline, and by June ’06 home prices were no longer rising. That was the first point that home prices did not rise or decline by 1%. Which would imply that the securities issued in that environment of home prices stayed below 0% that the BBB could default. Yet the demand of the BBB was so great on