The man who predicted the financial crisis, Part I

The weekend edition of the Wall Street Journal profiled John Paulson, whose firm made $15 billion by systematically betting against the value of American homes. Paulson himself took home $4 billion.

How’d he do it? Research.

Grasping for new ideas, [Paulson researcher Paolo] 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.

By the spring, Mr. Paulson was convinced he had discovered the perfect trade. Insurance on risky home mortgages was trading at dirt-cheap prices. He would buy boatloads of credit-default swaps—or investments that served as insurance on risky mortgage debt. When housing hit the skids and homeowners defaulted on their mortgages, this insurance would rise in value—and Mr. Paulson would make a killing.

And so he did. In hindsight, we logically conclude that Paulson is brilliant. But who was saying that three years ago?

I’m a defense analyst, so I really have no idea if money men should’ve been paying more attention to Paulson. But regardless of the discipline, a major crisis seems to clear away the underbrush and reveal a proud few who saw what was coming. And regardless of the discipline, it remains extremely hard to tell if those few were lucky or smart.