The 2008 Crash Made Certain People Obscenely Rich
In September 2008, the American financial system stopped working. Banks refused to lend to each other. Credit markets froze.
In September 2008, the American financial system stopped working. Banks refused to lend to each other. Credit markets froze. Lehman Brothers, a 158-year-old investment bank, filed for the largest bankruptcy in US history. The stock market shed trillions in value. Unemployment climbed toward 10 percent. Millions of Americans lost their homes, their savings and their jobs in the space of months.
The crash had been building for years. Banks had spent much of the early 2000s handing out mortgages to people who could not afford them, bundling those loans into complex securities, slapping AAA ratings on them, and selling them to investors around the world. Everyone in the chain made fees. Nobody wanted to ask whether the underlying loans were any good. When they turned out not to be, the whole structure collapsed at once.
What the official story tends to skip over is that while the crash wiped out millions of ordinary people, it made a small number of 2008 financial crisis winners extraordinarily rich. The money did not disappear. It moved.
John Paulson: The Man Who Made $20 Billion
Before 2007, John Paulson ran a midsize hedge fund in New York that specialised in merger arbitrage. He was successful by ordinary measures, worth tens of millions of dollars. On Wall Street, that made him unremarkable.
Starting around 2005, Paulson became convinced that the US housing market was a bubble held together by bad loans and wishful thinking. He began buying credit default swaps, which are essentially insurance contracts that pay out when mortgage-backed securities fail. Almost no one took him seriously. The housing market had never collapsed on a national scale. Ratings agencies continued stamping mortgage securities with top-grade ratings. Banks continued originating the loans. Investors continued buying the packages.
Paulson held his position through months of losses, through investor complaints, through ridicule from rivals who thought he was wrong and reckless. He was not wrong.
In 2007 alone, as the first cracks appeared in the mortgage market, Paulson’s fund made $15 billion. His flagship credit fund gained 590 percent in a single year. One of his other funds was up 353 percent. Paulson himself personally took home roughly $4 billion that year, a record for individual compensation in hedge fund history at the time. By comparison, when George Soros made his famous bet against the British pound in 1992, he earned $1 billion for his firm. Paulson had done fifteen times that in twelve months.
In 2008, he kept going. He pivoted from betting against mortgage securities to betting against the financial institutions that held them, buying credit default swaps on Bear Stearns, Lehman Brothers, and British banks including Royal Bank of Scotland and Lloyds. Over the two years of 2007 and 2008, Paulson and his firm made roughly $20 billion. He personally earned around $6 billion. Gregory Zuckerman, the Wall Street Journal reporter who wrote the definitive account of the trade, called it the greatest single trade in financial history.
Michael Burry and the Investors Who Saw It Coming
Paulson was not the only one of the era’s 2008 financial crisis winners. A handful of other investors had identified the same structural rot in the mortgage market and positioned themselves to profit from it.
Michael Burry was a neurologist turned hedge fund manager who ran a small fund called Scion Capital out of San Jose. In 2005, he began reading through individual mortgage prospectuses, thousands of pages of loan-level data that almost no one else was bothering to examine. What he found convinced him that the loans underpinning mortgage-backed securities were far worse than anyone was acknowledging. He went to the major banks and asked them to create credit default swaps on mortgage securities for him to buy. The banks were happy to sell him what they considered cheap insurance on assets they believed were safe.
Burry spent years holding his position while his investors panicked, demanded their money back, and accused him of incompetence. Some investors attempted legal action to force him out of the trade. He refused to exit. When the market collapsed, Burry earned $100 million for himself personally and more than $700 million for his remaining investors.
Andrew Lahde ran a small Santa Monica hedge fund that very few people had heard of. He shorted subprime mortgage securities and made 870 percent in 2007. Then he did something almost no one else on Wall Street had done before: he quit. In a letter to his investors, he announced he was returning their money and walking away. He had enough wealth and had no interest in accumulating more. The letter was part resignation, part indictment of the financial industry he was leaving.
Steve Eisman, a fund manager who had spent years studying the consumer lending industry and watching subprime lenders engage in practices he considered predatory, also shorted the mortgage market and made substantial returns when it collapsed. He was later portrayed in Michael Lewis’s book The Big Short and the film adaptation that followed.
Warren Buffett’s Crisis Shopping Spree
While the hedge funds were profiting by betting against the system, Warren Buffett was profiting by betting on it. His approach was different, but the results were comparably lucrative.
When Lehman Brothers collapsed and Goldman Sachs was under severe pressure in September 2008, Buffett’s Berkshire Hathaway invested $5 billion in Goldman. The terms he negotiated were extraordinary. Goldman gave Berkshire $5 billion worth of preferred shares paying a 10 percent annual dividend, plus warrants to buy an additional $5 billion of Goldman common stock at $115 per share. Goldman was so desperate for the confidence that a Buffett investment would signal that it accepted terms no ordinary investor would have been offered. The preferred shares alone were paying Berkshire roughly $500 million a year, or around $15 a second. When Goldman repurchased the shares in 2011, it paid a 10 percent premium on top of the original investment. By the time all the returns were counted, Berkshire had made roughly $3.7 billion on the Goldman trade.
Buffett did the same with General Electric, investing $3 billion in preferred shares during October 2008 on equally favourable terms. That investment eventually generated more than $1 billion in profit. He made similar arrangements with other blue-chip companies that were desperate for capital in the depths of the crisis.
In total, Berkshire Hathaway made roughly $10 billion from the crisis-era deals Buffett structured between 2008 and 2011. The pattern was consistent: companies that would never have accepted his terms under normal market conditions agreed to them because they needed his name and his capital to survive. The crisis created the leverage.
JPMorgan and the Art of the Fire Sale
Jamie Dimon, CEO of JPMorgan Chase, spent the years before the crisis building what he called a fortress balance sheet. While other banks were expanding their exposure to mortgage securities and leveraging their balance sheets to maximum capacity, JPMorgan maintained higher capital reserves and more conservative lending standards. When the crash came, that discipline gave Dimon something his competitors did not have: the ability to act.
In March 2008, Bear Stearns, the fifth-largest investment bank in America, collapsed over a single weekend. Its stock had traded at $133 the previous year. The Federal Reserve, desperate to prevent a disorderly failure, brokered an emergency sale to JPMorgan. The final price was $10 a share. JPMorgan also received $30 billion in financing from the Federal Reserve to cover Bear’s most problematic assets. Six months later, Washington Mutual, the largest savings and loan institution in US history, was seized by federal regulators and sold to JPMorgan for $1.9 billion. The bank had been worth $45 billion before the crisis.
JPMorgan’s own executives acknowledged they got Bear Stearns cheaply. The bank projected the Bear businesses would add roughly $1 billion to annual earnings. The Washington Mutual acquisition brought JPMorgan a network of retail branches across California, Florida and Washington State that would have cost many times more to build from scratch. JPMorgan recorded an extraordinary accounting gain of $1.9 billion on the Washington Mutual transaction alone. In the decade following the crisis, JPMorgan’s profit grew from $14 billion to more than $24 billion. Its shares outperformed every major rival.
The Bear Stearns deal eventually cost JPMorgan around $19 billion in legal settlements and regulatory fines related to the mortgage practices of both institutions before the acquisition. Dimon has said in retrospect he would not do the Bear deal again for that reason. But the Washington Mutual acquisition was a clear and lasting gain, and the overall position JPMorgan built from the crisis made it the dominant US bank for the following decade.
The Banks That Survived Got Bigger
The financial crisis did not shrink the banking industry. It concentrated it. The weakest institutions failed or were absorbed. The strongest came out of the wreckage larger, with less competition, and with an implicit guarantee that the government would prevent their failure if things went badly again.
Bank of America acquired Merrill Lynch at the height of the crisis for roughly $50 billion. The deal nearly destroyed Bank of America when Merrill’s losses turned out to be far larger than expected, and the bank required a government bailout. The acquisition was messy and expensive. But it gave Bank of America one of the largest wealth management operations in the country, a position it had spent decades trying to build organically. Wells Fargo acquired Wachovia for a fraction of its pre-crisis value. Across the industry, institutions with strong balance sheets bought distressed competitors at prices that would have been unthinkable twelve months earlier.
The consolidation meant fewer banks, controlling more assets. The six largest US banks held assets equal to 55 percent of GDP before the crisis. After it, that number grew.
What the Numbers Actually Mean
Roughly 8 million Americans lost their jobs during and after the 2008 crash. About 3.8 million homes were foreclosed in 2010 alone. Household wealth in the United States fell by approximately $13 trillion between 2007 and 2009. The global economy contracted for the first time since the Second World War.
Against that backdrop, John Paulson made $6 billion personally. Warren Buffett made $10 billion for Berkshire Hathaway. JPMorgan acquired two major institutions at fire-sale prices and emerged as the most profitable bank in the country. A small group of hedge fund managers who correctly identified the fraud at the centre of the mortgage market collected returns that dwarfed anything their industry had ever seen.
None of the 2008 financial crisis winners caused the crash. Paulson, Burry and the other short sellers were reading the same information that was publicly available. The banks that structured and sold the defective mortgage securities, the ratings agencies that blessed them, and the regulators who failed to intervene bore the actual responsibility. The short sellers simply bet that the consequences would eventually arrive.
What the crash demonstrates is a principle that holds across financial history: crises transfer wealth rather than destroy it. The money that evaporated from stock portfolios and housing values moved somewhere. Some of it went to the people who had positioned themselves correctly. Some of it was absorbed by governments through bailout costs. Most of it simply ceased to exist as asset prices corrected to their real values.
The people who understood what was happening before everyone else had a narrow window in which their knowledge was worth billions. They used it.
Sources
- Zuckerman, Gregory. The Greatest Trade Ever. Crown Business, 2009.
- Paulson & Co. Wikipedia. https://en.wikipedia.org/wiki/Paulson_%26_Co.
- Michael Burry. Wikipedia. https://en.wikipedia.org/wiki/Michael_Burry
- John Paulson: The Contrarian Who Made the Greatest Trade in History. Verified Investing. https://verifiedinvesting.com/blogs/education/john-paulson-the-contrarian-who-made-the-greatest-trade-in-history
- How Market Crash Helped Hedge Fund Operator. NPR. https://www.npr.org/2009/11/06/120183535/how-market-crash-helped-hedge-fund-operator
