By Anthony Effinger
Bloomberg News
Sunday, December 2, 2007

The subprime crisis that has caused so much trauma for hedge funds and investment banks has brought only good news for John Paulson. He is the manager of more than $7 billion in hedge fund money keyed to mortgage credit.

Paulson started warning his investors back in the middle of 2006 that the frenzy to build and sell housing was a bubble about to pop. His firm, Paulson & Co. of New York, made big bets predicting the edifice would soon come crashing down. The wager paid off in the first nine months of 2007, when Paulson's Credit Opportunities funds rose an average of 340 percent.

That gain earned Paulson an estimated $1.14 billion in performance fees for the nine months ended Sept. 28. Fees on Paulson's other eight funds bring his total to $2.69 billion, which puts Paulson and co-manager Paolo Pellegrini at the top of Bloomberg's ranking of best-paid hedge fund managers.

Paulson's earnings from his hedge fund bets were three times those of the better-known Kenneth C. Griffin, chief executive officer of Citadel Investment Group in Chicago. His firm manages $16 billion and earned performance fees of $837 million for the first nine months of 2007. Griffin has thrived by buying up distressed assets. Citadel, for example, took over the energy trades of Amaranth Advisors after the Greenwich, Conn., hedge fund collapsed in September 2006 under the weight of $6.6 billion in wrong-way bets on the price of natural gas.

Paulson, 51, made his quick billions by buying credit default swaps -- instruments that rise in value as the risk of default increases -- on mortgage assets. And the hedge fund manager, who still takes the bus to work from his townhouse on East 86th Street in Manhattan, says the bleeding isn't over.

"Home prices nationwide have only fallen 3 percent so far," Paulson & Co. writes in the quarterly letter to investors that was delivered in October. "We expect a peak-to-trough decline of 15 percent to 25 percent to bring home prices back in line with disposable income."

Paulson & Co. operates a total of 12 funds. As a group, they hold $23.6 billion in assets. Paulson's letters to Credit Opportunities investors outline his strategy: Rather than depend on evaluations of mortgage-backed assets by rating companies such as Moody's Investors Service and Standard & Poor's, he and his staff dig into the securities and look at thousands of individual loans.

"Selecting individual securities in which to invest is highly complex and a virtual minefield for the uninitiated," Paulson & Co. wrote in its third-quarter report. "Investors who rely on faulty agency 'ratings,' Street research, or off-the-shelf models will invariably get burned."

Estimates of hedge fund managers' income are based on the simple formula most funds use: 2 and 20. The 2 is 2 percent of assets. Paulson charges 1 percent, a bargain in the land of hedge funds. The 20 is 20 percent of any profit made trading investors' money. By that reckoning, the fees generated by Paulson's four Credit Opportunities funds totaled $1.14 billion.

Paulson, who lives in a $14.7 million home in Manhattan, employs 54 people and shares his earnings with the teams of analysts and traders who help run his funds, a person familiar with his operation said.

He gave some of his profits back to ravaged mortgage borrowers in October, when he donated $15 million to the Institute for Foreclosure Legal Assistance, a nonprofit formed that month by the Center for Responsible Lending, a borrowers' advocacy organization in Durham, N.C.

"Given the success of our funds, we feel it is important to help those who have suffered the most as a result of predatory subprime lending practices," Paulson wrote to investors after the third quarter.

Bloomberg constructed its ranking of top hedge fund earners by using figures from Hedge Fund Research in Chicago and from data compiled by Bloomberg. Its list of best-paid managers came from a universe of 620 individuals who run about 2,000 U.S. and non-U.S. hedge funds with assets of at least $100 million.

Jenny Strasburg, Katherine Burton, Laurie Meisler and Jody Shenn in New York contributed to this report.