March Madness and Credit Default Swaps (CDS)

My 13-year old son Jack asked me today if betting money on the NCAA basketball pool was dangerous. As a parent –and a geeky one – and knowing that every question is a potential teaching moment – I launched into an explanation of the various betting structures that I had encountered in my career on Wall Street. I covered the strategies of filling out brackets and the joys and angst of draws in a lottery format.

But knowing that I had a captive audience –we were in the car – I steered the conversation into the most dangerous element of NCAA pool betting –the trading of individual teams. I explained that while a $10 draw in a $640 lottery is exciting as the team names get pulled, that traders quickly got bored. They wanted “action” to demonstrate their analytical skills as the tournament progressed and they took to offering to buy teams. I told him that how in the mid-1980’s people would pounce on the secretary who had pulled the hot ticket and say “Oh you got Duke, I’ll buy it from you for $64!”, or to others “Oh you got Gonzaga, I wouldn’t give you $4”. That quickly lead to a discussion of odds –how Duke was valued at 10:1 and Gonzaga at less than 100:1.
But traders quickly learned that a Duke long would not surrender her ticket for any reasonable price, and while the Gonzaga fans were loyal, that they already had $10 invested in their one ticket. At that point, a guy named Charlie (a trading assistant with the mindset of a future CDS trader) wandered over and explained “Oh you don’t have to own the ticket to sell it. You can sell it synthetically. Watch. Who wants to buy Gonzaga at $3?”

I asked him if he was worried that if Gonzaga won, he’d have to pay out $640. He said, “No, he’d followed the tournament for years and it was a statistical near-certainty that a 12 wouldn’t make it past the quarter-finals” as he sold three more units. “Free money” he noted. “I’ll just keep selling any of the lower seeds. I’ve made money doing this the last three years.”

My son asked me – “Wasn’t there a limit to how many teams this guy could sell”. I told him “no” and in fact Charlie got so involved in every bet that he became an office star and started crossing sellers of teams from his friends outside the office and to guys on our desk. He’d had friends who’d sell him 10 Gonzagas at $2.75 and then he’d resell them to buyers in our office at $3.25 netting $5.00 on a 10-lot.

With money involved my son was all ears, and he asked “So, did the guy get rich”?

I explained that as the tournament progressed, Gonzaga kept winning. “Well couldn’t Charlie buy Gonzaga back”, Jack asked. I said that there were some offers first at $10 and then $25, but that Charlie would have had to take a loss, he wasn’t keen to do so, and no one could make him buy.
Gonzaga kept winning and by this time people were willing to pay $60 just to get involved in this Cinderella success story. One morning, after a frantic midnight overtime win by Gonzaga, Charlie wasn’t to be found anywhere in the office. A round of “poor Charlie’s” over breakfast coffee lead to a whispers of “how much will he owe you if Gonzaga wins” by morning break. With growing questions as to who his outside sellers were, a concern grew into a panic by lunch as the tally of Charlie’s potential IOU’s grew from $50,000 to $100,000 to numbers that would have taken Charlie a lifetime to re-pay.No one knew how much Charlie had bet, or whether he, or his friends were “good for it”.
Some who had bought Gonzaga at $3 and sold at $10 feared that they might not only not get their $7 winnings, but that they might have to make good on the pool (maybe even to their boss ouch!) even if Charlie disappeared. Some senior traders insisted that they be paid the $7 profits upfront, but wouldn’t advance on any losses. Many of the Gonzaga longs were counting on their gains to offset other losses. They scrambled to do trades at crazy levels just to unwind exposures.

I explained to Jack that senior management had to step in and close down all betting as the office was totally focused on the “pool” to the point where no one was working. It was rumored that one VERY senior trader was pressed into taking over Charlie’s positions. We all actually breathed a sigh of relief when Gonzaga finally lost.

My son noted -”That’s messed up. They wouldn’t let that happen today, right?”

I smiled silently as we drove the last mile thinking (remember I’m a geek), that if my 13-year old son could grasp these issues, that maybe some Congressman could see all of the parallels to CDS: the lack of margin, the problems of price discovery, the absence of netting, the flaw of short-sighted models, the issues of counterparty risk, the daisy chain of IOUs, the fragility of the system to tail risk, and the prayer that someone larger than the market will be there to rescue it in a crises. OK, maybe Jack didn’t get all of those messages, but he now knows the concept that someone can bet beyond their capital limit, and that unlikely events can happen with consequences to those even not directly involved.

So in an effort to advance the discussion of centralized clearing of CDS along, I cheer – GO BIG RED (Cornell)! If AIG didn’t work, maybe we need another (NCAA) credit scare to teach this generation the risks of OTC, un-margined, synthetic trades.

P.S. I read years later that Charlie became a very successful hedge funder manager…..for a while.