Lay CDOs - For Three Years

I have recently finished reading “The Big Short” by Michael Lewis, who is fast becoming one of my favourite authors. He has a way of making the driest of subjects most interesting. "Moneyball" was the first book of his that I read, and I have written before that for anyone interested in baseball, this is a very good read. For those who prefer to wait for the movie to come out, filming begins in Oakland this week, with Brad Pitt playing the role of Oakland Atheltics GM Billy Beane.

But back to "The Big Short", where Michael Lewis has achieved the near impossible by making the story of subprime mortgage backed Collateralized debt obligations (CDOs) not just understandable, but also interesting.

While I have noted in the past the similarities between financial market investments and those in sporting markets, the book reaffirms this view with a definition of investing as “betting with the odds in your favour”.

Significant differences are found in both the amount of money in the market, and in the time frame over which the outcome is determined. The principal players in the book held their positions for around three years before the bet, or investment, against the CDOs paid off, but when it did the reward was huge, in the millions or billions of dollars.

Trading the sports markets is typically a much shorter time-framed event. The longest are probably the quadrennial World Cup / Euro football tournaments, the next Presidential / UK Election market or the next Manchester United Manager market, which has been running for years and may yet have a few more to run!

But typically sports markets last longer than a week. Excluding the bigger races, horse racing markets must typically be formed and settled in a matter of a few minutes. For the sports that I trade, the in-play time is typically less than four hours, and the markets are often only formed a day or two ahead of event time.

The story of "The Big Short" revolves around a number of individuals who each came to the realization that subprime CDOs were being rated too highly by the credit agencies, and that big Wall Street firms really didn’t understand the risk they were taking with them. The individuals found a way to effectively bet against them, and although it took three years or so for the bet to pay off, ultimately it did, and in a big way. They had correctly calculated that the odds were in their favour, stuck by their bet when it appeared no one else was sharing their opinion, and ultimately they hit the jackpot when they were proven right. People were being encouraged to take out mortgages that they could not afford, or would not be able to afford once the two year teaser rate expired, and however much the banks kept the price of the CDOs buoyant either through ignorance or deceit, ultimately the reality was that the loans would be defaulted upon.

Sports markets are of course different. The nature of sports means that what should happen, doesn’t always happen. It’s what makes sports so fascinating and interesting. After all, if stronger team A always beat weaker team B, then sports would not hold so much appeal. Quants would just run the numbers and announce the winners. Somehow, not quite as exciting. The element of chance is always going to be a factor. Players have good days and bad days. A gust of wind or a bad bounce can make all the difference, but in the long run, if your selections are fundamentally sound, the profits will follow. Just not in the millions, most likely!