Few investors have made as many mistakes navigating markets over the past two weeks as Philippe Jabre.

Mr. Jabre, one of Europe’s best-known hedge-fund managers, bought Japanese stocks on news of the earthquake, and then suffered when the Nikkei Stock Average quickly tumbled 13%. Making matters worse, Mr. Jabre got nervous and sold his shares last week, just before a rebound in Japanese stocks. The miscues cost his firm about $300 million, the worst few days of his career.

But as Mr. Jabre reflects on his decisions, he isn’t sure he made many mistakes.

“I keep thinking about it, what could I have done differently?” said Mr. Jabre, who manages $6 billion hedge fund Jabre Capital Partners SA. “I spent all last weekend asking questions” of friends, colleagues and clients, he said. “We couldn’t take the risk of the Tokyo Stock Exchange closing down, so we sold” Japanese shares.

Investors have been forced to negotiate treacherous markets over the past few years, perhaps none more uncertain than those of the past two weeks. They made on-the-fly judgments about the extent of the devastation from March 11′s earthquake and tsunami, the impact of the unfolding nuclear crisis, and their effects on the global economy.

A former star trader at British hedge fund GLG Partners, Mr. Jabre, 50 years old, left to start his own firm in early 2006. When most rivals were racking up huge losses in 2008, the Lebanese-born investor scored gains in one fund of 3%, 46% in 2009 and 4% last year.

Suddenly, however, many of his decisions are losers. At the end of February, Mr. Jabre’s firm was cautious about Japanese and U.S. markets. He told a colleague he was hoping for a pullback in prices, so he could plow some money in.

On the Friday the earthquake hit, Mr. Jabre saw his opportunity as stocks weakened. At the time, one of his funds, the JabCap Global Balanced Fund, held futures contracts on the Japanese market that would profit if prices declined, a form of protection for the fund. Mr. Jabre, who last year criticized investors for being “too scared” about the European debt crisis, was convinced Japan would rebound.

That day, he stole a few minutes in his private office and lit a cigar. He weighed his options before taking his spot on the firm’s trading floor, with a full view of the mountains and rivers surrounding old Geneva. Mr. Jabre, who once survived an avalanche while skiing, directed his traders to exit the bearish futures trades, believing prices would rise.

“We can take off our hedges and be 100% long,” he told a colleague at the time. Without the hedge, which had reduced his fund’s Japanese exposure to 9% of his portfolio, Japanese shares became 15% of his portfolio, a sizable wager.

News over the weekend soon arose about problems at Japan’s Fukushima Daiichi nuclear plant, taking Mr. Jabre by surprise. Monday and Tuesday brought big losses in Japan and elsewhere. Trying to assess the impact of the damage, Mr. Jabre consulted four nuclear scientists.

By Wednesday, the Nikkei had dropped 13% in four trading days. Several of Mr. Jabre’s funds faced losses, one of them as much as 10% for the month. To his traders, Mr. Jabre appeared calm. He wasn’t.

“I felt horrible, but I don’t express happiness or frustrations,” he said. “Emotions are the enemy of a balanced person.”

During the 2008 U.S. stock-market collapse, Mr. Jabre bailed on his positions after 10% losses, enabling the fund to survive a market that felled some rivals.

Mr. Jabre reasoned that if radiation spread to Tokyo or a nuclear reactor exploded, authorities could close the Japanese stock market, freezing his shares for months. “If we touch negative 10%, we get very, very, very nervous,” said Mr. Jabre, who promises his investors to keep losses to a minimum.

Last Wednesday, Mr. Jabre cut positions in Japanese and global shares, eliminating his firm’s entire exposure to all stocks.

“If we’re wrong [and the market rallies], we set the firm back,” Mr. Jabre remembers telling a colleague. “But we’ll be alive to fight another day.”

“People like us tend to sell high and buy low; to sell low feels very odd,” he said. “But this is the firm’s style, even if there’s just a one-in-six chance of a nuclear explosion, we couldn’t take the risk.”

Two days later, however, Japanese and foreign monetary authorities took steps to stem the rise in the yen, helping shares rebound. By this week, the situation at the nuclear plant showed signs of stabilizing, bolstering global markets, though Friday brought new concerns of a radiation leak. The Nikkei index is up almost 5% since Mr. Jabre bailed. “We got whipsawed,” he acknowledged.

Mr. Jabre bought global shares on Monday of this week, but he remains cautious about Japanese stocks and the yen. It isn’t clear how recent events will impact Japanese companies, Mr. Jabre said.

He now is calling clients, who include wealthy investors and institutions, to explain the recent losses. He acknowledged he shouldn’t have turned bullish so quickly after the earthquake. As for bailing out early, “it’s the first time a nuclear meltdown was at risk,” Mr. Jabre said. “It was hard to assess the consequences.”

The rebound in U.S. shares over the past week has helped his funds. A convertible fund that had dropped 5% during the worst of this month’s trading now is slightly positive for the year.

But the JabCap Global fund, one of his biggest with $1.5 billion in assets, remains down 7% this month and has lost 3% this year, worse than most competitors. Most of his investors understand his recent moves, Mr. Jabre said. Few have asked to pull their money and some are adding more cash, he said.

“The reason we’re still around is our risk management,” he said. “We’re telling clients that we’ve lost six months of performance, but we’ll be back.”

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

As financial markets struggle to digest the catastrophic effects of Japan’s earthquake, growing violence in the Middle East and resulting jolts to global economies, traders like John Brynjolfsson and Samer Nsouli are engaged in a furious fight to try to stay ahead of events.

Wednesday afternoon, Mr. Brynjolfsson was in the lobby of a Denver office building, waiting to meet a potential investor for his hedge fund, Armored Wolf LLC. Rather than review notes for the meeting, however, Mr. Brynjolfsson couldn’t take his eyes off a television screen flashing market prices.

Soon he was calling contacts at Wall Street banks, searching for information about what he describes as “a freefall panic” in currency markets that sent the yen soaring to its highest level in years, and the dollar tumbling, all between 5:10pm to 5:20 Eastern time on Wednesday.

Mr. Brynjolfsson dialed his trader, Tim Alford, who was back in the office in Aliso Viejo, California. Their $500 million fund already was short the yen, costing it money. Now Mr. Brynjolfsson wanted to add more bearish positions.

“It’s not worth it,” Mr. Alford told his boss, urging caution.

Around the same time, Mr. Nsouli was at his trading desk in New York, watching the historic plunge of the dollar against the yen.

“I can’t believe this,” Mr. Nsouli said to a colleague in the office of his $80 million hedge fund, Lyford Group International Ltd. Rather than make a currency move, Mr. Nsouli quickly sold U.S. stocks, expecting the dollar’s drop to weigh on shares. In a matter of minutes he would learn if he was right.

Mr. Brynjolfsson and Mr. Nsouli are called “macro” traders because they bet on global macroeconomic events. Unlike most mutual funds and other vehicles, these investors can trade stocks, bonds, currencies and commodities around the globe, a freedom that helps explain why they’ve seen a rush of money from investors, as global political and economic events have more impact on markets than ever before.

But with the freedom comes added pressure. Mr. Brynjolfsson and Mr. Nsouli hold hundreds of millions of dollars of positions in global markets, forcing them to react instantaneously to different events around the globe.

A coordinated intervention in the world’s currency markets as the G-7, in a very rare move, agrees to a concerted effort to drive down the yen. WSJ’s Jake Lee and Hong Kong Bureau Chief Peter Stein discuss.

One example is oil. The nuclear accident in Japan suggested to some traders that the prices of oil, natural gas and coal would rise, as Japan and other nations move away from nuclear power, putting new pressure on already stretched energy markets. Some investors have bid up these investments. Other traders countered that the falloff in demand in Japan is quite small, or that the events there would cause a slowdown in overall economic activity, something that should hurt oil prices.

“A nuclear leak can cause oil to rally or sell off, usually in the same time,” said Mr. Brynjolfsson, citing moves in Thursday’s oil market. “And instead of typical 25-cent or 50-cent moves it’s $1 or $3.”

As they desperately search for an edge, the investors are turning to new sources of information. Mr. Nsouli, a native of Lebanon, has begun to rely on Al Jazeera’s coverage of the events. And he’s using insights from emails sent by his cousin, who lives in Bahrain, about the violent protests in that country.

One email yesterday afternoon read: “hey buddy. situation has gone from bad to worse, and in the past 48hrs it has really spiraled out of control.”

Mr. Brynjolfsson has taken to peppering questions at his 84-old father, Ari, who spent 40 years as a nuclear scientist, asking about the potential impact of Japan’s nuclear crisis.

“The amount of confusion is extreme,” Mr. Brynjolfsson says.

Mr. Brynjolfsson and Mr. Alford spent much of Wednesday debating what to do. Early in the day, while he was on the way to his meeting, Mr. Brynjolfsson listened as a European energy minister called the situation in Japan a disaster. Global stocks soon tumbled.

Seconds later, Mr. Brynjolfsson shot off an email to his portfolio manager: “Fade the rantings of the EU commissioner,” using trading lingo for ignoring the minister’s sentiments.”In five hours we’ll find out he has no information beyond last night’s Rachel Maddow show.” Don’t shift the firm’s positions, he told Mr. Alford. “The guy didn’t know what he was talking about,” Mr. Brynjolfsson explains.

He had been consulting with nuclear and medical experts, asking about the impact escaping radiation could have on citizens of the country and what could be done to help them prevent injury. He also consulted his father, who wasn’t panicked.

“We’re overdoing it,” Mr. Brynjolfsson concluded to a colleague, saying his fund should consider buying uranium. Mr. Brynjolfsson also was tempted to buy Japanese shares. But he worried that even if he didn’t think the nuclear threat was great, others might.

“If 90% of experts say don’t buy Toyota it doesn’t matter if they never find radiation on car seats,” he says.

As the yen soared late in the day, Mr. Brynjolfsson became more convinced he had to act. He long argued that Japan’s heavy debt, slow economic growth and demographic challenges eventually will cripple the nation’s currency and Japanese government debt. The Bank of Japan will be even more likely to spend money and reduce the value of its currency to help the country rebound from the recent disaster, Mr. Brynjolfsson argued.

Mr. Alford, his trader, was less convinced. He was on the phone with traders in Wellington, New Zealand, trying to figure out why the yen was plunging, concluded that it likely was because it came at a time of little trading in currency markets.

“Someone could be messing around” with the market, he said. He argued that the market was in such turmoil it would be hard to short yen at the prices quoted at that moment.

Mr. Alford also told Mr. Brynjolfsson that even if he was right in the long run, other traders could be piling into the yen, some of them scrambling to exit bearish positions on the currency, making a short bet on the yen a likely losing proposition, at least in the near term.

Shorting Japanese government debt “is where hedge fund managers go to lose money,” Mr. Alford says, citing years of losses by those making this trade.

“I’m tempted.” Mr. Brynjolfsson says. “But Tim’s trying to protect me.”

He stepped up a recent effort to slice the firm’s positions in almost every market, from stocks to emerging market debt, preparing for even bumpier times for the market. But because he clung to his relatively upbeat outlook for the Japanese crisis, Mr. Brynjolfsson warned his team to exit bearish positions before bullish ones.

Mr. Brynjolfsson flew back to California on Wednesday night, arriving at his fund’s office before 6 a.m. He and his team continued to trim the firm’s positions, while holding onto some bullish bets. That helped yesterday, as stock markets rallied. Trying to relax from the action, Mr. Brynjolfsson walked to a Zen garden in his office complex, sitting by a koi pond, waiting to hear if the Denver investors would become a new client.

Back in New York, Mr. Nsouli also was startled by the huge move in the yen late on Wednesday. Instead of trading that currency, he decided to add short positions on the Standard & Poor’s 500. Within minutes of the yen move, he had sold $45 million of futures contracts on the S&P 500. Just a half an hour later, the position had gained 1%, and Mr. Nsouli quickly sold it, pocketing a quick $450,000.

By Thursday, his focus was again focused on the Middle East, an area he thinks will have even more impact on global markets in the weeks ahead.

“The most underestimated and overlooked issue is what’s happening today in Bahrain,” he said yesterday afternoon. Mr. Nsouli argues that there’s a 20% chance that Iran enters the situation, something that could bring the U.S. into military conflict with the nation.

Such a scenario would send oil prices surging, he says. So Mr. Nsouli has been buying up oil contracts, using any dip as a reason to buy more. That move paid off Thursday, as crude prices soared 3.5%.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Hedge-fund manager John Paulson personally netted more than $5 billion in profits in 2010—likely the largest one-year haul in investing history, trumping the nearly $4 billion he made with his “short” bets against subprime mortgages in 2007.

Mr. Paulson’s take, described by investors and people close to investment firm Paulson & Co., shows how profits continue to pile up for elite hedge-fund managers. Appaloosa Management founder David Tepper and Bridgewater Associates chief Ray Dalio each personally made between $2 billion and $3 billion last year, according to investors and people familiar with the situation. James Simons, founder of Renaissance Technologies LLC, also produced profits in that range, say investors in his firm.

By comparison, Goldman Sachs Group Inc., Wall Street’s most profitable investment bank, paid all of its 36,000 employees a total of $8.35 billion last year. James Gorman, chief executive of 76-year-old investment bank Morgan Stanley, is expected to receive compensation of less than $15 million for 2010.

Mr. Paulson and his fellow managers seldom take much of their profits in cash. Some of the profits are so-called paper gains, which reflect the rising value of their firms’ holdings, and could erode if those investments sour. Other gains come from selling investments, and most of those are rolled back into their funds.

Mr. Paulson and the other top managers made winning bets on commodities, emerging-market companies, bank shares and U.S. Treasury bonds, among other investments. These moves, along with profitable picks by other funds, are part of the reason the hedge-fund industry is back on its feet after a rough stretch. Assets managed by hedge funds have grown to a near-record $1.92 trillion, up 20% over the past year. Assets jumped almost $150 billion in the fourth quarter alone, the largest quarterly growth on record, according to Hedge Fund Research, Inc.

Still, the average fund gained just 10.49% last year, according to the research firm. That’s well below the 15% gain of the Standard & Poor’s 500 stock index, including dividends, and the 19% return of the average stock mutual fund, raising questions about whether the industry can profitably invest the influx of new cash.

Indeed, the enormous gains by Mr. Paulson and the other managers resulted from solid, though not spectacular, performance. Their personal gains came in part from the sheer scale of assets under their control. The largest hedge fund in Mr. Paulson’s $36 billion investment portfolio, Advantage Plus, grew 17% last year, while another big one rose 11%, falling below returns for the broader stock market.

Part of Mr. Paulson’s more that $5 billion profit came from his firm’s 20% cut of his funds’ profits, known in the industry as the “performance fee.” Those fees amounted to roughly $1 billion last year, according to a person familiar with the matter. An added plus for Mr. Paulson: A chunk of those profits are treated as long-term capital gains and taxed at a far lower rate than the standard income-tax rate.

More than $4 billion came from gains on Mr. Paulson’s investments in his funds.

Mr. Paulson amped up profits for himself and many of his investors in a novel way. He was worried about long-term weakness of the dollar and other major currencies, so he devised a way to embed a bet on gold into each of his funds—for those investors who opted for that approach. Mr. Paulson has placed the bulk of his own wealth in these gold-denominated funds and a separate gold-focused fund. Because gold rose sharply in value last year, the gold-denominated versions of his funds rose as much as 45%.

The performance last year, nevertheless, paled in comparison to his 2007 returns, when Mr. Paulson made a huge wager against subprime mortgages and his funds scored gains of as much as 590%.

Last year “wasn’t the greatest trade of all time, but to manage more than $30 billion and still have gains topping 30% is very rare in the hedge-fund business,” says Jeffrey Tarrant, who helps run Protégé Partners, a New York firm that invested in Paulson & Co. in the past.

One way to view the size of Mr. Paulson’s $5 billion profit: It is nearly as much as the $6.4 billion that Forbes magazine last year estimated as the total net worth of Steven Cohen, the well-known head of $12 billion hedge-fund firm SAC Capital. (Mr. Cohen likely added about $1 billion in 2010, one investor says, after 16% gains in his flagship fund).

Appaloosa’s chief, Mr. Tepper, who specializes in distressed-debt investing and manages around $16 billion, notched gains of about 30% by turning optimistic about U.S. stocks before many rivals. Mr. Tepper correctly anticipated the Federal Reserve’s recent efforts to boost the economy, steps that have helped the market rally.

Mr. Dalio’s Bridgewater Associates, which manages $86 billion in hedge funds and other vehicles, made an early shift to U.S. Treasurys, commodities and emerging-market currencies. He correctly anticipated that the Fed would flood the financial system with cash to help the economy, something that would boost bond and gold prices. Bridgewater also anticipated growth in China and emerging markets, which it figured would help commodities and currencies of those nations. Its hedge funds gained more than 30% last year.

Mr. Simons no longer runs day-to-day trading at Renaissance Technologies, which manages nearly $16 billion and specializes in lightning-quick computer-based trades, so his pay actually dropped a bit in 2010.

But Mr. Simons still owns the bulk of the firm and invests in its hedge funds. Renaissance’s two funds available to outside investors, Renaissance Institutional Equities and Institutional Futures funds, gained about 18% last year, following a disappointing 2009 when the firm considered closing them to outsiders.

Renaissance’s Medallion fund, which is primarily open to Renaissance employees like Mr. Simons and has long recorded big gains, climbed about 30%, according to people close to the matter.

The hedge-fund business now is so big that some managers are hinting they’ll return money to clients instead of investing it. Handling so much cash can make it hard to generate big gains in some trading strategies.

Mr. Tepper, for example, has told some investors to expect to receive some cash back in 2011. He returned $500 million to investors last year. This year, he may return several billion dollars, according to people close to the matter.

Other firms, such as Paulson & Co., have closed certain funds to new investors, but are actively raising new money for other funds. Mr. Paulson recently hosted a New York City event that featured speeches by former Fed chief Alan Greenspan and several chief executives of gold companies, aimed at boosting interest in his gold-focused fund.

Despite Mr. Paulson’s winning touch in 2010, he may face a challenge. Gold is down more than 6% so far in 2011, meaning he is likely starting out with losses.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Mr. Ward’s Armajaro Holdings Ltd. shook up the commodities market in July by buying a $1 billion cache of cocoa, enough to make 15 billion Hershey’s milk-chocolate bars. But since Mr. Ward made his audacious bet, cocoa prices have dropped 26%.

Two hedge funds run by Armajaro, including its CC+ Fund, which focuses on cocoa and coffee, lost about 6% of their value during the first two weeks of August, according to investors who have viewed the returns. And since then, prices have continued to decline, suggesting Mr. Ward could be coming under more pressure.

It isn’t certain the drop in cocoa is to blame for the recent losses. And some analysts say the recent decline in prices may be short-lived. An Armajaro spokesman declined to comment.

The funds remained up about 12% on the year through the middle of August, the investors say.

Mr. Ward, a 50-year-old trader, has gained a level of prominence in the commodities markets, having made big bets on cocoa at least twice before, in 1996 and in 2002.

Farmers work on cocoa pods at a farm in San Pedro, Ivory Coast, earlier this month. Cocoa prices have fallen since a large purchase in July. (Reuters)

Armajaro in July took delivery of 240,100 metric tons of the commodity—accounting for almost all the cocoa stored in approved commodity-exchange facilities across Europe, and totaling about 7% of the world’s cocoa supply.

The purchase was the second-largest delivery of cocoa beans on record, according to figures from ABN Amro, ranking only behind Mr. Ward’s 1996 strike.

Around the time Armajaro took possession of the cocoa in July, cocoa prices had reached 33-year highs amid worries about wet weather in the Ivory Coast, the supplier of 40% of the world’s cocoa.

Armajaro bet supplies out of the Ivory Coast would dwindle, driving prices even higher.

But instead, the weather has improved markedly, and optimism is growing that the next Ivory Coast crop will be plentiful. That has coincided with concerns that a weaker economy could hit demand for chocolate in the U.S. and Europe. There are signs Asia-based processors that provide cocoa butter to some developed markets have reduced production recently, according to a person familiar with the matter.

Cocoa prices have fallen 11% since the end of July on the NYSE Liffe exchange. They settled Thursday at £2,021 ($3,122) a metric ton. Prices are down 10% for the year.

The situation could easily turn in Mr. Ward’s favor, either because of supply shortages or increases in demand. For instance, political tension has been roiling Ivory Coast for years, and elections are to be held at the end of October, introducing the potential for short-term disruptions.

It isn’t known whether Armajaro has sold some or all of the cocoa it bought in July. Armajaro also hasn’t disclosed the price at which it started buying the beans.

Mr. Ward’s funds are volatile, so they could stage a rebound after the recent setback. One Armajaro fund scored gains of 18% in June of this year after losing more than 12% in February.

Mr. Ward has made money on cocoa in the past. His 2002 cocoa play netted him $17 million on a £300 million purchase, according to news reports at the time.

While Armajaro runs a hedge-fund business, with about $1.7 billion under management, it also is a large player in the physical market for cocoa beans. It buys cocoa in Ghana, Ivory Coast, Nigeria, Indonesia, Malaysia, Vietnam and Ecuador. It then sells that cocoa to processors. The group employs more than 1,000 people, according to its website.

Mr. Ward started Armajaro in 1998 as a cocoa merchant and later moved into asset management, opening his first commodities fund in 2004, he said in an interview posted earlier this year by Opalesque, a website that provides news about alternative investments.

Opalesque TV (insert), Reuters

Anthony Ward, inset, in an interview with alternative-investment website Opalesque, in January touted his weather data. His bet on wet weather hurting Ivory Coast cocoa supplies has become cloudy as the forecast improved. Here, workers carry bags of cocoa in San Pedro, western Ivory Coast, earlier this month.

“Pretty much all of you around the world will have had product that’s been sourced by Armajaro,” Mr. Ward said in the interview, of the firm’s cocoa- and coffee-supply business.

The firm puts a premium on data about the weather because of its potential to affect crops, and therefore the balance between supply and demand, he said. “We invest hugely” in weather data, Mr. Ward said in the interview. “We even have our own weather stations, our very own, that no one else has, in some parts of the world.”

—John James in Abidjan, Ivory Coast, contributed to this article.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Liam Pleven at liam.pleven@wsj.com

By GREGORY ZUCKERMAN

A Canadian insurer is turning to a seldom-used strategy to make a big wager on falling prices over the next decade.

Greg Zuckerman discusses a Canadian insurer that has wagered on derivatives that profit from a decline in consumer prices.
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

Prem Watsa’s Fairfax Financial has already made a $100 million paper profit by wagering on deflation.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Still, Fairfax isn’t selling its deflation protection, despite its recent run-up in value. It thinks bigger gains could be ahead if the U.S. experiences a painful bout of deflation.

“We are extremely concerned about a double dip in the economy and about a deflationary environment,” says Paul Rivett, chief operating officer for Fairfax’s investing department.

Derivative bets on inflation aren’t new. Some companies and investors pay small premiums to buy inflation “caps” or “floors” that pay off if inflation rises above or falls below a certain level. Others buy derivatives betting on moves in economic indicators like the CPI, the inflation indicator that is now running at an annual rate of about 1%.

But interest is growing among some larger investors for deflation derivatives like those Fairfax bought. Today it would cost about $330 million to protect the same $22 billion, dealers say.

Traders can sell these contracts to others in the “interdealer market,” where banks trade with each other, something that was rare for such contracts six months ago. About $4.5 billion worth of these contracts have been trading each month in the interdealer market, up from $2.5 billion a month last year, according to traders.

Fairfax was founded in 1985 by Prem Watsa, who has made a series of acquisitions; its name derives from the phrase “fair, friendly acquisitions.” Mr. Watsa’s investments for Fairfax have led some to dub him Canada’s Warren Buffett.

But in the U.S., Fairfax also has drawn attention for heated battles with short sellers; it has claimed these bearish investors helped drive down the insurer’s shares several years ago before they turned higher in 2006. Fairfax shares have soared to more than 400 Canadian dollars (US$377) a share from about C$100 four years ago.

The insurer has a solid track record anticipating bad economic times. In 2003, Fairfax bought credit derivatives wagering on weakness among lenders including Countrywide Financial, scoring several billion dollars of profits when the housing market cracked in 2007.

Lately, the company has been studying bouts of deflation suffered in the U.S. and, more recently, in Japan, and it is getting worried.

“People say they understand deflation, but they don’t understand how corrosive it is,” Mr. Rivett says.

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Fairfax wouldn’t comment on potential returns or how the trades were structured.

Some banks selling these derivatives say they are skeptical of deflation. Prices for the derivative insurance suggest a 20% chance of deflation over the next 10 years, traders say. The banks say they have hedged their exposure, or reduced their risk, by finding other investors skeptical of deflation to take the other side of the trades or by purchasing their own insurance.

But traders say there are no perfect hedges when selling these derivatives. Some could be on the hook in the event of steep deflation.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Mr. Pellegrini’s PSQR Capital has lost about 11% so far in 2010, according to a person close to the matter. The decline included a drop of about 8% in July, after bets against U.S. Treasurys and other moves went awry. The loss has made it more difficult for him to raise cash from investors.

Mr. Pellegrini’s fund gained more than 61% last year, and he had hopes of growing the firm, which he launched after leaving Paulson & Co. But investors have proved reluctant to place money with midsize hedge funds over the past year. The decision was reported by AR Magazine.

In a letter to his investors this morning, Mr. Pellegrini, who has been bearish on financial assets, the dollar and government bonds, said he could reopen his firm to outsiders in the future. For the time being, the firm will invest only his own money.

“While my views on global economies haven’t changed, I’ve concluded that substantial additional work is required to position the Fund to profit consistently from those views,” Mr. Pellegrini wrote.

Mr. Pellegrini, 53, has been buying industrial commodities over the past year. In his letter, he told his investors he would return their money by September 30.

The move by Mr. Pellegrini comes two days after billionaire investor Stanley Druckenmiller, who once ran George Soros’s hedge-fund firm, told clients he is ending his 30-year run managing money for clients, citing the “high emotional toll” of not performing up to his expectations.

A spokeswoman for Mr. Pellegrini declined to comment.

After joining Paulson & Co. in 2004, Mr. Pellegrini, a former banker and native of Italy, made little mark at the firm as a merger analyst. But soon he began to analyze the soaring housing market and quickly turned bearish. In 2006, Mr. Pellegrini provided Mr. Paulson with data that served as evidence that the housing market would likely collapse. He also helped Paulson & Co. find the riskiest subprime-mortgage securities to bet against, steps that led to the largest trading gain in history.

After leaving Paulson & Co. at the end of 2008 to start his own firm, Mr. Pellegrini led a relatively quiet life, splitting time between his firm’s offices in New York and Bermuda.

His relative anonymity ended in April when the Securities and Exchange Commission charged Goldman Sachs Group Inc. with civil fraud when the company failed to disclose that it worked in part with Paulson & Co. to design a $1 billion collateralized debt obligation. Paulson & Co. eventually made $1 billion of profits from the CDO. It was one of the series of deals that Mr. Pellegrini helped create so Paulson could expand its bearish housing wager.

During the SEC’s investigation of Goldman, Mr. Pellegrini answered questions posed by government officials, according to people close to the matter, telling them that he and Mr. Paulson did nothing wrong. Mr. Paulson and his team, including Mr. Pellegrini, never were charged.

Goldman recently settled the charges, paying the SEC $550 million.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Zuckerman’s book depicts the evolution of hedge fund megastar John Paulson’s massive payday resulting from his timely bet against sub-prime mortgages when housing prices appeared to have a one-way ticket to the moon . Zuckerman’s portrait of the colorful gallery of individuals who won and lost as a result of the housing meltdown makes the book a compelling read even for financial novices.

“The Greatest Trade Ever” has recently received renewed attention amidst the SEC’s allegations regarding Goldman Sachs role in Paulson’s trades. Who thought a book about the hedge fund industry could be a page- turner?

Space is limited, so reservations requested. Call 781-431-1160; events@wellesleybooksmith.com. The event will be downstairs at Wellesley Booksmith, 82 Central St.

John Paulson hasn’t been accused of any wrongdoing. But the hedge-fund billionaire has gone on the offensive to reassure investors that his huge firm will emerge unscathed from a case that has drawn him into a political and legal vortex.

The steps, including a conference call with about 100 investors late Monday, come amid indications from some clients that they might withdraw money from his firm after a lawsuit brought by the government against Goldman Sachs Group Inc. related to an investment created at his firm’s request.

Investors have indicated they are concerned that scrutiny over the firm’s deals may spread, including to overseas regulators. They said they wanted to protect themselves in case new information emerges that could damage the hedge fund, they say. Another issue, they say: The legal case could simply prove a distraction for Mr. Paulson.

“Some of the callers asked pointed questions, almost like a court inquisition, but most people were supportive,” said Brad Alford, who runs Alpha Capital Management. “I felt reassured that he did nothing wrong.”

“It’s not a rush for the doors,” said another investor in Paulson & Co. who has communicated with larger Paulson investors since Friday, when the government unveiled its Goldman case.

Mr. Paulson sent a letter to investors Tuesday night saying that in 2007 his firm wasn’t seen as an experienced mortgage investor, and that “many of the most sophisticated investors in the world” were “more than willing to bet against us.”

Mr. Paulson’s firm focuses on largely liquid investments, those relatively easy to sell without pushing prices much lower. Even if a number of investors ask out, the firm likely will be able to sell investments without crippling their holdings, investors say.

Some traders have been examining Mr. Paulson’s top holdings and positions in which filings indicate he has been a substantial holder since the news, they say. When the news of the lawsuit broke on Friday, some of these stocks, including Conseco Inc., Cheniere Energy Inc. and AngloGold Ashanti Ltd., fell sharply.

The case has delayed the initial public offering of a Canadian investment fund, Propel Multi-Strategy Fund, formed to give investors exposure to two funds advised by Paulson, according to people familiar with the offering. Propel didn’t respond to requests for comment.

On the Monday night conference call, some investors asked if Mr. Paulson or anyone at the firm had received a government notice of potential civil charges, called a Wells notice, according to people familiar with the call.

Mr. Paulson said no. Mr. Paulson said the case wasn’t a distraction that was affecting the firm’s investments, and that he was confident the public glare would abate.

On the conference call, Mr. Paulson calmly explained the trade with Goldman, which involved a “short” bet on mortgage bonds. He said that the very nature of the transaction required both a “long” and “short” investor, suggesting that investors knew that a bearish investor had bet against the deal.

Mr. Paulson suggested to clients that the large investors who purchased the Goldman deal and others relied on rating firms, and didn’t do enough of their homework, investors say.

The hedge-fund firm has a deadline next Friday for investors who want to withdraw money on June 30. Paulson allows most investors to pull out four times a year, but they need to give at least 60 days notice. Investors can cancel redemptions before the end of June.

Magnetar Capital LLC, another hedge-fund firm that, like Paulson, was heavily invested in collateralized debt obligations in 2007 also has been working to reassure investors that it believes its mortgage-linked investment strategy was sound and can withstand regulatory scrutiny.

Investors in Magnetar, which oversees some $7 billion in assets, also have a deadline next week to request June withdrawals of money. The Evanston, Ill.-based firm sent an 11-page letter to investors Monday saying that it didn’t control which individual assets went into CDO deals in which it invested.

It isn’t clear whether scrutiny of Magnetar will rattle its investors, who have known some details of the firm’s strategy for several years. An article this month in news outlet ProPublica was the latest to assert that Magnetar designed deals built to fail that caused cascading losses for investors on the other side of the trades. The hedge fund’s strategy was the subject of a Jan. 2008 Wall Street Journal article. Magnetar told investors this week that it based its mortgage-CDO strategy on statistical models, not a fundamental belief that the housing market would slide.

A Magnetar spokesman said, “Our communications with investors have been very positive and supportive.”

—

Stephen Grocer and Ben Dummett contributed to this article.

Paolo Pellegrini, a former top executive at hedge-fund Paulson & Co., told investigators at the Securities and Exchange Commission that he had informed ACA Management LLC that his firm was betting against the transaction at the center of a lawsuit the SEC brought against Goldman Sachs Group Inc. (GS), according to a person familiar with the matter.

The testimony, in late 2008, could undermine the government’s case against Goldman, which is accused of misleading ACA, the deal manager, about Paulson’s bearish position on the deal.

Pellegrini and the Paulson team worked with both Goldman Sachs and ACA to structure the deal.

(This story and related background material will be available on The Wall Street Journal Web site, WSJ.com.)

SEC spokesman John Nester said, “Our case is built on a thorough evidentiary record that includes testimony, documents, handwritten notes and emails that will be presented in court at the appropriate time.”

Details of Pellegrini’s testimony were reported earlier by CNBC.

The SEC in its complaint alleges that Goldman “misled ACA into believing” the Paulson firm “shared a long interest with CDO investors.” Goldman has denied wrongdoing and is fighting the charges.

ACA Management, an asset-management company set up under the umbrella of bond insurer ACA Financial Guaranty Corp., earned fees for overseeing investment portfolios of mortgage securities, corporate loans and other credit assets. Goldman engaged the firm when Paulson approached it looking for a way to extend its bearish bet on the housing market, the SEC complaint alleges. The CDO management business at ACA was headed by Laura Schwartz, a former Merrill Lynch investment banker who previously worked in divisions of the bank that originated securities backed by U.S. subprime loans and commercial mortgage debt.

Ms. Schwartz was a main point person in the discussions between ACA and Goldman and was at an early 2007 meeting with representatives of Paulson and Goldman, according to Goldman’s responses to the SEC’s “Wells” notice of possible civil charges, regarding the issue. After that meeting, Ms. Schwartz emailed a Goldman employee to ask for feedback on the meeting and said she wasn’t clear about how Paulson wanted “to participate in the space,” the Goldman papers said.

Ms. Schwartz, when reached on her cellphone, did not stay on the line. She no longer works for ACA. A representative for ACA Financial didn’t comment.

Last fall, when Goldman responded to the SEC’s Wells notice, the securities firm argued that whether ACA perceived Paulson to be the so-called “equity” investor in the CDO–and therefore having a “long” position–was “of no moment.” ACA, Goldman has argued, was supposed to be an independent expert on selecting mortgage assets.

Goldman argued in documents it submitted to the SEC that Ms. Schwartz, who was deeply involved in selecting the assets for the Abacus deal, should have known from previous ACA-managed deals that hedge funds could have both long and short positions in a CDO. Goldman cited an ACA-managed CDO that closed in late 2006 whose equity investor was a hedge fund called Magnetar Capital that also took short positions in the same deal. “Certainly, ACA could have questioned Paulson about its interests if the information was significant to it,” Goldman’s Wells response to the SEC said.

At ACA, Ms. Schwartz’s roles included reviewing and approving securities that would be part of investment pools the firm oversaw. In presentations to investors, she often talked about her extensive experience analyzing residential mortgage-backed securities and ACA’s expertise and ability to select mortgage securities, according to people familiar with the matter.

ACA Management managed CDOs put together by several Wall Street firms including Bear Stearns Co. and UBS AG (UBS), according to records reviewed by The Wall Street Journal. At the end of 2007, ACA Management was overseeing around $19 billion in CDOs, the bulk of them bundles of mortgage-backed or asset-backed securities. Of about 30 CDOs managed by ACA, more than half were issued during 2006 and 2007, according to the company’s financial statements.

NEW YORK — Gregory Zuckerman is a senior writer at The Wall Street Journal and author of The Greatest Trade Ever: The Behind-the-scenes Story of How John Paulson Defied Wall Street and Made Financial History.

Thanks to a huge and successful bet that the U.S. housing market would crumble, John Paulson’s firm, Paulson & Co., made $15-billion (U.S.) in 2007. He personally took home $4-billion (U.S.).

Here, Mr. Zuckerman speaks about the controversial 2007 deal that made Paulson & Co. $1-billion and prompted the Securities and Exchange Commission to file civil fraud charges against Goldman Sachs Group Inc. on Friday.

In your book, you describe some of the exact transactions that have now landed Goldman in hot water. How did you hear about them?

Covering the story at the Journal I heard rumblings and complaints for over a year. All kinds of competitors levelled accusations. There were investment bankers, at some of the top firms on the street, who criticized [Paulson] behind the scenes. So there was a lot of smoke – so I figured there must be some fire as well.

Many of the accusations were blatantly wrong. I got to the point where I was comfortable reporting what had happened. Then there’s the question: Was there something improper or not? I’m of the belief that it’s a really fascinating grey area. Especially for Paulson, one can level criticism and there may be some ethical issues, but it’s much harder to say it’s illegal.

You wrote that not every bank was willing to do these kind of deals. So why some and not others?

The ironic thing is that at Bear Stearns, of all places, a senior banker there turned Paulson & Co. down. They may have had some notion of how it might look on the front pages, which is what Goldman Sachs is seeing right now. Clearly, selling these deals to investors is a whole other level than what Paulson did, which was going to the banks and asking them to create this … paper.

You also have to remember what the period was like back then. This was late 2006, early 2007, when people still thought that John Paulson was tilting at windmills, that he was a merger-arb [specialist] who didn’t know that much about real estate. Now we look back and say, “How do you not warn investors that Paulson had a role in creating these things?” At the time, even if he told investors, I’m not sure how many of them would have run the other way.

Some reviewers have said you’re too nice to Mr. Paulson in the book.

I don’t see him as either as a hero or a villain. He’s a great character to me and I love great characters. I’ve been accused of lionizing John Paulson, but he has condemned the book and won’t speak with me … If some people think he was unethical I can understand that view. Other people think he did nothing wrong whatsoever. I’m open to that argument as well. I don’t think it’s my job to shove an opinion down the throat of my reader.

You can argue that he should have been satisfied in betting against billions of dollars of potentially dangerous mortgages and he shouldn’t have taken the step of going to various investment banks and asking that they create more products so he could short them. By the same token, he didn’t sell any of the stuff to investors.

Yes, more toxic mortgage assets were created because of John Paulson and his team, but someone had to be on the other side. These were big boys and sophisticated investors, and [Paulson] had no obligation whatsoever to tell them not to take the other side of this trade. Paulson was very, very focused on making a lot of money from what he saw as a coming collapse of the mortgage market. I don’t believe they saw [these deals] as improper.

Do you think more investigations connected to similar deals will be forthcoming?

You would think so, because this was one of many that John Paulson and his team entered into and that other hedge funds also worked on. I know there are lists of CDOs that [regulators] have been examining since late 2008, if not earlier, so they clearly have been digging into all this stuff. It could be this one was the worst.

In the book, you profile others who also bet against the housing market, including some little-known investors who made huge profits. What did these people, John Paulson included, have in common?

It’s just startling to me, and remarkable, that the experts who should have known better got it wrong and it’s these outsiders who made the most money: John Paulson, who was a merger-arb [specialist]; Paolo Pellegrini, who just a couple of years before doing this trade was living in a one-bedroom apartment with no money in the bank and no job; Michael Burry, a doctor-turned-investor, who knew stocks, but didn’t know anything about mortgages.

It took some outsiders to figure out that a historic collapse was coming. In some ways it gives all of us encouragement that maybe we know a little bit more, and have a little bit more of a perspective than perhaps those on Wall Street, the so-called experts.