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In 2006, John Paulson, a merger-arbitrage manager with no mortgage background, used credit-default swaps to bet against subprime mortgage bonds. Starting in 2007 his funds made about $15 billion as housing collapsed, and he personally earned close to $4 billion that year. Many established mortgage experts had dismissed the trade.
If the underlying loans defaulted, the swap paid close to the full face value. That payoff structure capped the downside and allowed gains of many times the premium, which let the bet be sized far larger than a conventional short sale would allow.
Paulson's team, led by analyst Paolo Pellegrini, charted home prices against their long-run trend. An outsider with no stake in the prevailing view can see a mispricing that insiders miss by testing the model's hidden assumption, here that home prices keep rising, against long historical data.
A correct contrarian trade can still fail if the holder cannot endure the stretch before the market agrees. Several of Paulson's peers had identified the housing bubble early, then took losses or quit because premiums bled away while investors doubted them. Profiting from a bubble depends as much on patience, conviction and funding stability as on analysis.