## The Real Cause of the Financial Crisis: An MIT Blackjack Team Perspective

By Guest Author Semyon Dukach

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 (MIT Blackjack Team) 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.

### 17 Responses to The Real Cause of the Financial Crisis: An MIT Blackjack Team Perspective

1. DeedInLieu says:

Thank you Semyon Dukach for sharing what many of us have realized is happening with this “bailout” garbage being forced onto the American taxpayer all in the name of saving the economy, or the joke about maintaining the “faith” in the economy. I quote from the article:

“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.
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”.

How can there be faith in the economy if the same people who cased this mess are now in charge of fixing it, all they are doing is “doubling down” and praying for a miricle.

2. Tom says:

Regarding the MIT Blackjack team, the made-for-t.v.-special “Making Millions” said you guys improved on Dr. Edward O. Thorp’s formula. Uhm, that is news to me. How did you improve on it exactly?? Using a Big Player and spreading out bets with a larger bank roll was covered in his original book, Beat the Dealer. Although your story is a neat & sexy one, he did not get the credit he deserved when the movie “21″ was produced. Kevin Spacy, shame on you.

3. Harry Tran says:

This is always going to happen when you let a bunch of hedge fund managers invest in anything they please in order to get the highest rate of return for their portfolios. And they know one thing that many of the average investors don’t which is information, and these days information is key to any transaction and it is a force that makes one party stronger than the other party. Which allows them to take advantage of the misinformed.

4. Amitabh says:

Semyon Dukach, thank you for the lucid explanation of the past and present (and most probably future) financial crisis.
Iteventually boils down to greed, doesn’t it? But why blame just the fund manager alone. It is a vicious cycle where the investors look for better and better returns in shorter and shorted time. They – we – are the ones who push the fund managers to play Martingale.
Your post above echos what Nassim Nicholas Taleb has so wonderfully put in his book The Black Swan. (I am pretty impressed by Taleb and many of my own blogs are inspired by his books!)

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6. Bigbuilder says:

Great analysis. Greed is indeed the root of the problem, but greed is a human trait that will never go away. The challenge is to structure both our government and the economy in ways that preclude making Martingale bets with money that is insured by the government. People lend to banks at an artificially low rate since their deposits are insured. Banks lend to hedge funds because there is a short term gain in earnings on the spread. If deposits were not federally insured, the fuel for the fire would be less and there would be more care by the banks.

Milton Friedman had it figured out: There should be two types of banks: One that invests only in U. S. Government bonds and for which deposits are fully insured to any level. The other which can lend or invest in any way but for which there is no insurance.

An additional subsidy by the Government is the false sense of security provided by the Securities laws and other regulations that apply to financial institutions. The average joe assumes a degree of regulatory skill that is simply not possible and makes investments based in part on that assumption. If the Government said: “Hey, you are on your own…don’t rely on us to protect your investments!” the result would be a very different system of managing risk.

7. Tom says:

This is a bit of a simplistic argument (although at least partially correct.) Banking leverage and lack of controls were a major part of this crisis – again – like many before it.

8. Jamie says:

My only point of contention here is the use of the term, intuition. Many successful traders use a bit of intuition, in sifting through both the technical analysis and the fundamentals, in determining enter and exit levels for their positions.

The whole “going with the gut” works great, if sound money management practices are already in place. The whole double down mentality is that of a gambler’s folly than that of a long term successful trader. It’s important to recognize when one’s system isn’t producing and to re-tool periodically.

All and all, most people go with the herd. The idea that real estate only goes up was echoed by millions of home owners, bankers, and real estate agents for the past decade, yet, there’s been numerous boom/bust cycles in RE, throughout our history, including Los Angeles, a century ago where even the RE fundamentals, that LA would in the future be one of the nation’s largest cities came to fruition nearly ~70 years later, was proven to not predict the short term RE boom, followed by bust, of that time period.

9. You’d get my vote! Why don’t the bankers and politicians understand this, or do they understand it all too well???

10. Dicebucket says:

Blaming the greedy folks in our financial institutions for the current financial mess is like blaming the maggots for the death of the dear on the side of the road. The opportunity was presented to them by the REAL culprits in this matter.

Here’s the whole story, dating from 1999!!:

1999: Early Warning –New York Times:
http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

2003 – 2005: Calls call for more regulations; opponents poo-poo risk of any harm from sub-prime lending. “Sub-prime loans are virtually riskless”: Franklin Raines, Fanny CEO
http://www.breitbart.tv/?p=184743

2005: Fannie Mae/Congressional Black Caucus relationship

2008: Wrap-up: Continuous warnings ignored, opponents block new regulations, culminating in bailout:

11. moneycreation says:

Great article!
I actually think the problem is an unavoidable part of the debt based monetary system. The core of the problem is the way money is created leading to the necessity of pyramid scheme since the money system by it self is a pyramid scheme. I explain this an why the system need to have bubbles in my blog using simple animations :

“The whole credit system is an “emperor’s new clothes” trick where we are fooled into thinking that “no money” (credit) in the form of digital ones and zeros is money. The whole illusion is based on the fact that we accept that the phony money banks make up by debt, binding everything and everyone , really exists and that we can withdraw them as cash when ever we want.

To make us keep the money in the banks’ fantasy world in the form of credits, we need to be tricked into believing that the money is “growing” . “

Please read the rest and I would very much appreciate your thoughts (I would also very much appreciate some help improving the text since English is not my native language)

http://moneycreation.wordpress.com/2009/01/16/3/#comment-7

12. Robert B. says:

The author’s presumption that there is such a thing as “strategy of sound fundamental analysis ” when attempting to gauge market entry points for put options to enhance returns is, by definition, a lose-lose proposition. The recent implosion of the stock market and the massive losses for investors using classic fundamental analysis is a case in point. Fundamental analysis is not a market-timing” tool and never has been.

An investor without a clue about the direction of price action in a particular stock is not only well advised to stay clear of the market, but is certainly advised to stay away from put options.

That’s unless he has a serious financial death wish….

13. John Perkins says:

I wish someone would realize what is causing this whole crisis comes down to a multitude of moments where the consumer, eager to buy a car, a stereo, a widget, looks for the least priced version and purchases it, without realizing or caring it was made in China, who we have a 5 trillion dollar debt to already. The pigeons have come to roost for their decision to pay for cheap labor produced products, they have given themselves a giant paycut that was delayed by 25 years. And the companies of America are required to move overseas to compete, and so on and so on but it all starts with the

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15. [...] The Real Cause of the Financial Crisis: An MIT Blackjack Team Perspective [...]

16. [...] Real Cause of the Financial Crisis: An MIT Blackjack Team… March 21st, 2009 | Tags: A fellow blogger wrote a fantastic post today on “The Real Cause of the Financial Crisis: An MIT Blackjack [...]

17. [...] anymore. Semyon Dukach, one of the members of the MIT team, wrote an interesting piece called The Real Cause of the Financial Crisis: An MIT Blackjack Team Perspective. He argues that how we manage money needs to be radically altered and describes the desired [...]