The Greatest Trade Ever?

http://econlog.econlib.org/archives/2009/11/outsiders.html

Paulson and his friends needed three things: insight, timing, and a trading vehicle. The insight was relatively simple--all they had to do was see that house prices had shot past fundamental values and that any drop in house prices would lead to widespread mortgage defaults. One of my friends saw it, and he made money shorting New Century Financial, a subprime mortgage lender that went bankrupt.

The timing issue comes from the fact that if you are too early, you get wiped out by the last wave of euphoria. That is where the trading vehicle came in. The Outsiders discovered credit default swaps on mortgage securities and on mortgage security tracking indexes. Credit default swaps behave like out-of-the-money put options. If the market rises against you, you can stay solvent a lot longer buying out-of-the-money puts than you can taking a straight short position. Because credit default swaps were esoteric and generally not available to individuals, the Outsiders had an advantage over people like my friend--they could take larger positions at less risk.

As those credit default swaps began to pay off, the Outsiders started asking themselves, "who has been selling us these things?" That is when they figured out that major financial firms would be the next to fall. So they rolled their bets over into bets against AIG, Freddie, Fannie, Bear, Lehman, and so forth.