Finding OPPORTUNITY in DANGER is how John Paulson made $15 billion

Prior to 2007, John Paulson was barely mentioned in investment circles. He did not appear on television, was not invited to prestigious seminars, nor was he on the list of Wall Street oligarchs. To many, Paulson is just a small, quiet and somewhat bland fund manager.

But then, he made one of the boldest bets in modern financial history, and won big. How does a person who is looked down upon by the financial world make billions of dollars from a collapse that the entire system did not foresee? This is not just a story about money, but also a lesson in vision, steadfastness, and tolerance when you're the only one who believes you're right.

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The real estate binge: When the whole of America thought home prices would rise forever

From the early 2000s to 2007, America witnessed an unprecedented real estate boom. House prices rise continuously year after year, causing people and houses to rush into the game as if they could not lose. A house is not only a place to live, but also speculative property, a “money printer” that everyone wants to own.

Banks are stepping up lending, including to people with weak credit records. Subprime mortgages became the watchword of the era. It is believed that even if the income is insufficient, it is still possible to get a home loan, because “house prices will always rise.” It is such a common belief that it almost becomes the truth.

Complex financial instruments such as MBS and CDOs were born, packaging thousands of sub-standard loans and labeled AAA. The entire financial system seems hypnotized by greed and blind self-confidence. Borrowers, banks, investment funds and even credit rating agencies are caught up in a spiral: the more expensive the house, the more borrowed, the more the profits shift, until it all falls apart.

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Paulson's retrograde perspective amid real estate craze

While much of Wall Street is reveling in the profits from real estate, John Paulson is starting to feel insecure again. He was not carried away by the crowd. On the contrary, he looked deeply at the numbers, and found a chill.

Paulson found that U.S. home prices have doubled in less than a decade, while people's incomes have remained virtually constant. This means affordability is not keeping up with house prices, a very clear warning signal for those who have witnessed asset bubbles.

He also carefully analyzed the profile of mortgage loans. Default rates began to climb, while many subprime loans were issued to people who did not have sufficient income, did not have secured assets, did not even need to prove their ability to repay. “NINJA” type of loans (No Income, No Job, No Assets) are rampant throughout the market. For Paulson, this is the time bomb.

While Wall Street still believes that “everything is fine,” even upgrading sub-standard debt-based derivative financial products to AAA, Paulson held firm: “This market is going to collapse. It's just a matter of when.” That composure and determination became the first step for the historic bet.

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Make the bet: Profiting from the collapse

John Paulson doesn't invest like the majority. As Wall Street poured money into real estate-related assets, he took a different tack: profiting from the breakdown of the system itself.

The instrument he chose was a Credit Default Swap (CDS), a form of financial insurance contract. Normally, CDS are used as a hedge against default, but Paulson used it to make bets. He did not buy houses, nor did he short sell shares of real estate companies. Instead, he bought CDS tied to sub-standard loans issued to borrowers who could not afford it.

The strategy is simple in essence: if the borrower cannot repay the loan, the loans will break. At that point, the CDS holder will receive a huge insurance payout.

At the time, not many imagined that the market could collapse. But Paulson believes in his data and reason. In a world where greed overrides prudence, he bets on what no one dares to think about.

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Steadfast to Wall Street's contempt

When John Paulson started accumulating CDS contracts against the sub-standard borrowing market, much of Wall Street laughed at him.

Large banks such as Goldman Sachs and Deutsche Bank sold Paulson's CDS, willing to collect millions of dollars in premiums each year in exchange for “risk” that they consider to be almost zero. With them, the housing market cannot collapse. Paulson betting in the opposite direction to the whole system is considered insane.

Even inside the Paulson & Co. fund, many associates wondered. Paolo Pellegrini, with whom he developed the housing market risk analysis model, once said that he himself repeatedly wondered if he was wrong, as the market continued to grow day by day, and the fund's bets continued to lose in the early stages.

But Paulson didn't flinch. He believes in the data: default rates on subprime loans are rising rapidly, borrowers are unable to repay, and the financial products “packaged” from these loans are overvalued.

The market may ignore the truth for a while, but it can't do so forever. Paulson understood that and he stuck to it, even if disregarded by the entire system.

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Markets crash and history is rewritten

In 2007, the first signs of disaster began to show. The mass of subordinated borrowers are no longer able to repay their debts. Default rates skyrocketed. Stock companies, investment banks and financial hedge funds, which already hold trillions of dollars of derivative products from subprime loans, began to stagger.

In 2008, when Lehman Brothers collapsed, AIG was bailed out by the US government for $180 billion. The entire U.S. financial system wobbled in its biggest crisis since the Great Depression of 1929.

But while the whole market fell into turmoil, John Paulson emerged as the biggest winner.

With the CDS contracts he persistently bought since 2006, Paulson made more than $15 billion in returns for his investment fund, of which he personally pocketed $4 billion, in just one year. That's the biggest personal profit a person has ever made in Wall Street history, outstripping legendary names like George Soros or Warren Buffett in any individual year.

From a little-known fund manager, Paulson became the new icon of the global investment scene, lauded for his ability to spot risks that the entire system ignored, and dared to act before it was too late.

The history of world finance was rewritten, and the name John Paulson became part of it.

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Lesson from John Paulson: Going against the crowd calculatedly

John Paulson wasn't the first to see the housing bubble. But he is the rare person brave enough to act, while Wall Street is still ecstatic in profit-taking.

He does not rely on hunches, much less follows the crowd. Paulson quietly collected data on subprime loans, analyzing default rates, financial leverage levels and even the murky structure of CDO products. And then he realized: this is a tower built on sand.

When he began betting against the property market by buying credit risk swaps (CDS), many ridiculed him. Banks were even willing to sell him large quantities of CDS, as they considered “betting on an American housing collapse is crazy.”

Paulson was not only under financial pressure -- he was also under psychological pressure when almost the entire industry was on the other side of the front line. But he kept faith in the numbers he saw.

In the end, when the bubble burst, it was all nonsense: Paulson was right. And it was the isolation of the delusional mob that underpinned the biggest win in the history of the investment industry.

The lesson here is not just about the money. It's a reminder in investing, sometimes you have to be brave to go backwards to get it right. Believe in the data, believe in the analysis, and be ready to be alone when the rest is going in the wrong direction. For the moments of life do not come from dimensionality, but from the ability to remain steadfast in paradox.

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The Legacy of a Distinct Investor

John Paulson is not a typical Wall Street star. He did not have a huge network of power, did not make waves in the media, nor did he seek glory. But he produced the most concussive blow in modern financial history with only steadfastness, astute analysis and an unshakable faith in data.

Paulson proves that you don't have to be famous or powerful to change the game. Sometimes, it only takes one person who understands the problem and is brave enough to act when the whole world turns away.

That's the legacy Paulson left behind: a symbol of critical thinking, of daring to question the “obvious,” and of the power to go against the calculating crowd.

And the bigger question is: Is today's market repeating old illusions? If so, who will be the next Paulson?