John Paulson, CEO of the top-performing hedge fund family Paulson & Co., says the process of de-leveraging is a little more than half complete, and market opportunities will soon emerge in the financial services sector.  Paulson, whose funds earned some of the highest returns in the hedge fund industry over the last year by betting against sub-prime mortgages, described his outlook to a group of institutional investors on December 3, 2008.

Paulson said he anticipated the credit crisis and, as a result, reduced leverage and increased cash in his funds.  He limited equity exposure by increasing short positions and reducing long positions, and he bought credit default protection against financial services holdings as well as against some of his short positions.

Going forward, Paulson is preparing for “great opportunities on the long side,” he said.

Over the next two years, he sees the “best opportunities ever” in three distressed markets that together total more than $10 trillion: mortgages, banking and finance, and high-yield debt. 

Paulson is looking at distressed mortgages, which he characterized as very complex, because of the large number of individual tranches and the need to analyze data at the loan level.  Paulson said 99% of the owners of this debt are not able to perform analysis at the necessary level of detail.  Buyers typically bought these securities based on their AAA rating and, following credit downgrades, became forced sellers, creating opportunities for his fund.

In the finance area, Paulson sees opportunities in the debt securities of firms like AIG, CIT, Ford Credit, and GMAC.  He said these could be similar to Wachovia’s bonds, which traded as low as 50 prior to its merger with Wells Fargo but have since risen to 90.

High-yield opportunities will emerge in the leveraged loan and corporate markets, but only after default rates peak, Paulson said.  It is still premature to buy, he said, citing Moody’s estimate of a 16% default rate in the next six months.  Recovery rates on defaulted debt will be lower than in previous recessionary cycles, and Paulson said this will affect performance.

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