Sunday, May 4, 2008

The $3.7 billion dollar man

John Paulson made $3.7 billion last year, taking realized profits for himself on unrealized gains for his funds. Does anyone but me find that a bit unauthentic?

I wrote about this entire credit default swap and pricing here. You need to re-read the piece to understand the junk that is going on in hedge fund land, and the chicanery going on in credit default swaps.

In today's NY Post, we see that Paulson was down for the month in his funds.
John Paulson, the hedge-fund titan who earned superstar status after earning billions by correctly predicting the collapse of the mortgage market, slipped slightly in April betting Wall Street firms such as Bear Stearns would collapse and default on its debt.

One Paulson fund that invests in things like mergers and bankruptcies fell 3.4 percent last month; a second dropped closer to 2 percent. The funds are up for the year, but the declines come when most hedge funds are expected to post positive monthly returns.

Paulson was using arcane instruments known as credit default swaps to bet companies like Bear would default on their debt. Instead, JPMorganChase in mid-March agreed to buy Bear and support its obligations. Spreads on these bets widened - in some cases by several hundred basis points - as confidence in financial stocks returned.

Jim Cramer, of picked up on this over the weekend with an article about these swaps on his site:

Better. It's better. The credit markets are better. Those who have all of those reams of credit defaults, the ones meant to profit from the imminent demise of the financial system, are right now feeling the sting. They, alone, unwound, praying for negatives, are the source right now of the upside....

Not only that, but we could also be in a moment where there could be gigantic bond issuance to clear up short-term problems.

And best of all, we are not seeing the hidden shorts. Hedge funds bet against the system using credit default swaps, bets that the bonds of institutions would spread in value from Treasuries or go belly-up. The hedge funds levered up in this trade. The price of these swaps is plummeting. Those who are stuck in these positions are going to go belly-up. And the banks that are technically on the other side will zoom.

Recall that the biggest worry two months ago was the $4 trillion credit default market and whether there was counterparty risk. There is, but this time it's on the hedge funds' side.

This is something to watch as the big macro funds that made these bets, one by one, try to get out of these stupid pieces of paper that they are rapidly proving so wrong on.

The hedge funds have been profiting by marks on swaps and securities that materially overstate the losses that the other parties (the banks) will have to take. That materially overstates the profits that the hedge funds have in their unrealized positions. But the hedge funds take 20% of the profit in these unrealized positions, as if they could actually realize those gains. They can't, and that's why they don't cover them. Which is why we had the huge start of the April Fool's stock rally because Q1 for the hedge funds ended on March 31. Press your shorts so you get the benefit of the lower marks, and then try and make up the losses in the next quarter.

But these funds need a depression to book their phantom profits.

Has anybody taken a look at FairFax Financial (FFH 279) a stock the shorts have been squealing about since they pressed it down to the high 80's a couple years back? They had $700 million of gains on these credit default swaps in the first quarter, and gave back $300 million of it in April.

In this volatility exists in stock land where are the bodies in over-leveraged hedge fund land as the financials rally and these swaps tighten?

The banks say they are taking writedowns of which they'll eventually be able to reverse. Maybe that's true, or maybe it isn't. We know S&P now stopped rating second mortgages:

May 1 (Bloomberg) -- Standard & Poor's will stop rating new bonds composed of U.S. second mortgages, saying it's too hard to assess the debt while the housing slump continues.

The recent deterioration of the loans has been ``unprecedented'' and the ``market segment does not allow for a meaningful analysis,'' New York-based S&P said in a statement...

``The problem with seconds is it's either good, or it's zero,'' said Brad Golding, a managing director at Christofferson Rob & Co., a New York-based money manager.

When people are a couple of hundred thousand upside down on a home loan, they walk away. They spend $995 here to get the help to do it right:

They then spend $1,000 at the corner credit repair agency to repair their credit.

This behavior is not in FICO scores or in S&P models. That's why these second mortgages are either good, or they are zero.

But the banks which the hedge funds have bought swaps on, have all the Central Banks in their corner. It's not good or zero, but good today, and better next year.

And that's not in their playbook when you bet on a depression!

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