Kid Dynamite of the Friday In Vegas blog posted an excellent article – “Synthetic CDO’s, Spanish 21 and Sports Betting” (also posted on SeekingAlpha and Clusterstock) – which uses gambling, sports betting, and even references to Susquehanna in an effort to explain why perhaps Goldman Sachs and other financial institutions are not totally at fault for some of the recent investment losses suffered through so-called CDOs – Collateralized Debt Obligations. The CDOs were backed by so-called sub-prime mortgages which were made to borrowers with questionable credit histories.
It is yet another example of how the world of sports betting and card speculating can be used to educate non-investors about the world of investing. However, the piece also shows how perhaps gambling, and poker, can be used to educate professional investors about how to view investment opportunities.
A key point from Kid Dynamite’s article is that learning effective gambling requires you to always look for any kind of edge that the other side has in a game. In gambling the other side is either the “house” in games such as Spanish 21, or other players in games such as Texas Holdem Poker. Taking this analogy to the world of investing helps to develop a mindset that you should always consider why someone is willing to take the opposite side of your trade or investment decision. If you are willing to buy shares in a particular company, why is there a willing seller. The corollary to this in Kid Dynamite’s article is that one should always be careful when taking the other side of a trade with Goldman Sachs, due to their successful track record.
However, I think that there is an unexplored side of this article and it is to do with the well worn investment phrase “This time it is different”. This phrase is all too often ignored by even seasoned investment professionals.
The theory put forward about Goldman (and other investment banks and associated firms) committing fraud in the sub-prime market is that CDOs were filled with “trash” mortgages that had no hope of repayment.
Indeed there was an element of “trash” mortgages being placed into these sub-prime CDO vehicles, but the CDO structurers did not think that the majority of the mortgages would not be repaid. Like “Junk Bonds” in the 1980s the theory behind sub-prime CDOs was that the higher interest rates on the underlying mortgages would compensate for the higher level of defaults.
Where the investment world (including the professionals who structured and purchased the CDOs) fell short in the analysis was falling for the “this time it’s different” story in relation to the US housing market.
In gambling (as readers know I like to use Texas Holdem as the best comparison to investing) one realises that the rules and cards are always the same and that a consistent strategy should be adhered to on an ongoing basis, even if it seems that due to the recent results that the rules and cards are different.
By thinking that “this time it is different” it’s like going to play a game of Texas Holdem and thinking for some reason that the pack of cards is different because you are performing well, until you get busted out through poor risk management when the run of cards reverts to the mean.
The CDO structurers and purchasers assumed that “this time it is different” and that an asset class – US housing – could never fall in value across the country. And so models were calibrated, structures were developed, and marketing documents were created that were based on US housing valuations always increasing.
In booms an element of fraud always emerges to some extent, and in the sub-prime crisis fraud did cause a higher level of underlying trash mortgages than expected. The uncovering of the fraud can often prick the bubble as it did to some extent in the sub-prime crisis, but booms are generally founded on sound theory that is extrapolated too far because of “this time it is different” expectations.
Investors, both retail and professional, need to ingrain into their mindsets that the world of investing and its inherent laws rarely changes, just like the rules of Texas Holdem (and other games of speculation).
Sometimes investing returns (and runs of cards) can be different for extended periods of time before snapping back to normal, often with savage and far-reaching consequences.
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