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Paulson Calls a Bottom in the Mortgage Market

By Alex Dumortier, CFA - Updated Apr 5, 2017 at 8:08PM

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It's worth listening to someone who has a clue.

If you were hoping to find out what Treasury Secretary Hank Paulson thinks about the mortgage market, I can’t help you -- I was referring to a different Paulson. Not to worry, though; “my” Paulson -- whose first name is John -- is a more credible authority in this area. A hedge fund manager who is no relation to the Treasury Secretary, he has an impeccable track record of successful calls on which he has built a multibillion-dollar fortune:

  • Last year, Paulson earned $3.7 billion personally. What is really impressive, however, is not the amount but the way in which he earned it. In 2006, while “investors” were still flipping condos in Miami and Phoenix, Paulson had already begun betting on a breakdown in the subprime mortgage market. The strategy paid off handsomely in 2007 -- his Credit Opportunities fund gained nearly 600%!
  • In June, Paulson predicted that worldwide losses due to the credit crisis could ultimately reach $1.3 trillion. At the time, the most dire estimate was that of the International Monetary Fund (IMF), at $945 billion. In September, the IMF raised its estimate to... $1.3 trillion. The IMF has approximately 1,300 professional economists on staff; Paulson & Co. had a total of 45 employees as of July 2007. Estimated losses to date are already approaching $1 trillion.
  • 2008 is turning into one of the worst years in the history of the hedge fund industry, with the average hedge fund down 15.5% in the year to October. Despite this, Paulson has achieved a 29.4% gain for his Advantage Plus fund. All of his funds are up at least 15%.

Paulson has not publicly called a mortgage market bottom, but his actions are a good hint that we may be reaching one: He recently told his investors that he started to buy residential mortgage-backed securities (MBSs) during the week of Nov. 10. His purchases were timed to take advantage of price drops after Hank Paulson announced the government would refrain from buying troubled assets as part of its $700 billion bailout program.

When an early (and correct) bear turns bullish ...
... it’s worth paying attention. Unfortunately for most of us, Paulson (Hank) may have passed on owning assets that will generate healthy returns for Paulson (John) and his investors instead.

Still, the Treasury Secretary will take some comfort from any credible sign the mortgage market may have found its bottom. The other people who are hoping John Paulson is right? Bank CEOs. Even with a tab that is now running in the hundreds of billions of dollars, their exposure to mortgage loans, mortgage-backed securities, and related derivatives classified as Level 3 -- the murkiest sort -- remains substantial:

Company

Level 3 Assets (in billions)*

Level 3 Assets as % of Shareholder Equity

Goldman Sachs (NYSE:GS)

$67.9

149%

Merrill Lynch (being acquired by Bank of America (NYSE:BAC))

$55.3

144%

Citigroup (NYSE:C)

$157.6

125%

Morgan Stanley (NYSE:MS)

$78.4

219%

JPMorgan Chase (NYSE:JPM)

$140.8

96%

Wachovia (NYSE:WB) (being acquired by Wells Fargo (NYSE:WFC))

$25.2

50%

Washington Mutual (being acquired by JPMorgan Chase)

$9.9

38%

Source: company SEC filings. *It’s important to note that not all Level 3 assets are mortgage-related.

The table shows that such losses have already exacted a huge toll, with several large institutions being folded into sturdier organizations. The firm that blazed the way down that walk of shame? John Paulson’s former employer, Bear Stearns, which was acquired for a pittance by JPMorgan Chase in May. One bank’s dreck is another man’s fortune -- provided he goes short at the height of the excess and long at the depths of despair.

Hedge funds have had a rough time recently. Here are my thoughts on how to profit from hedge fund selling.

More Foolishness:

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor selections. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$35.37 (4.26%) $1.45
Citigroup Inc. Stock Quote
Citigroup Inc.
C
$53.99 (3.65%) $1.90
JPMorgan Chase & Co. Stock Quote
JPMorgan Chase & Co.
JPM
$118.66 (2.84%) $3.28
The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
GS
$347.68 (3.29%) $11.06
Morgan Stanley Stock Quote
Morgan Stanley
MS
$89.29 (3.39%) $2.93
Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$44.61 (2.79%) $1.21

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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