CONTROVERSIAL HEDGE FUND FIGURE JOHN PAULSON MAKES HUGE PROFITS FROM THE BANKRUPTCY REMAINS OF LEHMAN BROTHERS

Hedge-fund manager John Paulson made $3.7 billion betting against subprime mortgages, the market that ultimately helped destroy Lehman Brothers Holdings Inc. Now, his fund is poised to make hundreds of millions picking through the investment bank's remains.

Mr. Paulson's fund has been snatching up Lehman debt at steep discounts since the day the investment bank collapsed, betting prices would rise while panicked investors fled. Now, as Lehman's estate prepares to wind down, Mr. Paulson's fund could reap profits between $350 million and $726 million on the Lehman trades. Those figures are based on plans being considered in a federal bankruptcy court in New York and a Wall Street Journal analysis of investment disclosures related to the case.

Over two and a half years, Mr. Paulson's fund, Paulson & Co., purchased more than $7 billion worth of Lehman bonds in about 1,800 transactions. The average cost of those trades was just 13 cents on the dollar, according to the Journal's analysis. Some Paulson trades in the disclosures represent transfers of bonds from one of the firm's funds to another, slightly inflating the number of trades reported but not the overall average cost.

A little-known hedge fund, Owl Creek Asset Management, also bought Lehman debt right after its downfall, and it is poised to reap a profit of as much as $71.6 million, the Journal analysis shows. Owl Creek representatives didn't respond to requests for comment.

The court disclosures offer a rare window into the trading strategies of hedge funds such as Paulson, which is involved in a broad scuffle over the best way to wind down Lehman's estate. Paulson is following a classic distressed-debt-investor template. Such investors buy debt in troubled firms they think are undervalued, then often battle in bankruptcy court to earn the best possible gains.

Mr. Paulson is now immersed in a three-way fight over Lehman in bankruptcy court and is pushing for a recovery on the bonds he holds of roughly 25 cents on the dollar, higher than two other plans under consideration.

Away from Wall Street, the outcome of the legal battle has ramifications for the municipalities, pension funds and manufacturers that invested in Lehman before it collapsed. These types of creditors face steep losses and make up much of the more than $350 billion in claims against the estate.

The California Public Employees' Retirement System and San Mateo County bought the same bonds Paulson owns, but paid face value for them in the years before Lehman failed. Both are aligned with Mr. Paulson's fund on its bankruptcy plan, which would give them a better shake than the other proposals. Even so, Calpers would lose $68 million under the Paulson plan, while San Mateo would lose about $115 million.

"This is taxpayer money," said San Mateo County Counsel John Beiers. The funds go toward county services such as police officers, firefighters and school districts, he said. Calpers's representatives declined to comment.

But every cent recovered on the bonds, which were issued by Lehman's parent holding company, will reduce recoveries for other creditors to Lehman's operating subsidiaries.

That includes a Savannah, Ga., pension fund for dock workers that is still trying to recover more than $40,000 on foreign-exchange trades it executed with a Lehman subsidiary before the bankruptcy. A distressed-debt investor recently offered to buy the claim for 15 cents on the dollar, but the fund decided to hold out, said J. Wiley Ellis, a lawyer representing the pension fund.

"We don't have enough involved to participate in those [bankruptcy] proceedings," Mr. Ellis said. Instead, the fund is avidly watching from the sidelines to see which faction wins in court, he said.

Bond giant Pacific Investment Management Co., an Allianz SE unit, holds about $4.7 billion in Lehman debt but didn't disclose details of its trades in the filings the Journal analyzed. Pimco representatives declined to comment.

Even amid recent calls for greater transparency on Wall Street and in markets, the trading disclosures could represent one of the last detailed looks at how hedge funds and others trade in and out of troubled companies' debt.

A judge ordered the Paulson-led group to reveal details of the trades, citing a longstanding bankruptcy rule. But that rule is set to change in December, meaning investors trading in and out of companies under bankruptcy protection will no longer have to reveal prices or dates of transactions, only their aggregate holdings.

The Lehman disclosures show Paulson moving with characteristic pluck, pouncing on Lehman bonds the day Lehman filed for bankruptcy protection, Sept. 15, 2008. While markets sank into chaos, Paulson was busy buying more than $251 million of the bank's bonds at about 35 cents on the dollar. The bonds had been trading at about 80 cents in the days before Lehman sought Chapter 11 protection.

Mr. Paulson's confidence stemmed from research done months before Lehman foundered, said a person familiar with the matter. After determining that subprime-mortgage borrowers would default en masse, the fund began analyzing the banks that had the most exposure. That homework allowed Mr. Paulson to quickly analyze Lehman's worth and make a call on when to start buying the bank's bonds, this person said.

Paulson kept buying in the ensuing months, paying 12 cents on the dollar in October after the government unveiled its $700 billion Troubled Asset Relief Program. The fund picked up more bonds for as little as eight cents on the dollar on Dec. 1, soon after American International Group Inc. received a government bailout.

By Jan. 5, 2009, the fund had bought bonds with a face value of more than $6 billion, representing 90% of its total investment. Paulson subsequently sold some of its position, and the firm now holds a $4 billion claim. If the Paulson-led plan wins in court, the hedge fund would make a profit of about $726 million on the bond trades, a 78% return, according to the Journal's analysis.

Creditors of Lehman's operating subsidiaries, led by Goldman Sachs Group Inc. and hedge-fund Silver Point Capital LP, have proposed an alternative plan that would only give bondholders 16 cents on the dollar. Even under that scenario, Mr. Paulson would earn a profit of about $350 million, or a 38% return, the analysis shows. The Paulson-led bondholders may ask these other creditors to reveal details of their trades.

Like Paulson, Owl Creek paid just 13 cents on the dollar for its bonds, on average, a far lower price than several other hedge funds that placed bets on the debt. If bondholders recover 25 cents on the dollar, Owl Creek would turn a nearly $72 million profit, a 94% return on its $76 million investment.

Note: To determine how investors have fared on their Lehman trades, the Journal analyzed a bankruptcy-court document that details how much debt a Paulson-led group purchased and sold, and the dates and prices of the transactions. The group includes a mix of hedge funds, municipalities and institutional investors.

When a member of the Paulson-led group sold debt, the Journal subtracted the proceeds from the amount paid for all the claims the investor had acquired. The Journal then subtracted that remaining exposure from the potential payout each investor might receive under Lehman's various wind-down plans to estimate potential profits.

On November 13, 2008, John Paulson testified (see below) before the U.S. House Oversight Committee about the risks hedge funds pose in the financial markets following the financial meltdown in September 2008.  You might find his testimony very interesting. 

 

COMMENTARY:    John Paulson is no stranger to controversy.  Paulson & Co., Inc, his hedgefund trading company, played a key role in Goldman Sachs being fined $550 million (SEC record fine) by the SEC for non-disclosure of vital information regarding CDO's underwritten by Goldman Sachs that had been "cherrypicked" and then shorted by Paulson & Co., Inc.  

According to the SEC's fraud charges filed against Goldman Sachs on April 16, 2010,  the SEC alleged that Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing the CDO deal, known as Abacus 2007-AC1, and that Paulson & Co., Inc. made a substantial profit from those CDO's, while other investor's in those CDO's lost over $1 billion.

Here's what an SEC press release says about Paulson & Co., Inc,

"In its April 16 complaint, the SEC alleged that Goldman misstated and omitted key facts regarding a synthetic collateralized debt obligation (CDO) it marketed that hinged on the performance of subprime residential mortgage-backed securities. Goldman failed to disclose to investors vital information about the CDO, known as ABACUS 2007-AC1, particularly the role that hedge fund Paulson & Co. Inc. played in the portfolio selection process and the fact that Paulson had taken a short position against the CDO."

Goldman Sachs executives avoid prison time by settling with the SEC for a fine of $550 million while Paulson & Co., Inc. got off scott free.  The complete SEC's July 15, 2010 press release announcing its $550 million fine and final settlement with Goldman Sachs can be found HERE.

Paulson & Co., also made a lot of money on gold, and probably still is.  In the first quarter 2009, Paulson & Co. invested $3.7 billion in gold, increasing its total investment to $4.3 billion. About 46% of the equity portfolio is now allocated towards gold and gold stocks.

Not familiar with Paulson & Company, or founder John Paulson? You should be, and here’s why:

• Paulson’s bet on the subprime mortgage debacle earned $3.7 billion in 2007.
• The company made an estimated £606 million profit selling short British bank stocks in September 2008. 
• John Paulson ranked #2 on Alpha’s Highest-Earning Hedge Fund Managers of 2008.
• Two of Paulson & Co.’s funds ranked #1 and #4 on Barron’s Top 100 Hedge Funds 2009list.

John Paulson BIO

John Paulson is the founder and president of Paulson & Co., an employee-owned hedge fund headquartered in New York. He earned his bachelor's degree in finance from New York University's College of Business and Public Administration (now called NYU Leonard N. Stern School of Business), where he graduated first in his class. He earned his MBA from Harvard Business School. He began his career at Boston Consulting Group before leaving to join Odyssey Partners, working under Leon Levy. He later worked in the mergers and acquisitions group at Bear Stearns. Prior to founding his own firm, he was a partner at mergers arbitrage firm Gruss Partners LP. In 1994, he founded his own hedge fund with $2 million and two employees.

Paulson & Co. Investment Philosophy

Paulson explains his investment philosophy in a Wall Street Journal interviews as follows:

"The flexibility of having long and short exposure across the capital structure allows us to optimize performance across market cycles. Our goals are capital preservation, above average returns over the long term, and low correlation to the markets."

As the market recovers from its shortfalls of the past years, Paulson is betting on strong economic growth in the recovery:

“it is time to be in the stock market,” he says, and that now is not the time “to be under-invested”.   

Hedge Fund Portfolio Analysis - December 31, 2010

The fund consists of 102 Stocks with a total value of $ 29.27 billion. There have been 39 recent buys. In 2010, the Paulson and Co. funds produced over $8.4 billion of gross gains. Please review the chart below for sector breakdown.

Top Ten Holdings

(GLD) / (AU) / (C) / (BAC) / (APC) / (HIG) / (STI) / (CMCSA) / (COF) / (MGM)

Top Five Holdings Review

For Paulson, all that glitters is gold. 14.93% of Paulson’s holdings are in GLD alone, with approximately 22% in gold securities altogether. Paulson’s gold investments returned over 30% in 2010. Secondly, he has two large bank positions, global money center banks Citigroup and Bank of America, turn around plays from the 2008 financial crisis trading at less than book value. And finally, an energy play with Anadarko. Paulson believes we will have double digit inflation within the next three to five years. Paulson stated inflation, “is already becoming a problem in emerging economies, especially because of rising commodities prices.” Please review the following analysis of Paulson’s top five holdings, recent adds, buys, sells and closeouts.

SPDR Gold Trust

SPDR Gold Trust is an investment trust. The objective of the trust is to reflect the performance of the price of gold bullion. The Trust primarily holds gold. The sponsor of the Trust is World Gold Trust Services, LLC. BNY Mellon Asset Servicing, a division of The Bank of New York Mellon is the trustee. HSBC Bank USA, N.A. serves as the custodian.

The GLD closed Tuesday at $136.27, down $2.59, incurring a 1.87% loss for the day. GLD was recently trading as high as $140.03 on 3/11/11 prior to the recent downturn. It was trading for $110.40 a year ago, providing a gain of 27% over the last year. If you want to invest in gold, GLD is one of the purest plays.

Courtesy of an article dated May 10, 2011 appearing in The Wall Street Journal and an article dated March 16, 2011 appearing in Seeking Alp