In 2005, John Paulson and his analyst Paolo Pellegrini examined historical housing data dating back to 1919 and discovered an unsustainable anomaly: U.S. home prices, which historically rose in tandem with the rate of inflation, had detached completely from fundamentals, driven by speculative non-prime lending.
The Setup
Paulson realized that rating agencies (Moody’s and S&P) were granting AAA ratings to complex Collateralized Debt Obligations (CDOs) backed by BBB-rated tranches of subprime mortgages. If national home price appreciation merely flattened to 0%, the underlying subprime loans would suffer catastrophic defaults, completely wiping out the lower and mezzanine tranches.
The Mechanism
Rather than shorting homebuilder stocks or financial equities—which carried high borrow fees and uncertain timing—Paulson bought Credit Default Swaps (CDS) on BBB-rated subprime bonds. Because market consensus viewed residential real estate as impervious to nationwide decline, the cost of CDS protection was mispriced: Paulson paid roughly 1% per annum for protection that paid out 100% on default. This offered an asymmetric 100:1 risk-to-reward payoff.
The Outcome
By late 2006 and early 2007, early-payment defaults spiked. The ABX index plunged. In 2007 alone, Paulson’s Credit Opportunities funds gained over $15 billion in profit, making it the most lucrative financial trade ever recorded.