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 analyzing 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 realization 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 favor 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 course not - 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 math 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 math 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 math - and that he KNEW that I knew the math, 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 math." 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 realize 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.
-KD
27 comments:
Who were the buyers? People keep talking about pension funds and the like. The counter parties who got checks from AIG (funded by the Federal Reserve loans) to buy out their interest in the AIG bailout CDO were all big banks - page 20 of the SIGTARP audit:
http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_to_Limit_Payments_to_AIG_Counterparties.pdf
The 27 billion was for the fair value of what had been a 62-billion-dollar CDO.
anon - those are CDS you're thinking of - something different from what this post is about.
Great post - the gambling analogy is entirely apt. I've been writing about this for years. In the UK there is much more acceptance of this point of view (even if it isn't shouted from the rooftops); the (sometimes) hysterical reaction in the US to the suggestion that betting and investing are of the same cloth is perhaps just a manifestation of a truth that is too uncomfortable for god-fearing citizens to ponder.
In any event, while I don't think GS or the sell-side exactly covered themselves in glory with respect to the CDO market, I concur that the lion's share of responsibility lies with the professional buy side that absorbed all this flotsam and asked for more.
Kid Dynamite
Your analogy comparing investing to gambling is good, but falls short with regards to the Abacus Insurance trade. Goldman went to the Nationally recognized rating agencies and made the case that the majority of the bonds were AAA, which is either duplicitous or fraudulent considering they were making the bet that these securities(insurance) would blow up and pay Goldman handsomely.
Nice story, Kid. I think you could even go back to Tom Sawyer and the whitewashed fence. But eventually the kids learn not to do deals with Tom Sawyer--the fitting outcome here would be a boycott of GS's prop desk.
BTW, did you see the item on the Chinese company which refused to pony up some collateral demanded by GS? To use your bookie analogy--unless they have some way of breaking that guy's thumbs they're going to be out of that business soon.
We are definitely playing Spanish 21 in 3 weeks!!!! PAI GOW!
I think your sports analogy is a good one but I think you missed the best point. Even in sports betting, if someone has material, non-public information that person can radically skew the odds, and we (for the most part) have tried to make such one-sided bets illegal. Point-shaving, bribing players for information, betting on one's own teams -and sometimes one's sport - are all against the law.
Maybe GS didn't do the equivalent of point-shaving, but it was like they had someone in the locker rooms feeding them up-to-the minute injury reports on every player on every team that was playing.
You say that pension fund managers should have done their homework, but they simply didn't have the capability. Then you say that the managers shouldn't be buying instruments they don't understand. And while that's true, I will note that there are rules in place to prohibit these managers from buying any NON-HIGHLY rated securities.
If the Rating Agencies didn't bless these things (with the help of GS), there would have been no market. So why are these parties not more culpable?
some good comments this morning.
anon @ 9:31am:
"Maybe GS didn't do the equivalent of point-shaving, but it was like they had someone in the locker rooms feeding them up-to-the minute injury reports on every player on every team that was playing."
maybe - and there is nothing wrong with that - INFORMATION is the most valuable commodity!
you responded to your own point when you said that the fund managers didn't have the capability to do the analysis. That's a HUGE point - if you don't understand the game, DO NOT PLAY. you can't blame the casino after the fact when you didn't read the rules - Spanish 21!!! being prohibited from buying non-AAA paper is not a license to blindly buy AAA rated paper without analyzing it.
also, you ask why the ratings agencies aren't more culpable - they certainly SHOULD be! but in my mind, the culpability of the buyers and of the ratings agencies lies well above the culpability of the brokerage houses. Still, no one is blameless - i'm not attempting to argue that GS acted like saints here, although I am tempted to say that they did little wrong other than win the game.
which brings me to Anon @ 6:41am's comment - great comment, and it illustrates one thing that GS probably certainly did that is morally bankrupt at BEST, and potentially fraudulent at worst
Great post. I think one of the big problems with the banks is that their models tell them to make the bet every time and so they do it. Now, they've got an earful of cider and expect someone else to clean it out for them. They've all gotten the same educations and been taught the same lessons and when they get crazy and think outside the box, it doesn't matter because they're all thinking outside of the same box and coming up with the same things. Straight intelligence is a great thing to have, but it is extremely dangerous without some common sense keeping it in check.
Great portfolio managers have the advantages of:
a) Gathering info
b) Filtering info
...and then acting on it. This takes time....
Your analysis is very accurate.
But wasn't GS the underwriter? And if so doesn't that come with a representation of good faith? And even if that is not so, if GS had no more responsibility to the buyers than a book to a bettor, you have to admit that it is naive of them to think the buyers should just lay down. If all is fair then it is just as fair to get the best attorneys to find a gullible jury to hand those profits back to the buyers.
it's not like an underwritten bond for a corporation though - it's a structured OTC trade.
clients want more exposure to the housing market. GS says "here's a product that will give you more exposure to the housing market"...
it's also important to realize that, as my friend Ted just wrote me, "I think a large number of people don't get the point because they don't understand that "client" in the wall street sense means about as much as a "client" to a hooker (ie a "john") - they are big bags of money for taking, the "relationship" is only as good as its last transaction, and if it is too cheap you should check yourself for STDs afterwards."
i responded "yes - and people confuse that with the ADVISORY relationship - which is TOTALLY different"
I don't mind GS (The House) making money off me (The Client).
Because, I am a shareholder in The House.
Very good post as usual.
I think a large problem with arguments against the banks is a fundamental misunderstanding of their purpose and history. The banks are in the financial services industry, services being the key word. As they provide services, they hedge out as much of the risk as possible and collect spreads/fees. There is nothing fraudulent providing customers with what they want and having the customers lose when the bet goes against them.
I also liked the discussion of counterparty intelligence. It is one of the most overlooked part of investing. Most regard their analysis as superior or that they have just as much information. For example, very few people should feel confident trading energy against the integrated companies. I know of certain ones that besides controlling and monitoring a large amount of the physical activity hire navy SEALs for current information around the globe. If you feel confident being on the other side of that trade, you are a fool/savant.
"anon - those are CDS you're thinking of - something different from what this post is about. ..."
Well, the checks totally 27 billion were for the CDO(s). The Fed bought the CDO(s) from that list of banks and put the CDO(s) into Maiden Lane III.
The 35 billion posted as collateral was essentially CDS-provided protection/insurance. 27 plus 35 equals 62 - the par value of the CDO(s) in question.
I'm just trying to figure out who the victims actually were. I agree with you that a pension fund is staffed with all sorts of lawyers, accountants, financial wizards, mathematicians, etc., and they are responsible for the entire decision made by their side of the purchase Their responsibility extended beyond merely reading and understanding every word of the prospectus, regardless of the page or the print size.
But if the buyers of the most famous CDO in history, the AIG bailout CDO now held by Maiden Lane III, all of whom appear to have been banks - many of whom also created and sold CDOs, then your argument is all the more compelling.
The NYT keeps selling this story: GS victimized these poor people with known bad assets and then made huge profits betting against the victims. Is this even really true? I have a lot of doubts about the scenario they are selling.
I'm just trying to get all the pieces on the board because I sense that they are not all on the board right now. Did the banks in the AIG bailout buy the CDOs back from the original buyers? Who were they? Were they also hedged? It sounds like they, if they exist, perhaps were - by the banks that sold the CDO(s) in question, and then those banks purchased CDS from AIG to hedge their risk to the CDO(s) buyers.
KD, I'm trying to find an email for you but can't. Could you send me an email so I can write back - regarding reprinting an article at Phil's Stock World?
Ilene
ileneca@gmail.com
models are only as good as the inputs.
A couple of thoughts...
1. Your assumption that a financial process is Poisson. It is often Fractal, looks Fractal, behaves Fractal.
2. There are a million cheats. Insider information, market manipulation, regulators in the tank. The recent spate of gold manipulation on a daily basis is a great example. It was always possible to buy lousy debt at a dime on the dollar. What screwed retail investors was the crooked rating agencies on all these mortgage products, permitting the sale of high risk mortgages at good prices.
3. Transaction costs are high in gambling and investing. Gambler's ruin has one proverb; invest in sensible well run companies with a big moat, and don't day trade.
This is 6:41 a.m. anonymous.
Would have loved to be the fly on the wall when Goldman requested the comfort letter from counsel.
Fantastic post Kid Dynamite.
I've written a new post at my own site which expands on your own thoughts in terms of showing how gambling can teach investors that "This Time It's Different" is a flawed precept that can lead to serious losses.
Keep up the good work.
John (aka The Masked Financier)
KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion(except in multiple exhibitions), and I can't imagine losing to anyone who has spotted me a rook and queen.
All that said, I never gamble, and as an actuary, I know the odds of most games that I play.
Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.
Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn't get that.
So did you ever end up playing speed chess in the interview? Outcome?
Great post
Excellent post. A guy I knew a long time ago that taught me a bit had a much simpler mindset but very much along the same lines. "The first question to ask, always, is, whats in it for them?"
the chess match never happened.
kid just an off topic question. the gambler u know who spends 30+ hours handicapping. whats is win %?
kd: long time reader first time writer
great story
just wanted to point out the rook and the queen is clearly hubris on the susquehanna guys part, even if he got the white pieces and the queen side rook removed. I ran a quick game against chessmaster (wiki estimates its elo at 2790, it estimates its own elo at 2844), and it wasnt that difficult to win, 29 moves and i had mate. (i was playing white but am more than confident black wouldnt be too hard either.)
FWIW, i am not that good at chess, and probably if i played USCF events would be a 1450ish player.
so yeah, i think polishing off Bobby Fischer with that spot is fair, unless you have 2 minutes to complete your moves and they have 50 or something.
~theunrepentantgunner
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