Bitten by the gold bug
John Paulson, who made billions in the 2007 US subprime mortgage crisis, is now losing huge sums after a wrong-way bet on the gold market
On a conference call with investors last month, John Paulson, whose bet against the US subprime mortgage bubble in 2007 has been called "the greatest trade ever", boasted that one of his biggest hedge funds would have been up 15 per cent this year -- if only he had not owned gold stocks.
The wishful computation of returns highlights the challenge for Paulson as he seeks to resurrect his reputation as a Wall Street icon and reverse US$9.4 billion in losses for clients in the past two years.
Paulson has done well investing in companies undergoing mergers or restructurings, a strategy where he got his start as trader. Yet his big bets on macroeconomic developments, such as his wager on gold, have undermined that performance.
Jay Rogers, president of Alpha Strategies Investment Consulting in California, which advises hedge-fund investors and managers seeking to raise money, said: "It's a bit of ego on his part: 'I made billions of dollars and did this big trade and I'm a genius.' That hubris leads him to make big bets, and unfortunately most of them have gone wrong."
Ever since Paulson made US$15 billion in 2007 for investors by predicting the tumble in the US housing market, he has stumbled from one losing macro trade to another, chipping away at gains that are still among the largest in hedge-fund history. He has been too optimistic about the US economic recovery and overly bearish about the European debt crisis. Gold, which Paulson forecast would strengthen as investors sought a hedge against inflation, instead entered a bear market this year.
Paulson & Co, once one of the world's biggest hedge funds, has seen its assets slide more than 50 per cent, from a peak of US$38 billion in 2011. Paulson's US$500 million Gold Fund, most of it the 57-year-old billionaire's own money, lost 27 per cent last month, bringing the decline this year to 47 per cent, according to two insiders.
He continues to stand by his gold wager even as the metal fell 13 per cent this year.
Peter Rup, chief investment officer at New York-based Artemis Wealth Advisors, which manages money for family offices, said: "While the trend lasted, terrific, but we could be sitting at US$800 gold in a heartbeat, and his investors are going to be mighty unhappy."
The history of hedge funds is replete with managers who scored big on a trade, only to falter later. Philip Falcone, whose Harbinger Capital Partners made US$11 billion by betting against securities backed by subprime mortgages, has since seen his fortune turn amid a money-losing bet on the wireless venture LightSquared.
Paulson started a gold fund in January 2010. He bought producers including Barrick Gold Corp, and also loaded up on the miners for his Advantage funds, which wager on corporate events. As recently as last year, mining stocks accounted for a quarter of the Advantage funds' assets.
Paulson, who had not made gold investments on that scale before, brought in experts to help him. Victor Flores, a senior mining analyst at HSBC, joined in November 2009. John Reade, a former mining engineer who was UBS's head of metals strategy, started two months later.
A few years earlier, Paulson hired Alan Greenspan, the former Federal Reserve chairman whose last years at the central bank coincided with the formation of the housing bubble, as an economic adviser.
While Greenspan was a gold bug, not all of Paulson's advisers shared that view. Martin Feldstein, a Harvard professor who joined Paulson's economic advisory board less than two years ago, had previously argued that gold historically has not worked well as a hedge against inflation or a declining dollar. "Gold is a purely speculative investment. Over the next few years, it may fall to US$500 an ounce or rise to US$2,000 an ounce," Feldstein wrote in a paper in 2009, the year Paulson started betting on gold on a large scale. "There is no way to know which it will be. Caveat emptor [buyer beware]."
Feldstein, who sits on President Barack Obama's economic recovery advisory board and also advised presidents Ronald Reagan and George Bush, wrote on the commentary website Project Syndicate that between 1980 and the end of 2000, the price of gold fell while inflation more than doubled. And while the dollar fell by almost half against the yen between 1980 and 2005, gold started and ended those 25 years at around the same price, he said.
"Gold may be a good hedge against very high rates of inflation even if there is too much volatility for moderate and low inflation rates," Feldstein said.
Paulson & Co said it consulted with Feldstein "on economic conditions generally, not about gold". Greenspan, in a statement provided by Paulson's firm, said that gold was "an excellent hedge against inflation" over the past eight decades.
"Since 1933, when the US detached itself from full gold convertibility, the price of gold, despite wide fluctuations, has trended ever higher with inflation," he said. "The average annual increase of the consumer price index in the US has been 3.7 per cent, while the price of gold rose at 4.8 per cent annually."