Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

May 5, 2010

Derivatives and Playing the Ponies

Growing up in the shadow of Belmont Park, I learned success in finance is much like running a book.

After all, pari-mutuel wagers are derivatives-contracts to pay contingent on the future value of an asset, namely horse's ability to finish in the money-win, place or show.

Track owners profit from the public's appetite for risk and reward, much as does Goldman Sachs does writing derivatives, called swaps, on mortgage backed securities for investors choosing long or short positions on foreclosure rates.

Margins are thin for track owners-ponies are costly to feed and train, and grandstands too expensive, not to mention the acquisitive State of New York, which taxes the betting pool.

Then, I quickly learned about synthetic securities.

One of my eleventh grade classmates received $50 from her father, when he hit the numbers at Belmont. It seems an enterprising financier with a virtual betting window, off track, took two dollar wagers on the daily haul at the track. He paid $250 to those correctly picking the last three digits of the total gross, published each day in the Daily News.

Wow, I explained to my father, "The bookie pays out 125 to 1 on a bet with 999 to 1 odds, and he has no ponies, track or taxes to pay-he's getting rich!"

Wisely my father replied, "Careful son, bookmaking is illegal and the man does have expenses. He pays for protection to stay out of jail and not get his thumbs broken."

Having affection for my hands, I took up something equally questionable-economics.

Long after I distanced myself from the smell of stables-with a Ph.D. and house in a tonier suburb-I recognized the connection between the track and derivatives when I viewed the Eddie Murphy 1983 classic "Trading Places."

In that gem, Don Ameche and Ralph Bellamy, playing elites on Wall Street, bet they can teach an ordinary ghetto kid commodities trading.

Showing him a glass of orange juice, some gold and a few other items, they explain some of their clients think prices will go up and others down, and their firm sells positions in both directions.

Mr. Murphy responds, "Well it sounds to me you guys are a couple of bookies."

The scions agreed, he understands.

So does Goldman Sachs, where Ivy Leaguers create synthetic securities by grouping slices of mortgage backed securities, which form the indexes used to track subprime mortgages.

Like the take at Belmont, the value of those slices are objectively observable, and financial houses simply sell offsetting long and short bets, take a commission for the service-no mortgages to bundle into bonds or huge fixed income investors to sell, and its perfectly legal.

But in the Abacus deal, which is the focus of the SEC investigation, Goldman let a bettor taking the short position help pick the mortgages without telling investors purchasing the long positions.

That's not much different than a bettor bribing a jockey to pull back on the favorite in the seventh race without posting the information.

In the 1967 film, "The Flim Flam Man," George C. Scott circuits the south bilking famers, store owners and others with similarly rigged games and wagers.

If Lloyd Blankfein or his pals end up in jail, because the Justice Department convinces a jury that rigging synthetic securities trading is akin to paying jockeys to pull up on ponies-as it should-then I will send them a boxed set of those two films and the 1950 "Asphalt Jungle."

In that classic, a refined ex-con, a man of taste and breeding, fails to put his genius to good purposes and cannot resist that last big heist.

He ends up in the slammer!

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.