Play Ball! How Rotisserie League Baseball Crashed the World Economy

I kid you not. Fantasy baseball invented what Warren Buffet calls “financial weapons of mass destruction” – synthetic derivatives.

As we all know fantasy sports provide an answer to the age-old puzzle: I’m getting older. I can’t play any sport too well anymore, and never really could. But I think I’m smart enough to manage a professional team. The problem, of course, is not my prodigious talents. Rather it is the supply of major league baseball teams – there are only 30. Due to reasons beyond my control (connections, not talent) I’m not likely to get my chance. So for six months of the year I have to watch some jerk manage my favorite team.

Along comes fantasy baseball and it solves the supply problem. It creates an unlimited number of teams to be managed. I now can let it rip. Also, it allows me to gamble, yet another activity that goes hand in glove with sports.

We didn’t know it at the time, but your favorite pastime – rotisserie baseball – provided the perfect model for Wall Street. It solved their supply problem. It solved it so well that it nearly took down the world economy.

You see Wall Street got into its own game of fantasy finance. It started when a few large firms realized that they could make heaps of money, I mean heaps, by pooling high risk loans, mortgages and other forms of junk debts, and then slicing up the pools into securities that made it appear as if the risk had been removed.

Somehow, the large firms – you know the names – were able to persuade the rating agencies to bless most of those slices with AAA ratings, and those slices returned higher interest rates than other AAA-rated securities. So major investors flocked to them. The big profits came from packaging them, selling them and trading them. It turned into the most lucrative enterprise in the history of finance. (For all the gory details and comic relief click here.)

But our blessed bankers had a problem similar to the one we managers faced with baseball. There was a limited supply of junk debt. At first they scoured the country for more and more subprime loans and such, which of course, encouraged their proliferation from South Beach to Las Vegas. But it still was an awkward, clunky process. You had to get someone to make the loans, you had to get title to thousands of them for your pools, you had to package them up — all of which cost you time and money. And it put you in a risky position since you were holding all that junk – kind of like getting stuck with a roster full of injured players.

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So some genius financial engineer figured out how to break the bottleneck. Let’s create a fantasy layer of derivatives so that we don’t have to own the real thing. We can do it all AS IF we owned the underlying real assets.

Here’s how they did it. Imagine that each synthetic security is the same thing as a fantasy baseball team. The synthetic financial security, like your team, goes up or down in value depending on how the underlying assets perform, be they subprime loans or major league baseball players. You can measure how much up or down based on their numbers, pure and simple. Bingo, you no longer have a supply problem.

In effect each of our fantasy baseball teams is a synthetic derivative. It “derives” its value based on how 700 or so real major league baseball players perform. If your team does well, it goes up in value – that is you are likely to be in the money at the end of the season.

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Same goes for synthetic CDOs. In effect they provide insurance against default for those slices of the junk debt pools. The better the underlying debt performs, the more value for the synthetic CDOs have. As long as there is a market of buyers and sellers for the synthetic version, there is no limit to how many you can create.

In both fantasy finance and in fantasy baseball, this builds an upside down pyramid teetering on something real. Those 700 major league baseball players are at the bottom point of the pyramid, the only “tangible” asset in our beloved game. Above them are millions of fantasy baseball teams. I hate to break it to you, but all of them are synthetic and worthless without those 700 real players doing their thing.

Our fantasy teams also sit in the middle of their own little economy. Around them are a supply industry of stat services, books, magazines and websites. Some of the big boys, like ESPN, might actually be making some real money from it all.

In Wall Street’s fantasy finance game, the tangible assets are the homes that support the junk debt, that support the pooled slices, that support the insurance policies on those slices. This upside down pyramid based on those houses also includes bizarre synthetic products like CDOs squared and cubed. And yes, there is quite an economy built up around them – like most of the world’s financial system.

Here’s the rub. Since the entire fantasy finance upside pyramid rested on housing prices, bad things can happen when those prices stop rising. In fact all that has to happen was for housing prices to flatten. They didn’t have to fall in order to crash the entire pyramid of debt.

Let me put this in stark terms than even the most financially challenged fantasy baseball owner can understand: What happens when there’s a strike or lockout? Yep, it’s good by fantasy baseball. All of our wonderful fantasy teams turn into……toxic assets with no value!

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And the entire fantasy baseball economy comes crashing down as well – no stat services, no books (including one that I wrote and lost during the last baseball strike. Unfortunately, there was no TARP program to bail me out.)

So when housing prices leveled out it was as if the major leagues went on strike. But fantasy finance is just a bit more potent than our cherished pastime. When it crashed, it led very quickly to a global economic meltdown. The big boys on Wall Street play with a lot more chips.

So next time you’re tempted to blame Obama or Goldman Sachs or Greenspan for the crash, think also of those deranged lads who gave birth to fantasy baseball some 30 years ago at La Rotisserie Française in New York.