In the fall of 2007, John Paulson was scoring huge profits:
His firm, Paulson & Co., would make $15 billion in 2007.Mr. Paulson’s personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J. K. Rowling, Oprah Winfrey and Tiger Woods put together. At one point in late 2007, a broker called to remind Mr. Paulson of a personal account worth $5 million, an account now so insignificant it had slipped his mind.
Mr. Paulson, known as J.P., bet that the housing market would collapse and risky mortgages would tumble in value. The moves put the fund manager from Queens, N.Y., alongside Warren Buffett, George Soros, and Bernard Baruch in Wall Street’s pantheon of traders. And as one rival fund manager later would say, with equal parts envy and respect, “Paulson’s not even a housing or mortgage guy…. Until this trade, he was run-of-the-mill, nothing special.”
Everyone but Paulson, it seemed, was making money in the housing market, so he had one of his analysts look into it — and it all seems so simple in retrospect:
Mr. Paulson charged Mr. Pellegrini with figuring out whether homes were, in fact, overpriced. Late at night, in his cubicle, Mr. Pellegrini tracked home prices across the country since 1975. Interest rates seemed to have no bearing on real estate. Grasping for new ideas, Mr. Pellegrini added a “trend line” that clearly illustrated how much prices had surged lately. He then performed a “regression analysis” to smooth the ups and downs.The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.
“This is unbelievable!” Mr. Paulson said the next morning. The chart was Mr. Paulson’s Rosetta Stone enabling him to make sense of the housing market. They had to figure out how to profit from it.
Mr. Paulson went on to buy CDS insurance, betting that CDOs would fall:
Paulson & Co. eventually bet against about $5 billion of CDOs. Months later, they had made more than $4 billion of profits from these trades—including $500 million from a single transaction—according to the hedge fund’s investors and an employee of the firm.