Paulson in line for $726m payout on Lehman debt

John Paulson, the hedge fund manager who made billions betting against the risky mortgages that bankrupted Lehman Brothers, is set to reap another small fortune from his investments in the defunct bank's debt.

Paulson & Co, Mr Paulson's fund, bought up more than $7bn (£4.3bn) of Lehman's bonds after the bank's collapse in September 2008 at deep discounts to their face value.

After paying an average of 13 cents on the dollar in those trades, Mr Paulson could make as much as $726m on his purchases – a 78 per cent return – if he is successful in a legal contest between Lehman creditors. If the lowest settlement proposal is approved by the bankruptcy court, Paulson & Co will still make about $350m, or a 78 per cent return, according to calculations by the Wall Street Journal.

Mr Paulson's proposed settlement is in a three-way competition with other Lehman creditors and calls for payment of about 25 cents on the dollar for the Lehman bonds that Paulson & Co owns.

The fund's investment strategy on Lehman was based on buying up the stricken investment bank's debt from frightened investors in the belief that the price would rise.

Mr Paulson hit the headlines after making $15bn for his fund – and $4bn personally – in 2007 from betting against the US housing market. On one day alone in 2007 his fund made more than $1bn from the positions it had taken. The decision to use credit default swaps to short-sell complex securities that had parcelled up mortgages sold to poor people is ranked as the greatest single trade by a hedge fund.

The trade was based on the belief that the mortgage market was heading for disaster because millions of "sub-prime" borrowers were taking out loans they would not be able to afford to repay.

That bet was proved correct in 2007 when the realisation that banks held vast quantities of the mortgages packaged up as bonds caused the global debt markets to freeze.

Lehman Brothers was eventually brought to its knees the following year as fearful counterparties pulled funds from the bank over fears about its huge exposure to the stricken US mortgage market.

Before 2007, Mr Paulson was a relatively obscure multimillionaire hedge fund manager in Manhattan who had started his fund with just £2m. Now he is one of the hottest properties in the financial world and is worth $16bn according to the Forbes Rich List.

After betting against the US housing market Mr Paulson went on to take positions in September 2008 against financial companies that were hit by fears over their risky assets, including Royal Bank of Scotland, Barclays and Lloyds in Britain.

He then turned his attention to profiting from a recovery in confidnence and made a reported $5bn last year as his fund reaped $1bn from betting on the revival in the value of Citigroup shares.

Mr Paulson's spokesman declined to comment yesterday.

How the deal was done

* Just as John Paulson acted early to bet against the US mortgage market in 2006, so his hedge fund started snapping up Lehman Brothers' debt on 15 September 2008, the day of its bankruptcy.

* Through about 1,800 transactions it racked up more than $7bn of the bank's bonds at steep discounts. The sellers were more-traditional investors cutting their losses after the bank's implosion.

* Paulson & Co bought most of its Lehman debt holding – more than $6bn – within four months of the investment bank going bust, according to the Wall Street Journal. He was able to act quickly because his fund's analysis of Lehman as the market collapsed gave him the confidence to buy up the bonds.