In 2006, the biggest risk-taker on Wall Street looked like John Paulson. This certainly wasn’t based on Paulson’s past behavior. Paulson managed a middle-of-the pack hedge fund. He made careful, boring deals. He rode the bus and liked to ride his bicycle. In other words, he was the anti-Gordon Gekko.
The risk Paulson was taking? He was betting against the mortgage market using credit default swaps. Insuring $1 million in high-risk mortgages was dirt cheap – around $10,000. If all of the homeowners made their payments, Paulson would be out $10,000. If all of the homeowners defaulted, he would make the entire value of the bundle – $1 million.
For Paulson to make money, these high-risk borrowers needed to default. At the time, most analysts thought that a perfect storm of rising unemployment rates, higher interest rates, and poor local economic health was needed to trigger widespread defaults. However, Paulson’s extensive modeling showed widespread defaults required just one trigger: flatlining home prices. With home appreciation rising at 5 times the rate seen from 1975-2000, there was plenty of room to fall back.