More on derivatives

by cactus

Last week I wrote A Simple Explanation of How The Use of Derivatives Created The Great Recession.

I want to clarify things with an analogy that at first glance may seem unrelated. Let’s talk about poker. Its a game that seems to have grown in popularity in the last decade, especially with the advent of on-line poker, even if the rate of increase seems to me (and I haven’t had time to pay much attention lately so take it for what it is) to have slowed in recent years.

Poker is different from most casino games in that you only play against other players, not against the house. The casino – online or glitz and mortar takes a rake, which is a piece of each pot. In a tournament, the casino’s rake comes off the sum total of the entry fees (“buy-ins”); what is left after the rake is the prize pool.

When the rakes are small enough, and they usually are, a good player can have a positive expected return. So… investors willing to risks can finance players by covering the buy-ins of the players in exchange for a percentage of their winnings. Though poker is a game of skill, luck still matters a great deal, so it probably makes sense to spread one’s investment either across a large number of tournaments by the same player, or across a large number of entrants in the same tournament. I know of examples where this is being done informally, and I have seen business plans for web-based versions of these approaches on a wider scale, but the market, as such, is currently very unsophisticated. Its good for the players – they can enter more tournaments, at lower risk. Despite giving up a share of their winnings, they stand to make more money by being able to play more tournaments and tournaments with more expensive buy-ins. I understand that one well-known professional player, Chris Moneymaker (and yes, that is his real name) produced a monster return both for himself and his backer by qualifying for and winning the World Series of Poker with this sort of financing scheme.

Its not difficult to imagine how such a market could evolve… if the money is there. Over time, buying shares of a player’s winnings in a package of tournaments (say ten) in exchange for a share of the player’s winnings might become common for good players. Over time, some enterprising individuals who know and are trusted by many of the better players might find themselves a niche aggregating players together. The result – instead of being able to buy into the earnings of a single individual in a ten tournament package, you could buy into the earnings of ten or fifteen players over ten (or more) tournaments. It diversifies the risk a bit for all involved, especially if there was some sort of limited prize sharing among the players in the package. Of course, that’s a lot more expensive than financing one player… so that would lead to two additional developments.

Development 1 – exchange markets would develop. That would allow for liquidity (investors could more easily get into and out of investments). It would also allow securities to change value over their lifetime. (If none of the players cashed in the first tournament or two, the value of the security would drop, for instance.)

Development 2 – margins. Some deep pocket entities would be willing to loan investors money in order to buy into such packages.

If the market got to this point, perhaps some really sophisticated investors would jump in. They might find – using sophisticated math – that it pays to pepper each package of players with a long shot or two. They might notice other thing – perhaps their models would show that a given security contains too many players with a similar style, or who likely to knock each other out of a given tournament. Short it.

Meanwhile, the aggregators might notice the growth in demand, and start packaging more marginal players together. Its all good though – someone with a Ph.D. in econ (or even better, Math or Physics) could demonstrate that a bunch of marginal players put together do, on average, do almost as well as the top players, and hey, its Poker, all you need is a chip and chair. And a bunch of MBAs could put that proof on 17 powerpoint slides and sell it to the county treasurer in any number of locations in this country (and elsewhere), and we’re not just talking the sticks either.

If the money keeps flowing in, and the story resonates like tulips, Florida swampland or Pets.com, eventually you have rubes all over the country who think they’re going to finance a comfy retirement by plonking down for the buy-ins for some slicks who will draw to an inside straight every time. And you can even get insurance on your expected winnings, so what could possibly go wrong? Especially when every taxi driver and waiter in the country, not to mention every editor at the National Review, will happily give you advice on how best to play the derivatives market for poker. Heck, the guy in the Oval Office starts suggesting that this is probably what the country should be doing with its Social Security – everybody could direct their own account.

That’s about when the doo-doo will hit the fan. And here’s how it starts… a big investor loses big time. His package of “Poker Geniuses from Blowing Rock, North Carolina, Class B-7” comes up a dud. Unfortunately, the dude is leveraged up 50 to 1. Which makes sense, because he couldn’t lose so it was guaranteed money. Unfortunately, he did lose. So he’s gotta pay his creditors, and he does so by liquidating some other positions. Due to leverage, a lot of positions. That pushes down the value of those positions, and similar securities. But it does something worse… for some reason, it makes a few people re-evaluate the likely pay-offs of the securities that they themselves are holding. And if “Poker Geniuses from Blowing Rock, North Carolina, Class B-7” can come up empty, what about the “Potted Plant Poker Playas of Playa del Rey, L Team?” The folks holding the last tranche to pay off on something they just realized is a dog, and which has already lost value on the market when the big guy started selling left and right to meet his obligations – what are they going to do? Bear in mind, Goldman beat them out the door by six months, and they’re leveraged up. 50 to 1. And a payment is due at the end of the week and nobody is answering their calls.

So the market collapses. In fact, a few other markets collapse – who knows who has lost so money on Poker derivatives that they are going to go under, and that big multinational that wants a bridge loan does have a division that plays in this kind of thing, right? No bridge loan for you. It turns out that some of the big guys – the folks who aggregated the players in the first place, and thus understood what sort of dogs were being financed in the first place – bought into their own sales pitch and are holding piles of this crud. Inevitably, there’s a bail-out for some of the big boys. The Fed or the Treasury takes the crud off their hands, and gives them top dollar to boot. After all, they’ve convinced the government that without that market, nobody is going to finance a company that manufactures patio furniture in Indiana. Of course, none of them does get around to loaning money to that company that manufactures patio furniture in Indiana, but that’s a trivial detail. Enough of the big boys are made whole that everyone who counts is happy. And there is little thing called blackjack…

So, what did I miss?

by cactus

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