John Paulson 2008 Year End Report
-Their largest fund, Paulson Advantage Plus, was up 37.6% net vs. SP500 -36.9%
-They aggressively added to Anheuser Busch position in October 2008 becoming the largest shareholder as the deal spread blew out on InBev’s $70 cash offer. When it closed, they made the largest profit on a spread deal in their history
-Their merger arb funds had a good year up 6.3% and 12.55% for their 2x enhanced product. They have a conservative strategy of hedging market exposure, focusing on corporate spreads, targeting competitive bid situations, and the occasional short opportunity
-Their main “event arbitrage” fund, Paulson Advantage Funds, had “another extraordinary year.” Their short event exposure was concentrated on financial firms that they believed were at the risk of failure
-They estimated what the losses would be looking at bank balance sheets and then compared it to “tangible common equity”. They did a ranking of high to low and shorted accordingly
-8 out of the top 10 on their list either failed or had to be recapitalized by governments
-The most over-valued were Fannie Mae and Freddie Mac. The companies’ assets were extraordinarily leveraged. Their analysis showed they were both insolvent if you excluded goodwill, marked their assets to market, eliminated deferred taxes, and properly reserves for non-performing loans. Freddie had negative common equity of $65 billion compared to reported regulatory capital of $37 billion. They felt a government bailout was inevitable
-Their analysis was accurate. Performance of their short portfolio was 90% on average in 2008
-Their long event portfolio was concentrated in areas that do better during recessions like healthcare, utilities, and consumer staples. Nevertheless they lost money in almost all their long positions
-Fortunately they had more shorts than longs and their shorts went down more
2009 Outlook
-For first half of 2009 they have:
1) Slight short exposure to equity markets
2) Remain short financials
3) Focus on long distressed opportunity: mortgages, bankrupt debt, distressed, and capital restructurings
4) Focus on strategic merger deals
-They remain short financials as they don’t believe we are through the financial crisis. Goldman Sachs estimates total U.S. credit losses to be $2.1 trillion this cycle compared to $1 trillion realized losses to date indicating we are only half way through the crisis
-As credit crisis spreads from subprime, all other credit categories will have higher losses threatening the solvency of more financial firms
-The problem with banks is they don’t have enough tangible common equity to absorb anticipated losses
-That being said, he believes the biggest driver of returns in 2009 and 2010 for their fund will be long distressed opportunities. They estimate the total distressed opportunity to approach $10 trillion in mortgages, corporates, financials, and sovereigns. They are targeting a 50% allocation in their Advantage Fund to distressed debt
-Mortgage securities have fallen to a level where they are now buying previously AAA-rated tranches
-As mortgage bonds are being downgraded many holders are selling simply because they don’t have the ability to analyze the underlying collateral, this creates mis-pricing opportunities
-Defaults are accelerating resulting in billions of dollars of defaulted bonds and levered loans. There is no leverage available from banks to buy, so prices fall huge on bankruptcy announcements. Levered buyers are now forced sellers. They can sift through and find good opportunities
-There are also event arb opportunities in debt. GMAC 2011 note appreciated 65% in value when it was announced they would receive TARP funding and become a bank holding company
-They still believe it’s too early to buy financial stocks. They are being very company specific and research intensive
-They took a 24.9% stake in the $1.6 billion recap of IndyMac
-AUM is $28.8 billion at the beginning of 2009, down 1% from 2008
-Madoff fraud highlighted several areas important for investor protection: custody of assets, administration, and auditor selection. Madoff was both the custodian and administrator for his fund and used a 3 person auditing firm
-Paulson uses JP Morgan and Goldman Sachs as prime brokers. All assets reside within them or for cash custodial accounts at Bank of New York Mellon. The administrator is IFS, a division of State Street Bank. Auditors are Deloitte & Touche and Rothstein Kass
-They remain bearish on the U.S. economy and believe the recession will extend to late 2009 and likely into 2010. U.S. stimulus package will likely cushion the decline, but it won’t halt the down-turn and likely have long-term consequences