Profiting from Subprime: The Other Paulson

Not everyone is losing from the subprime mortgage bomb. Hedge-funder John Paulson is said to have earned $3-$4 billion last year profiting from the implosion of subprime mortgages. That’s cash folks. Not the kind of illiquid paper wealth that Bill Gates or Warren Buffett have. And Paulson earned it in one year. The previous record for hedge fund compensation I believe was set last year when John Arnold at Centaurus was on the other side of the trades that drove Amaranth under. It is believed that Arnold made $1.5 to $2.0 billion in 2006.

George Soros, perhaps the most famous hedge funder of them all, made his mark when he “broke the Bank of England” in 1992. That trade reportedly netted him $1 billion. Plenty of course, but his mark has now been surpassed by at least the two guys above.

There’s lots of interesting stuff to talk about here. How is it that these guys made so much money? Well the first thing readers need to understand is the compensation structure of a hedge fund. I spent five years at one so I know this structure well. The key is 2 and 20.

A management fee of 2% is charged on assets under management, analogous to the management fee that you pay when you invest in a mutual fund. In addition, most hedge funds keep 20% of profits as well.

So for instance: say XYZ Fund begins with $100 million of assets and rises 50% over the course of the ensuing year. At the end, assets under management are $150 million, of which profits are $50 million, 20% of which is $10 million. Oh and there’s the $2 million management fee collected during the year too.

You understand now why Wall Street traders want to be hedge fund managers, not mutual fund managers. They get paid very handsomely to bet big with other people’s money.

Some hedge-funders take 50%(!) of profits, like Steve Cohen at SAC Capital. Why are investors willing to pay ridiculous fees like this? Because some managers are really THAT good. SAC reportedly returned 13% this year AFTER that hefty fee, significantly beating broader market indices.

Lots of hedge fund managers certainly AREN’T worth outsized fees. Guys like Paulson are.

Paulson earned his pay because he figured out HOW to profit from the decline in subprime mortgages. And because he bet big. Think about that problem for a second. You know house prices are going to fall. But how do you place a multi-billion dollar bet on that outcome? You can short housing stocks, but there are only so many stocks out there to short. And anyone who’s ever shorted a stock knows that it can be VERY difficult to borrow enough shares to make a bearish bet of substantial size.

Paulson used highly complex trading strategies involving credit derivates and indices tracking subprime mortgage backed securities. Trades like this aren’t available to individuals. They must be structured through an investment bank and are typically only available to large institutional investors.

Now for the numbers behind Paulson’s gains. According to the WSJ, Paulson’s firm began the year managing $7 billion. His two primary funds returned, get this, 590% and 350% respectively. That’s in one year folks.

Good traders learn how to profit from volatility.

The kicker to this story is that Paulson–who’s not related to the Treasury Secretary–just hired Alan Greenspan, the man many blame for creating the subprime crisis in the first place.

Oh and by the way. Hedge fund profits aren’t taxed as income, they’re taxed as so-called “carried interest.” What does that mean? Paulson will likely pay 15% on his 2007 windfall, not 35% like the rest of us…..that’s an extra $700m the tax man can’t get his hands on…..

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