I recently found myself awake in the wee hours, making a last-minute attempt to fill out some NCAA tournament brackets. As I pondered whether VCU really could make it to the Sweet Sixteen, I began to think about the detailed statistical model I could craft.
My theoretical NCAA tournament model would be built a lot like those used on Wall Street to buy and sell many speculative instruments, including those nasty credit default swaps that brought down AIG (NYSE: AIG ) .
Specifically, my model would be based on applying historical statistical relationships to current data.
This all made me wonder: Is there a difference between what Wall Street has been doing and out-and-out gambling?
A very fine line
Credit default swaps have been mercilessly maligned during the financial meltdown, and for good reason. It was largely collateral on CDS contracts owed to counterparties such as Goldman Sachs (NYSE: GS ) , Bank of America (NYSE: BAC ) , and Deutsche Bank that brought AIG to its knees. And it was hundreds of billions worth of CDS contracts outstanding that made the collapse of Lehman Brothers so scary.
Credit default swaps can be used a few different ways. The most legitimate is as protection against the default of a borrower. For example, let's say I'm Wells Fargo (NYSE: WFC ) and I loan $100 million to Citigroup (NYSE: C ) . Since I'm a bit nervous about Citi's future, I buy a default swap from Goldman Sachs that guarantees my $100 million in the case of default. My return on the loan to Citi is lowered by the premiums I pay Goldman, but I've also protected my downside.
Credit default swaps are also used for hedging purposes. In the example above, Wells Fargo may want to take out a CDS on Goldman, in case Goldman folds at the same time that Citi does.
Though people often refer to CDSes as insurance, they're different in all the important ways. Most notably, there are no reserve requirements and you don't have to be exposed to the insured risk to take out a CDS.
That has allowed CDS contracts to be pure speculative bets. Somebody without direct, or even indirect, exposure to Citi's debt can still take out a CDS against Citi -- a move that amounts to "I'll bet you that Citi goes bust," which isn't all that dissimilar to "I'll bet you that Memphis wins the NCAA tournament."
Using the house's money
The fact that Wall Street has been flipping around instruments similar to the tickets in Wynn Resorts' (Nasdaq: WYNN ) sportsbook is only part of the problem though. After all, you don't see MGM Mirage (NYSE: MGM ) flirting with bankruptcy because it bet the wrong way on the recent Roy Jones Jr. fight (MGM is flirting with bankruptcy for completely different reasons.)
For years, Wall Street has been doing what the folks in Vegas wouldn't dream of doing: making massive bets with house money.
It's been as if Steve Wynn had levered up a bunch of the company's equity and given it to some inside "specialists" to gamble at competing casinos. If he had savvy specialists, the profits could be great. But big, highly leveraged bets might mean that a bad run by some hotshot gamblers could put the entire company at risk. Sound familiar?
There's a big difference between our ultrarisky Wynn described above and the actual Wall Street firms, though. Even if Wynn levered its balance sheet to 30-to-1, its resulting $48 billion in assets would pale in comparison to the $885 billion in assets at Goldman or the near-$2 trillion on the books at Citigroup.In addition, the Wall Street firms were so interlinked that a failure had a high probability of cascading through Wall Street and the rest of the U.S. banking system.
With all that said, we don't want to decry risk taking. Our great economy was built on people taking risks, whether it's going off in search of new ideas, starting a business, or financing a start-up company. Demonizing risk taking would assuredly shove us off the path to a healthy, recovered America.
Fortunately, it seems like the government has caught on to what does need to be done: minimize the impact of the failure of any single institution. The rallying cry of big financial institutions as they put their hands out for government alms has been that they're "too big to fail." And doggone it, they've been right. The shock waves through the system after the failure of Lehman were a warning about what might happen if Citi or AIG were to fold.
Looking ahead, there need to be regulations to prevent financial institutions from becoming bloated companies that have the potential to hold the U.S. economy hostage. This isn't just some silly game involving a ball and a net, you know.
Of course, not everybody agrees that more power is what the government needs now. Check out what some of my Foolish colleagues think, and then weigh in with your own take.