« Profiting From the Crash: How John Paulson took home $10 million a day betting on a fall in home prices »

It was the fall of 2007, financial markets were collapsing, and Wall Street firms were losing massive amounts of money, as if they were trying to give back a decade's worth of profits in a few brutal months. An investor named John Paulson somehow was scoring huge profits. His winnings were so enormous they seemed unreal, even cartoonish. 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."

John Paulson launched his hedge fund in 1994. His forte was investing in corporate mergers that he viewed as the most likely to be completed, among the safest forms of investing. When he met with clients, they sometimes were surprised by his limp handshake and restrained manner, both unusual in an industry full of bluster. Younger hedge-fund traders went tieless and dressed casually, feeling confident in their abilities thanks to their soaring profits and growing stature. Mr. Paulson stuck with dark suits and muted ties.

By early 2006 the 49-year-old Mr. Paulson had reached his twilight years in accelerated Wall Street-career time. He had been eclipsed by a group of investors who had amassed huge fortunes in a few years. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never had seen. Everyone seemed to be making money hand over fist. Everyone but John Paulson.

"This is crazy," Mr. Paulson said to Paolo Pellegrini, one of his analysts.

Mr. Pellegrini felt his own pressures. A year earlier, the stylish native of Italy had called Mr. Paulson looking for a job after a career of disappointments. Paulson & Co. likely was his last stop on Wall Street.

Mr. Pellegrini spent hours in Mr. Paulson's office, debating how to deduce a turn in the housing market. 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.

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