Eager for a chance to run his own portfolio, Pellegrini, then 47, approached Paulson in the summer of 2004, asking for a job. “He said, ‘My analysts are more junior than you,’” Pellegrini recalls. “I said I didn’t care.”

Paulson had founded his firm in 1994 and built up two specialties. First was merger arbitrage, a strategy in which traders typically buy the stock of a possible takeover target and short that of the acquirer. The other was event arbitrage -- wagering on corporate developments such as earnings surprises and stock buybacks. Still, he was also looking for a way to make money from what he saw as a growing credit bubble.

Paulson, who makes all investment decisions at the firm, orchestrated the research and assigned Pellegrini to look into housing -- something he was familiar with from his time at Mariner. The surest bet against the housing market would be to buy credit-default swaps on subprime mortgage-backed securities. CDSs are insurance-like contracts used, in this case, to speculate on the default of a bond.

A Nervous Time

Pellegrini says the critical question was whether adjustable-rate mortgages would default as they reset at higher interest rates. Pellegrini believed they would, so in April 2005 Paulson & Co. began buying CDSs in small amounts for its existing funds.

The first year the trade was in effect was a nervous time. “From early 2005 to early 2006, it wasn’t clear the trade was going to work,” Pellegrini says. “People thought we were throwing money down the drain. We asked, Are we missing something?” Pellegrini says he would wake up in the night pondering the trade.

Before he increased his bet, Paulson wanted proof of a housing bubble, and he thought Pellegrini could produce it. “The mortgage market lends itself to deep quantitative analysis and modeling,” Paulson says. “Paolo excelled in this area.”

Finding the Bubble

Pellegrini and his colleagues zeroed in on numbers from the Office of Federal Housing Enterprise Oversight’s home price index from 1975 to 2000. He drew a regression line through the data points that showed prices would have to fall 30 percent to 35 percent just to get back to the historical trend.

“After hearing a lot of arguments for and against the presence of the bubble, we had a simple and clear insight of our own to go by,” Pellegrini says. He recalls that Paulson broke into a smile when he showed him the proof that houses were overpriced. “John doesn’t smile,” Pellegrini says. “It felt great.”

The next step was to determine the relationship between home prices and defaults. Pellegrini hired a New York firm called 1010Data Inc. to help him integrate two databases: One, compiled by Santa Ana, California-based First American Corp. and called LoanPerformance, tracked 6 million securitized subprime mortgages. The other was based on an S&P/Case-Shiller home price index, sorted by postal code. The combined database showed that even if home prices merely flattened, defaults would surge. “There was a very strong relationship between mortgage losses and home prices,” Pellegrini says.

A Tough Sell

Paulson & Co. began drumming up money for two new funds -- called Paulson Credit Opportunities and Credit Opportunities II -- that would be dedicated to the subprime bet. It was a tough sell. With the housing market still galloping upward, investors wanted details of both Paulson & Co.’s research and how the trade would work.