Mr. Pellegrini spent hours in Mr. Paulson's office, debating how to deduce a turn in the housing market. Mr. Paulson charged Mr. Pellegrini with figuring out whether homes were, in fact, overpriced. Late at night, in his cubicle, Mr. Pellegrini tracked home prices across the country since 1975. Interest rates seemed to have no bearing on real estate. Grasping for new ideas, Mr. Pellegrini added a "trend line" that clearly illustrated how much prices had surged lately. He then performed a "regression analysis" to smooth the ups and downs.

The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini's figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.

"This is unbelievable!" Mr. Paulson said the next morning. The chart was Mr. Paulson's Rosetta Stone enabling him to make sense of the housing market. They had to figure out how to profit from it.

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