When the housing market started to crater in 2007, a small coterie of hedge-fund managers who had bet the bubble would burst cashed in their chips.
They’d made big wagers that the crazy lending could not last, and they were right. The returns were staggering — anywhere between 100 percent and 500 percent.
Four years later, hubris, poor timing, bad judgment and the law of diminishing returns have pummeled the high rollers. Most of them now manage less money than they did four years ago when the big winnings bolstered their coffers.
Led by John Paulson, whose subprime short is the stuff of legend, these men became the new rock stars of the investment world. Other subprime winners included Phil Falcone of Harbinger Capital Management, John Burbank of Passport Capital, Steve Eisman, then of FrontPoint Partners (now Emrys Partners) and Kyle Bass of Hayman Capital Management.
There is no doubt that the subprime “mother of all trades” required brilliant thinking — and a willingness to go against the grain. But such trades are few and far between. “It’s hard to follow success with success,” says Simon Lack, a hedge-fund critic and former insider who worked at JPMorgan.
At first, it seemed Paulson would buck the odds, as he bet correctly on the banking industry’s collapse and its quick turnaround. But 2011 was disastrous as he held onto losing bets way too long.
If Paulson was idolized by everyone else, he seemed to believe in his own omniscience.
“Managers may think they’re right, but it’s only a matter of time, and the market tells you you’re wrong,” says a disappointed Paulson investor.
Paulson became the third-largest US hedge-fund firm before losing a third of his assets last year.
Size itself can be a problem, given the temptation to take on bigger risks in order to get commensurate returns. That appears to be the case with Falcone, who took on huge regulatory risk by investing billions in wireless startup LightSquared, which is now bankrupt.
Hayman’s small size may have been a blessing. At the beginning of 2008, the Dallas-based firm had only about $600 million in capital after making 500 percent on the subprime trade itself.
Bass became a widely quoted expert on sovereign debt woes, from Ireland to Greece to Japan. He now manages $1.1 billion.
Bass’s big bet — what he calls insurance against sovereign mismanagement — is on Japan’s default.
“If Japan blows up, he looks brilliant,” says Lack. Bass puts his odds of success at about 70 percent, and he plans to continue rolling the dice until he wins.
Perhaps the smartest post-subprime move was made by Andrew Lahde, a small California-based hedge-fund manager who gained 875 percent in 2007.
In a good-bye letter to investors, he thanked “stupid” traders and advocated legalizing marijuana. That’s called quitting while you’re ahead.
