Paulson faces big test as clients mull future (Reuters)

By Svea Herbst-Bayliss and Matthew Goldstein Svea Herbst-bayliss And Matthew Goldstein – Mon Oct 10, 5:12 pm ET

BOSTON/NEW YORK (Reuters) – Hedge fund manager John Paulson, long lionized for his successful bets on the collapse of the subprime mortgage market and the surge in gold prices, is now facing the toughest challenge of his career.

With one of Paulson's largest funds down nearly 50 percent for the year and several others also posting big losses, the big question is whether the manager's large and wealthy fan base will scurry for the exits and seek to redeem billions of dollars by year's end.

"There will be a lot of internal discussion at big and small investors alike about the allocation to John Paulson and whether to redeem it or to keep it," said Professor Jim Liew, who teaches hedge fund strategies at New York University's Stern School of Business.

A spokesman for Paulson, who is scheduled to have a conference call on Tuesday with investors to discuss Paulson & Co's dismal third-quarter results, declined to comment.

Most investors have until October 31 to submit a redemption notice for the manager's largest funds -- the Paulson Advantage and Paulson Advantage Plus. So it is still too early to know just how much money investors will seek to pull.

This year alone, Paulson's assets have fallen from a peak of $38 billion to a little under $30 billion because of investment losses and earlier redemptions.

So far, Paulson has sent signals to his investors that redemptions have been coming in at slower pace than a year ago, when the main Advantage fund was up 11 percent while the Advantage Plus fund gained 17 percent.

Some Paulson investors, who declined to be identified, also pointed out that even in years when Paulson was one of the $2 trillion industry's top performers, he has been asked to give money back.

In 2008, a year when Paulson's Advantage Plus fund rose 37 percent, the manager returned more than $10 billion to investors, people familiar with his firm said. That was the year, of course, that Paulson cashed in on his big bet that the subprime mortgage market would collapse.

Ironically, Paulson's troubles now look a bit like the misfortune that has hit Philip Falcone and his Harbinger Capital Management, another hedge fund that rose to fame on the subprime trade and has now fallen on hard times. Harbinger Capital, which once managed over $26 billion, is now down to about $4.5 billion assets under management.

NO MORE MONEY

But what will be different this year is that Paulson will likely not be able to count on a big rush of new money coming into his firm through banks' wealth management platforms, which have been active sellers of the Advantage funds in the past.

"There is no new money coming in this year," said one person who follows the hedge fund industry closely but is not permitted to speak publicly about individual funds. Several industry investors noted that Wall Street firms tend to be unforgiving if they were seduced by a manager's enormous returns but got in just after the big so-called Alpha moment.

"The firm gathered so many assets following a classic pattern: investors pile into a manager after they've had a stellar year. But past returns are not necessarily related to future ones, as we've seen with Paulson and many others, and more assets actually make putting above-market returns on the table more difficult," said Adam Zoia, chief executive of Glocap, which tracks the hedge fund industry.

When Paulson holds his call with investors on Tuesday to explain what happened in the third quarter, clients will be ready with a battery of questions ranging from how much money Paulson personally lost during the last turbulent weeks to what his outlook is for the economy.

"It would seem that the biggest issue Paulson has is that he has no repeatable global macro investment process, as the issues we are facing now are eerily similar to 2008, but he interpreted them in two different ways," said Daryl Jones, Director of Research at Hedgeye Risk Management, which sells investment research to hedge and mutual funds.

TOUGH CALL AHEAD

NYU's Liew added, "He's going to be beaten up like crazy on the call."

No matter what, many on Wall Street are expecting Paulson's assets under management to shrink dramatically over the next months. Already, some on Wall Street are beginning to point fingers at Paulson, blaming selling by his funds for bigger-than-normal stock drops in companies like Bank of America (BAC.N), Transocean Ltd (RIGN.VX) and AngloGold Ashanti Ltd (ANGJ.J).

Still, some Wall Street brokers with clients invested in Paulson are saying now is not the time to bail on him -- the losses are so steep, and the odds are, he has nowhere to go but up.

(Additional reporting by Katya Wachtel; Editing by Gary Hill)

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Report says Goldman duped clients on CDO prices (Reuters)

WASHINGTON (Reuters) – In a frenzy to protect its interests at the start of the credit crisis, Goldman Sachs Group Inc sold mortgage-linked derivatives to clients at inflated prices and misrepresented the nature of the deals, according to documents released by a Senate subcommittee.

Carl Levin, the Michigan Democrat who heads the Senate Permanent Subcommittee on Investigations, told a press briefing on Wednesday that Goldman had "exploited" clients and that top executives had lied to Congress during testimony in 2010.

"They gained at the expense of their clients and they used abusive practices to do it," said Levin, adding there was still time for regulatory agencies to take action against Wall Street.

The company said that while it disagreed with many of the conclusions, it took seriously the issues explored by the subcommittee.

The bipartisan subcommittee issued a report Wednesday on Wall Street's role in the 2007-2009 financial crisis, and used Goldman Sachs as one of its case studies.

As the market for related credit derivatives ground to a halt in 2007, Goldman management became increasingly concerned about the company's exposure.

Top executives held a meeting on May 11, 2007, to develop a "Gameplan" to value those assets. A few days later, Dan Sparks, who headed Goldman's mortgage division, estimated the company might have to take a $382 million write-down on its portfolio.

"I think we should take the write-down, but market at much higher levels," Sparks told Thomas Montag, then the head of sales and trading, in an email message, according to the subcommittee report.

Another executive, Harvey Schwartz, expressed concern about that tactic, saying, "don't think we can trade this with our clients andf then mark them down dramatically the next day."

Nonetheless, Goldman's collateralized debt obligation sales team actively targeted clients who would be most receptive to buying related CDOs, in hopes of getting additional sales commissions, according to the subcommittee.

FURTHER CHARGES?

Levin and his panel's report stopped short of accusing Goldman of illegal behavior, but Levin said regulators at the Securities and Exchange Commission or the Department of Justice could take the probe further.

The SEC filed civil fraud charges against Goldman last year related to a CDO deal known as Abacus, which the subcommittee also examined in its report. Goldman paid $550 million to settle the claims without admitting or denying wrongdoing.

A source familiar with regulatory investigations into Goldman said all the transactions detailed in the committee's report "have already been subject to review by the SEC staff." The source would not comment on whether the SEC's probes are over or whether it plans to pursue additional charges.

A year ago, Levin's subcommittee held a public hearing into Goldman's practices at which top executives were hammered for selling clients securities that Goldman was betting against.

Since then, Goldman has taken steps to address its perceived conflicts of interest and transparency issues. In January, the company unveiled a new reporting process after a months-long review by a Business Standards Committee.

Goldman spokesman Michael DuVally said the changes "will strengthen relationships with clients, improve transparency and disclosure and enhance standards for the review, approval and suitability of complex instruments."

Levin said he plans to refer certain issues from the report to the Justice Department and SEC, though he would not be more specific about the referrals.

Sources familiar with the panel's investigation cautioned against relating the referrals to Goldman specifically. No referrals have been decided on yet, and Senator Tom Coburn, the ranking Republican on the bipartisan committee, would have to agree.

The subcommittee's report said Goldman management provided the sales team with "talking points" to reassure clients who were wary about the deals. The sales team also advocated for pushing the products onto clients abroad who might be less familiar with the deterioration of the U.S. housing market.

COLORFUL LANGUAGE

Goldman executives and traders used colorful and aggressive language in early 2007 as they strove to extract as much profit from clients as possible.

At one point, Goldman tried to engineer a short-squeeze in the collateralized debt obligation market to drive up prices and maximize its own gains, according to emails and other documents released by the subcommittee.

Michael Swenson, who was then head of Goldman's structured products group and is now a managing director, said traders ought to "cause maximum pain" and "start killing" short investors, with the hopes of leaving "people totally demoralized."

Though the plan ultimately failed, Deeb Salem, a trader involved in the short-squeeze maneuvering, called the idea "brilliant" in a self-evaluation.

There were also interesting tidbits from a Morgan Stanley employee who became increasingly frustrated by Goldman's behavior related to the a CDO deal known as Hudson.

As mortgages went bad and ratings agencies downgraded related bonds, Morgan Stanley advocated for a rapid liquidation of the Hudson CDO. That process took more than a year to perform.

"I broke my phone," a Morgan Stanley trader told a colleague in an email message, after a frustrating conversation with his Goldman counterpart.

Morgan Stanley ultimately lost more than $930 million on the Hudson deal, while Goldman ultimately earned almost $1.7 billion by shorting related securities.

(Reporting by Lauren Tara LaCapra; Editing by Tim Dobbyn)

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