(This guest post originally appeared at the author’s blog)
As expected, my last post, “Fiduciary Duty and the Victim Mindset” sparked a lot of discussion. There are several intelligent comments on both my site, and on the republished version at Seeking Alpha, most of which I’ve done my best to respond to with clarifications of why I think my post is reasonable and accurate.
I had the epiphany this morning that the proper analogy with these CDO’s lies in sports betting. I left the following comment (edited slightly here) on another blog this morning:
“To me, financial markets are not unlike sports bookmaking. In the bookie world, you have the “Squares” who are analogous to the retail investors. These are the guys who say things like “oh man – Tom Brady is wicked pissah – the Pats are SO totally gonna cover the 7 point spread,” with little or no reasoning or analysis to back up their decision. They also might be guys who pay someone else (like a newsletter writer) to pick games for them (of course, these newsletters are almost always scams)
Then there are the professionals – I actually know a guy who was one of the biggest NFL bettors in the 80’s. He still handicaps NFL games – he spends 30 hours+ a week analysing the different matchups, weather, psychology, etc. Some weeks he finds several good bets, some weeks he finds none.
Now, in the investing world, pension fund managers need to be the PROFESSIONALS – they can’t be in the “square” camp, and just say “hey – I paid the newsletter (ratings agency!!!) for the picks, if they lose, it’s not my fault.” That’s amateur (square) thinking, and I could possibly be convinced that it’s an acceptable excuse for RETAIL, amateur investors (but note, again, the culpability lies with the RATINGS agency here). Professionals, however, can’t be allowed to make such excuses, or the system will never change! Similarly, you can’t blame the bookie when you lose for having offered you an unfair bet.
Both sports betting markets and financial markets are efficient ENOUGH that you have to do your own work – and LOTS of it – if you expect to generate alpha.
Some people will deride me for making the analogy of markets to a casino or bookmaking operation – but I’m reasonably certain that most traders (myself, and everyone I know at least) do expected value calculation on their trades just like you’d do in the casino or in the sports book. It’s not “Kid Dynamite is a naive immature gambler” – it’s the realisation that in both financial markets and in gambling markets, it’s not a crime to have more information than the guy on the other side of the trade/bet.”
People keep throwing the word “fraud” around here. As the NY Times article which prompted my original post explained, Goldman was creating these synthetic CDOs as far back as 2004. It took YEARS for them to blow up. I find it hard to use the fraud label there – it’s just another case of most of the investing world being totally ignorant to the risks involved. There were few who saw the risks, and they positioned themselves accordingly – GS was in this camp on these synthetic CDOs, it seems. Sellers of synthetic CDOs didn’t have to, as Tommy Boy so eloquently put it, “Take a dump in a box and mark it guaranteed,” and coerce investors into buying them. Investors were screaming for yield- they were begging to buy these products. Blame it on the system, blame it on the ratings agencies, blame it on the investors – but don’t put the lion’s share of the blame on the virtual bookies – the sellers of the CDOs.
When you bet the Patriots, the bookie doesn’t have to tell you that Tom Brady is out with a bad shoulder – you have to do that research yourself. Similarly, when you buy a synthetic CDO, which you can’t do if you’re a retail rube, you shouldn’t expect the seller to tell you why he thinks you’re on the wrong side of the trade.
Felix Salmon summed it up nicely when he said “It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing.” Commenter Patrick Harden on my Seeking Alpha post came up with a similar conclusion: “It’s just common sense that when dealing with the Vampire Squid you are likely going to get the short end of the stick…Bottom line – don’t make deals with the devil. You’re not going to win.” My friend, “The Dude” emailed me: “Blaming Goldman for creating or making markets in these derivs is akin to blaming Steve Wynn for allowing an Asian billionaire to split tens all night long while downing tequila shots at the blacjack table losing the ‘whale’ millions in the process” Which brings me to my next analogy. I was walking through a casino many years ago when I saw a “Spanish 21” table. Spanish 21 is like regular blackjack, except there are a whole bunch of rules added that favour the player. These rules are listed boldly on a little placard at the table. I pondered these rules, and was amazed that the casino was offering such a game. Of course, there has to be a reason, so I asked the dealer “I don’t get it – what’s the catch?” “There are no tens in the deck,” he replied (a disadvantage for the player that negates all the other slight advantages). I smiled and walked away. Had I decided to sit and play, assuming I had an edge, I would have been an idiot. It would have been my own fault.
So, is everyone who trades on the buy side (money managers, that is) an idiot? Of courseot – but there is a theme that should be in the back of every investor’s mind at all times, especially in trades (bets) like synthetic CDO’s where there is exactly one person on the other side of every trade who will benefit from the exact opposite scenario you are looking for.
This brings me back to a concept I laughed at about 11 years ago when I was interviewing at Susquehanna. Susquehanna was a pioneer in the options trading world, and has a rigorous training program where they teach all new employees poker theory. The decisions one makes in poker in terms of expected value, having seen similar situations before, making quick calculations of the value of a bet, and being able to figure out what the person on the other side of the table is trying to do all have analogies to the trading world, which is why Susquehanna found it valuable to teach their employees this skill set.
Anyway, the interviews with Susquehanna were the most mathematically rigorous of any I’ve ever encountered. While most firms seemed content that as a maths major from MIT I probably had some chops, Susquehanna wanted to see them. I’ll never forget the first question in the interview, where the interviewer asked “what is the expected value of the number of heads if I flip a coin 1000 times.” DYKWTFIA ?!?!? “500,” I replied confidently. “And what’s the standard deviation?” He handed me a pencil and paper and told me to take my time. I managed to grind out the answer (nope, I couldn’t do it right now, 11 years later, but I can look up the methodology online (SQRT (n*p*(1-p)) and find that it’s about 16). He then asked me for a 95% confidence interval of the number of heads one could expect in extended repetitions of 1000 flips – easy – 2 standard deviations, or a range of 468 – 532. Finally, he offered me even money on a series of coin flips where he’d bet that the total number of heads would be more than 532. Layup, right? I just did the maths and knew it was a 40-1 prop. “Ok, I’ll take it,” I told him confidently.
The interviewer proceeded to explain to me that I knew the maths – and that he KNEW that I knew the maths, after all, he’d just watched me derive it. Why then, would I expect him to be offering me such a great wager? “Because you were testing me?” I hoped. No – it was because he had a guy on the floor of the CBOT who had trained himself to flip coins with a much better than 50% success rate for a desired outcome. The moral of the story was that you should always assume that the person on the other side of the trade thinks THEY have an edge too. The interviewer then asked me, and I swear this happened, although not in these exact words, “So let’s say you calculate the fair value of an option to be $1.50, and you’re in the crowd trying to buy 10,000. The market is relatively thin, and you are buying a few hundred options at a time. Suddenly, Goldman Sachs walks in and offers you 10,000. What do you do?”
“Take ’em!” The young, confident, and soon to be Kid Dynamite in me replied, “I know they’re worth more, I’ve done the maths.” The interviewer shook his head, and said that GS wouldn’t be selling them to me out of their generousity – that GS clearly had a different view, and that I should try to think of where my analysis could be wrong. Did I miss a dividend? Was there an imminent earnings event? Had news come out? This annoyed me greatly. “How can you ever trade then, if every time you trade you think that you might be on the wrong side of the trade or that your counterparty has more information than you do?” I was perplexed. The interviewer explained that it’s not every time, and it’s not every trade, but you should certainly be wary of eager and smart counterparties willing to put up sizable trades, and you should make darn sure you’ve triple checked your work.
I had speed chess listed on my resume, and the interviewer then told me that he had a guy who would play me in chess. He’d spot me a rook and a queen – a simply massive spot. I told him I would love to play the guy for money. “You shouldn’t, ” the interviewer told me, “you have no idea how good this guy is.” This is where I basically made the decision that I wouldn’t be working for Susquehanna, as I retorted, “But you have no idea how good I am – I am making the assumption that I could beat Bobby Fischer if he gave me that spot.” Still, the point is important – always try to know what you don’t know, and think about the other side of the trade.
There’s an old moral from Guys and Dolls, frequently quoted in poker prop betting circles: “One of these days in your travels a guy is going to come to you and show you a nice brand-new deck of cards on which the seal is not yet broken, and this guy is going to offer to bet you that he can make the Jack of Spades jump out of the deck and squirt cider in your ear. But son, do not bet this man, for as sure as you stand there you are going to wind up with an earful of cider.” Bringing it back to synthetic CDOs: buyers of these products needed and still need to realise that there is someone on the other side of the trade taking the opposite view and expecting to profit from it. It’s absolutely not about simply saying “buyer beware,” but I think that in the case of synthetic CDOs, the buyers were grossly negligent, and need to be held accountable.