
The real cause of the financial crisis -- An MIT Blackjack Team perspective - prakash
http://www.semyon.com/crisis.html
======
DanielBMarkham
"...The only solution is to forbid money management as we know it..."

That's a bold and provocative statement. I'd feel a lot better if the author
actually proposed some way of ending "money management as we know it" instead
of just throwing the blurb out willy-nilly.

Nobody disagrees about the premise: markets will always seek to find loopholes
in the system and in the human condition. Some people see this as a source of
growth -- after dozens or scores of such blowups, beginning way before the
Dutch Tulip Bubble in 1637, markets have continue to grow and become more and
more sophisticated. Whatever the fundamental flaws, it's obvious they haven't
prevented outstanding growth over the last several hundred years or so.

To propose a dramatic new solution, it's your job to make the case that the
benefits outweigh the drawbacks. Otherwise it's like speaking out against
eating because of all of the cases of food poisoning -- you're missing the
point.

~~~
Harkins
Though he doesn't suggest it in so many words, I understood him to be
proposing that money managers must be paid a flat rate rather than by
commission based on returns or total money managed, that it would remove their
incentive to take short-term risks to run up their personal reward.

~~~
frig
That doesn't work.

If I'm paid a flat fee to manage money, the people handing me money to manage
are still going to look for the manager with the highest returns (that's human
nature).

So, I still have an incentive to chase riskier short-term gains; I see less of
the upside than if I were also getting a cut of the gains, but the incentives
that arise from competition with other money managers remains in place.

~~~
zupatol
I think lots of people are ready to forego higher returns for higher security.
That's what I ask from my banker.

For a short while I was looking for a bank that would just have a portfolio
that follows the market instead of trying to beat it, and that would take less
fees because it took less effort to manage. I contacted two other banks, but
they didn't have anything like that. I found it was extremely tiring to speak
to bankers, they all seem to want to drown you with words. I eventually stayed
with my original bank just to stop wasting time.

~~~
natrius
I thought such things were common?

<http://en.wikipedia.org/wiki/Index_fund>

~~~
zupatol
They are common.

The problems they don't solve is how to allocate the assets between
currencies. Also part of my money is in fixed income papers. So even when not
trying to beat the market, there are some decisions I would like to leave to a
professional.

~~~
khafra
Dimensional Fund Advisors
(<http://en.wikipedia.org/wiki/Dimensional_Fund_Advisors>) diversify among
currencies, markets, and asset classes according to some math I don't really
understand. They seem pretty sharp, though, and they're low-load for the buy-
and-hold version (they have market timing funds designed to lower the
fluctuation at the cost of lowering the long-term return).

------
davi
I won't say this _is_ the best thing I've ever read on the subject, since that
would imply I have sufficient knowledge of the financial markets to accurately
evaluate what I'm reading.

Instead, let me say this _seems_ , or _feels_ like the best thing I've read on
the topic.

In addition to relating the crisis to the Martingale betting system, the
author describes how an ecosystem of bettors tends to converge on a
Martingale-like system when playing with other people's money, and taking a
percentage of the stake as a fee.

~~~
eru
And limited liability on the down side!

------
sokoloff
I don't have a lot of faith that outlawing performance-based money management
yields a stable system either. (I do agree that it is likely to yeild one less
to synchronized catastrophic implosions, until it naturally devolves back into
what I've seen twice in my 4 decades on the earth.)

Suppose we "agree" that 6% is the safe rate of return, and no money manager is
allowed to collect fees or bonuses based on performance. The next logical step
for anyone with a relatively large amount of money is to try to build their
own in-house (or in-family) money management arm to generate 7% or 8%. If that
attempt is successful, by whatever means including blind luck, that money
manager can go take his expertise elsewhere with a track record of "proven
high returns", or get a not exactly fund performance based raise or bonus.
(Call it a corporate profit-sharing bonus, or retention bonus, etc.)

Logically, once one group is doing it, others will try to follow. No wealthy
family is going to sit by generating 6% when someone in their same situation
is generating 8%. Those that don't have large enough investment nuts to start
with will pool with other not-quite wealthy investors, and eventually this
will trickle down to the common mutual fund. And then we'll see "funds of
funds" (or funds of fund, as we saw recently) that will take money, invest in
the latest 8% fund, pay out 7% (still beats the 6%) and pocket 1% for
expenses.

Trying to legislate away greed is like pissing in the ocean.

IMO, you need people to feel like risky investments are risky investments. If
they instead feel like they own an implied governmental put on their risky
investments, you just get more and more comfort with risk. People who make
bets that they can't cover need to feel the pain, and for those fallouts to
become public in the form of bankruptcies.

Banishing an entire category of financial work (fee-based money management)
because of some crooks, some bad bets, and some large failures is not the path
to a productive and efficient means of distributing capital to the businesses
who need it to generate growth, jobs, and new products, IMO.

I worry that a logical outcome of this proposal would be an end to pooled-risk
VC funds, and a substantial impairment to the liquidity and transparency of
the public markets. It makes for a good blog entry though, as long as you
don't think about it too hard.

------
mhartl
This essay makes some good points, but ultimately it fails to address the
titular 'real cause', due in part to an over-reliance on the personal
experience of the author. In this last respect it is typical of the genre;
Michael Lewis, for example, tends to focus on miscalculation of risk, and
particularly on the defects of the Black-Scholes model for pricing options---
based in large part on his experience as a Big Swinging Dick at Salomon
Brothers in the '80s.

Based on my reading of a bunch of these economic diagnoses, I'd like to
suggest a two-part litmus test for addressing the 'real cause' of the crisis:

    
    
      (a) Explain the system of central banks and fractional reserve banking.
    
      (b) Connect (a) to the present crisis.
    

I've become convinced that any explanation that falls short of this test
invariably misses the forest for the trees.

------
dantheman
_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._

There are a lot of assumptions, first and foremost that all investors are
trying to maximize their returns with no regards to risk. I know many people
who choose investments that are less risky and thus have less of an interest
rate.

People always look at money management from the investment side (ie, what is
my return) and don't think about what is actually going on... ie funding new
ideas/projects, if you outlaw money management then drastically alter the way
that people can get funding -- greatly increasing the misallocation of
capital.

A better solution would be to tell people to research what they're investing
in, if it doesn't look right or you can't understand it don't invest in it.

~~~
tome
> _A better solution would be to tell people to research what they're
> investing in, if it doesn't look right or you can't understand it don't
> invest in it._

Unfortunately for most people, that's almost everything.

~~~
dantheman
If we didn't have an monetary policy of inflation, merely depositing money in
a savings account would be a viable option.

~~~
aikiai
I don't see that to be true. There are plenty of low-risk, low reward options
out there if all you want to do is preserve your value.

Inflation has its own issues, but as I see it they are mostly social class
related.

~~~
kingkongrevenge
> There are plenty of low-risk, low reward options out there if all you want
> to do is preserve your value.

No there aren't. To preserve real purchasing power monetary inflation FORCES
you to speculate. Straightforward saving has been a loser's game for many
decades now. This was not always true and there were long periods of price
deflation and good interest rates before the establishment of the fed.

~~~
gravitycop
_Straightforward saving has been a loser's game for many decades now._

18% interest was a loser's game? <http://www.hsh.com/indices/6mocd80s.html>
Even as recently as 1989, CD rates were over 10%. In 2000, they were over 7%,
and in 2007, they were over 5%. <http://www.hsh.com/indices/6mocd00s.html>

~~~
kingkongrevenge
Yes, and go look at annualized monthly CPI increases during those periods.

~~~
gravitycop
Annualized monthly CPI increases were over 18% for 6-month stretches? How
about 5 years? There are 5-year CD's. From 1980 to 1985, the CPI went up only
30.6%. <http://cost.jsc.nasa.gov/inflateCPI.html> From 1989 to 1994, the CPI
went up only 19.5%. From 2000 to 2004 (as late as that calculator goes), the
CPI went up only 9.7%.

Right now, America, and the world, are experiencing _de_ flation. Yet, 6-month
CD's are paying over 2% interest.

~~~
kingkongrevenge
A few quarters here and there with decent real CD rates is not reflective of
how people actually go about saving. You have consistently lost purchasing
power if you plowed cash into savings accounts, CDs, and money markets funds.

When all factors are considered, including understated CPI figures, I believe
real returns to cash in the period in the 80s you point to were not even very
good. Especially when you consider the opportunity cost of your five year CD
and what played out in other asset classes during that five years.

~~~
gravitycop
_Especially when you consider the opportunity cost of your five year CD and
what played out in other asset classes during that five years._

What other zero-risk asset classes were we comparing against?

------
mattmaroon
Hedge fund managers get paid more on their performance than on size. Their %
of assets under management is generally about enough to keep the lights on.
And many hedge fund managers are heavily invested in their own funds.

What he describes with " 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.
" sounds more like a mutual fund, though selling out of the money puts does
not.

Hedge funds usually carry losses over from one year to the next as well.
They're definitely designed to align the interest of the manager and the
limited partners much better than mutuals.

In fact, in the long run hedge funds outperform mutual funds by a substantial
margin for exactly that reason. He's right that neither have pure
investor/manager alignment. The only way to do that is to lengthen the term
from one year to 10 or something.

------
larryfreeman
Very interesting argument.

I understand the article to imply that we need more government regulation
because the market cannot correct itself for pyramid schemes without severe
devastation to the economy (the Albania example).

For me, this argues conclusively that Fannie Mae and Freddie Mac may have been
the triggers for the current crisis but not the cause (in themselves, they
were not sufficient to cause the crisis). From the article's analysis, the
real cause of the current crisis was the lack of regulation of mortgage swaps.
The trillion-dollar mortgage swaps is what amounted to the Martingale system.

~~~
whacked_new
Are you familiar with the Albania example? I wish the author elaborated more
on it.

~~~
larryfreeman
Here's a Wikipedia article on the 1997 Albanian Crisis that was initiated by a
ponzi scheme: <http://en.wikipedia.org/wiki/1997_unrest_in_Albania>

~~~
whacked_new
Thanks! If we are to believe globalsecurity.org, which is quoted verbatim as a
"primary source" in the article, it seems like the UN played an important role
in restoring Albania's order.

------
whacked_new
Semyon gives Albania as a cautionary tale, but a cursory look at WP reveals
pitifully little. Anyone with more knowledge on the matter, aside of it being
simply a collapse from an overgrowth of unregulated Ponzi schemes? Is it that
simple? Finally, is this a textbook example in economic policy?

------
sireat
How about making perfomance based payouts only on longish returns, say 10
years? That is, money manager has to be consistently producing positive
returns over 10 years, before starting to collect comissions. Now, this can be
gamed too, but to much lesser extent than the current system.

------
kqr2
He doesn't take into account the misguided financial policy of the Federal
Reserve as well as deregulation measures.

Perhaps the SEC needs to act more like the FDA. Before new financial
instruments are allowed to be sold to the public, they need to be vetted and
_understood_.

Drugs are complex and drug makers would love to release their drugs early in
order to make a profit. However, as a society, we realize that would be
detrimental.

Regulation of financial instruments perhaps would stifle financial
"innovation", however, it would hopefully help prevent the spread of toxic
instruments as well.

------
jderick
This is the best explanation of how to get short term gain at the cost of long
term ruin I have seen.

However, let's not get caught up in the details. These bankers knew what was
going on. Wall Street told shareholders around the world that they had their
best interests at heart, when in fact they were selling them up the river.
There is a word for this kind of deception: fraud.

And yes, it is still illegal, even if "everyone is doing it".

The SEC should have stopped this a long time ago, and there is a name for that
too: corruption.

------
xenophanes
> The only solution is to forbid money management as we know it

Why it is impossible that people _voluntarily_ do not gamble their money with
slick money managers? That is what I'm doing...

~~~
tomsaffell
You can avoid funds. You can even get out the stock market altogether. But you
can't get out of the global economy... (unless you have a spaceship, or go
live in the woods)

------
cturner
Great case but...

> The only solution is to forbid money management > as we know it.

Terrible conclusion. Human nature is stupid, but powerful government is worse.

Let the markets rise and fall. Let people get burnt and learn from their
mistakes. Let the market emerge from the current situation with investment
firms that thrive because they give their customers confidence that they're
not doing dumb things.

------
ulf
Another direction one could take concerning this problem is change the reward
model of money-managers, similar to vesting in startups.

If fund-managers would not be paid their whole money annually, but
subsequently over a longer period of time, they might be more interested in
the long-term success of the assets they are managing. For example, if a fund-
manager would be entitled to 10M$ for one year, he could get paid 2M$ +
interests annually over five years. This way, accountability could be
strengthened.

------
azgolfer
I think one major cause of the problem is that every financial
show/book/article for the last 20 years has been telling people that funds are
a safe, smart thing to invest in. And they have been, but they have been
boring and have modest returns. It's not surprising that people are trying to
get a better return. The solution is what it has always been "Let the buyer
beware". If Madoff's customers hadn't skipped their due diligence, they would
have been fine.

------
natmaster
I have a great idea. Let's just bail them out when they loose the 100k for
$100 at blackjack. See, that way, they never learn!

------
zandorg
I've read a few books on junk bonds, and if they were a Martingale / pyramid,
how come Nelson Peltz, Carl Icahn, MCI, et al, became (and still are)
billionaires? They made out like bandits.

~~~
nostrademons
A pyramid scheme always has a few huge winners. They're the ones who get into
the pyramid when it's small. Depending on how broad the pyramid is, oftentimes
everyone except the bottom rung (the retail investors) ends up as a winner.

~~~
coliveira
What people forget is that capitalism is based on fear and greed. If you look
at a particular way, everything is a "pyramid scheme". For example: "Why
didn't people see that a company based on selling copies of music is not
sustainable?" -- this may be the excuse used by everyone when most music music
recording companies fail.

Any capitalist activity can be seen as a suckers game, because _price_ is
subjective. Financial markets are just a faster, larger scale version of other
markets.

~~~
stcredzero
So, a generalized successful capitalist formula:

    
    
      1 - Use greed to motivate Other People
      2 - So you can use Other People's Money
      3 - Get in at the beginning, get out early with the money
      4 - Leave behind suckers with worthless junk
    

Use your profits to begin the cycle again.

I prefer Warren Buffet's approach:

    
    
      1 - Look for good people producing genuine value
      2 - Make a bet on them

~~~
nostrademons
The difference between the two is really in how cynical the observer is, not
in anything that they're doing. For example, one of Buffett's first (and most
profitable) investments was in See's Candies. They make _chocolate_ , at
fairly high prices. Where's the value in that?

Then he used the money to buy companies like Coca-Cola (they sell _carbonated
sugar water_ , and in developing nations often steal much needed water from
indigenous people to do it) and furniture stores (which purchase furniture
from cheap laborers and sell it after a 4x markup).

This really makes perfect sense when you consider that "greed" is a synonym
for "what people want", with the only difference being that "greed" implies
that what they want is frivolous, unnecessary, or destructive. So Paul
Graham's maxim of "Make something people want" could, if you're cynical,
translate to "Exploit people's greed." The end result is the same - you have
something they desire - but the connotations are very different.

~~~
stcredzero
See's pays careful attention to freshness of ingredients. This is not only my
experience, but also the opinion of a panel of chocolatiers and food critics
hired by Consumer Reports to evaluate various brands of chocolates. For me,
they are a much better _value_ than Godiva. I prefer to give See's boxes as
gifts. Giving my friends and family pleasure is valuable to me.

Furniture stores - There is a value add to being able to go somewhere and try
out furniture. If you think 4X markup is way too much, then you have a
business opportunity on your hands. Get information to the consumer and
connect them to furniture makers. The consumer pays less, the manufacturer
gets more, and you get rich off of your cut.

Coca-Cola - I don't buy it. Others do. To them, it has some sort of value.

It's a stretch to equate "Make something people want" and "Exploit people's
greed." That Venn diagram is two overlapping circles, not just one.

------
kingkongrevenge
The financial crisis has little to do with probabilities or risk analysis.
It's not like blackjack. It was more like seeing that a ball was falling and
would eventually hit the ground. Everyone has latched onto discussions of risk
analysis and reward structures because it conveniently excuses widespread
idiocy and greed.

"Why did I just lose a fortune? Oh it's not my fault, it was a _Black Swan_!
And my fund manager's incentives were not properly regulated." No
acknowledgment is ever given to the notion that the financial markets have
worked exactly as they should: fools have been separated from their money.

~~~
jderick
When you have to define "fools" as "almost everyone in the world", I'm not
sure you have a workable definition.

~~~
anewaccountname
When you define "almost everyone in the world" as the <5% that own stock, then
I'm not s.......

------
newt0311
Typical mathematician knee-jerk reaction (including, often for me). Just
because money management is not perfect does not mean that it does not have a
high positive return. In fact, the largest money managers, the banks, are
absolutely critical to a productive economy.

