The real cause of the financial crisis, and the real solution
 -- An MIT Blackjack Team perspective

The mathematics of probability that govern the trade-offs of risk and
reward are fundamentally counter-intuitive.

The reason that  societies ban pyramid schemes outright, instead of
relying on the market to make them unprofitable, is that most people
trust their intuition, and their intuition leads them astray.   If you
were to wait for the market to run its course on a pyramid scheme, the
losses could devastate a whole country, as Albanians found out a few
years ago.

In our days of outwitting casinos around the world, we have come
across many people who thought that they also had a great system, but
were in fact compulsive gamblers who eventually lost everything.
Among the false systems that intuitively feel right, there is none as
insidious and deadly as the Martingale, where a player doubles his bet
after every loss.

The Martingale system works as follows: suppose you need an extra
$100.  You go down to your nearest casino, and bet $100 on a hand of
blackjack, or on any other almost 50/50 proposition.  Should you win
right away, you have reached your goal and gotten your money.  Now if
you lose, you bet $200.  If you win the second bet, you're up $100
over all and once again successful.  But a little more than one out of
four times you'll lose both, and end up down $300.  In that event you
simply bet $400.  If you lose again you bet $800, and you just keep
doubling your bet until you win once.  Clearly you have to win at
least once eventually, and with this system you end up with your $100
profit even if you start out losing for a while.  If you're willing to
bet up to ten times for instance, your chance of losing all ten bets
is close to one in a thousand.  That means that with a probability of
almost 99.9%, you will win one of those ten bets, and therefore walk
away with your $100.

Of course there's a catch that few people notice. When the unlikely
one in a thousand event happens and you do lose ten in a row, the
actual amount that you've lost is over $100,000, all risked to win a
mere hundred bucks.  You might not have any way of doubling up again.
You might even need some sort of bailout.

In the world of investments, there are many ways more subtle than the
Martingale to guarantee a better return over a period of months,
years, and even decades, at the cost of certain ruin way down the
road.  Let's say for instance that you're managing a hedge fund which
invests in stocks.  Your strategy of sound fundamental analysis is
fairly well understood.  You have found that you can generate an
average return of 6% per year, and so can most of your equally
qualified competitors who have access to the same talent pool and
knowledge base as you do.  But then one of your competitors realizes
that he can automatically increase his return to 9% by selling
something called "out of the money puts" on the market.  This means
that the competitor's fund essentially sells insurance against the
market crashing dramatically.  In normal times his fund will gain the
premium from selling this insurance which boosts his returns.
However, in the rare event of an extreme market crash his investors
will lose everything.  This form of Martingale can be easily tuned to
work for various time periods with various chances of collapse.

When investors see a fund manager generate a higher return than his
competitors, they will move their money into that fund and out of the
other ones.  And money managers are rewarded based on the size of
their fund, or the level of returns.  The managers do not risk their
own money.  If they can provide a bigger gain for a few years, they
win everything.  They might even be lucky enough to be retired by the
time their investors are paying the piper.  The managers who have the
discipline to understand and avoid the Martingale tricks will not be
able to compete on the basis of their returns over a few years, and
will eventually lose their funds and their jobs.

But many people managing large funds are men and women of integrity.
They will not willingly expose their investors to total loss in order
to line their own pockets with cash.  Yet the system as it presently
works does not allow them to compete without some kind of trade-off of
long term risk versus short term reward.   The solution that they
usually flock to is to create such a complex Martingale system that
they themselves cannot understand the longer term risk implications.
As long as the mathematical analysis of the risk of ruin lies beyond
the understanding of the CEOs, the money managing organizations can
stay competitive by employing their latest version of a
return-boosting Martingale, without admitting to themselves or to
others that they have been peer-pressured into the financial
equivalent of selling their soul to the Devil.

In the 80's the emerging Martingales were called junk bonds and LBO's.
 In more recent times they are known as mortgage backed securities and
credit default swaps.  You can regulate mortgages half to death and
try to control what kind of risks various kinds of investment
organizations are legally allowed to take.  You can even forbid short
selling and ban golden parachutes.  But as long as managers are paid a
percentage for managing other people's money, they will compete with
each other based on the returns they appear to generate.  The pressure
to create out-sized returns will eventually force them to invent the
latest complex scheme which will have the same effect: eventually the
investors lose it all.  Complex financial structures will once again
emerge that even the best professional investors cannot fully
understand.  People will always move their money into the places that
give the best return over a few years, no matter how many times they
are warned with the disclaimer that "past performance is no indication
of future returns." And eventually the crisis that results will reach
global dimensions beyond the means of a government bailout, especially
if part of the risk managing strategy becomes counting on bailouts
happening every decade or so.

The only solution is to forbid money management as we know it.  We
could certainly have people like Warren Buffet manage investors' money
alongside their own, with no additional percent-based compensation
beyond their own investment gains.  But we must remove the incentive
to create Martingales, and protect people from their own intuitive
desire to move their money into the funds which generate out-sized
returns, without understanding the long term risks which create them.

In our globalized free market world, almost everyone is ultimately an
investor, whether by owning a house or merely holding a job in a
company which depends on access to capital. The scope of the current
bailout has reached the point of real danger.  We must fix the
underlying problem before doubling down again as a society, or risk
going the way of Albania.

---
Semyon Dukach is an angel investor, high tech entrepreneur, and former
president of the MIT Blackjack Team.
http://en.wikipedia.org/wiki/Semyon_Dukach