A Subprime Bet for Paulson?

A hedge fund that has cleaned up by shorting subprime has given $15 million to a nonprofit lobbying for passage of bankruptcy legislation

A $20 billion hedge fund may have hit on a unique investment strategy for playing the subprime mortgage bust: fund a consumer-protection group. Paulson & Co., which has seen its assets under management soar this year through fortuitous bets in the subprime market, has given $15 million to the Center for Responsible Lending, a Washington nonprofit that has been lobbying on Capitol Hill for passage of bankruptcy legislation.

Paulson, run by former Bear Stearns (BSC) investment banker John Paulson, stands to rake in a windfall if the measure passes. The key bill, introduced last month, would allow federal judges to restructure mortgage terms and lower payments on the primary homes of borrowers in bankruptcy, a significant legal change. The process, known as a "cram-down" in industry jargon, is opposed by investment banks that trade in mortgage-backed securities.

Banks Oppose Legislation

The banks say that such wholesale mortgage revisions would wreak havoc in the already brutal subprime secondary market, where home mortgages are packaged together and sold as securities. They fear that allowing cram-downs would further dry up liquidity in the market and cause the value of mortgage-backed securities to collapse. In August, such fears led to severe paralysis in the credit markets and produced massive losses across Wall Street (BusinessWeek.com, 10/11/07).

Center spokeswoman Kathleen Day disputes the banks' analysis of the bill's potential effects. "People saying the markets are going to dry up is just a scare tactic," she says. "We think that's hogwash." The consumer group argues that bankruptcy judges are allowed to reset loan values for other assets, including credit cards and vacation homes, and that such discretion has not harmed the secondary markets for those products.

Paulson Senior Vice President Michael Waldorf says that the hedge fund decided to contribute to the Center for Responsible Lending's legal aid effort as a way to help homeowners. "We decided to make a positive contribution in addressing a serious economic problem. People are being thrown out of their homes," Waldorf said. "And if they don't have enough money to pay their mortgages, then they don't have enough money to pay a lawyer." He also explained that the firm invests in securities, and is not involved in loans or foreclosures. "We just invested because we saw that the subprime loans underlying these mortgage backed securities were unsound," Waldorf said.

Day says the $15 million contribution, disclosed on Oct. 11, comes with "no strings attached" and will be used to finance community groups across the country that provide legal aid to homeowners facing mortgage foreclosure.

Other Bills in Play

The issue has gained prominence in Congress as foreclosures have soared and many Americans face adjustable-rate loans that are due to reset in 2008. There are several bills in play that would change the mortgage bankruptcy rules. One key piece of legislation was introduced Sept. 21 by Representative Brad Miller (D-N.C.) and co-sponsored by influential House Financial Services Committee Chairman Barney Frank (D-Mass.).

"Responsible lenders who made loans on reasonable terms have nothing to worry about in bankruptcy court," Miller said of his proposal, "but predatory lenders will end up with the loans they should have made in the first place." If key senators on the Judiciary Committee can hammer out a deal on their side of the Capitol with a similar bill, the legislation could pass Congress this fall.

While the Center for Responsible Lending has lobbied for the bankruptcy proposal, the group says no funds from Paulson will be used for that purpose. "Not one penny will be used to lobby on bankruptcy or anything else," Day says.

The Center for Responsible Lending will coordinate with another nonprofit, the National Association of Consumer Advocates, to manage the money and distribute it to community groups across the country.

Stanley Brand, founder of the Brand Law Group in Washington, says that the arrangement seems to pass ethical scrutiny both under tax rules and under the new federal lobbying disclosure laws passed this year. As long as the Center for Responsible Lending keeps clear accounts of what the $15 million contribution is financing, he says, it can continue to lobby on Capitol Hill without registering as a lobbyist for the hedge fund or jeopardizing its nonprofit tax status. "There are loopholes in the law, and people find ways to exploit them," Brand says.

Shorting Subprime

Scott Talbott, a lobbyist for the Financial Services Roundtable, a trade association that counts among its members Citigroup (C), JPMorgan Chase (JPM), and American Express (AXP), complains that Paulson is making money on the backs of painful home foreclosures: "The firm has bet that Americans will lose their homes. If the bankruptcy bill is enacted, [Paulson] stands to make large profits."

New York-based Paulson, which has about $20 billion under management, has seen its coffers more than double this year, largely by taking a significant short position on the subprime market, correctly betting that defaults would increase dramatically. Traders familiar with Paulson's strategy told BusinessWeek earlier this year that the hedge fund made a massive, leveraged short bet (BusinessWeek.com, 3/8/07) on the ABX subprime index dropping. The fund reportedly scored a paper profit of hundreds of millions of dollars when the ABX index crashed, according to people familiar with the fund. The ABX subprime index measures the cost of insuring against defaults on subprime bonds.

Aside from the contribution to the nonprofit, Paulson is working to develop a broad coalition of consumer groups to advocate passage of the bankruptcy bill, Day says. The Center for Responsible Lending has been asked to join that group, but has not yet decided whether to do so, she says. Asked whether there was a quid pro quo in taking Paulson's $15 million and joining its coalition, Day says, "You'd have to ask them if they think it is—we don't think it is, and it hasn't been presented like that."

Paulson's Waldorf calls the idea of a quid pro quo "outrageous."

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