September 25, 2008

Markets and Martingales

Carroll Andrew Morse

I don't know a whole lot about the world of high-finance, but I do understand a bit about probability and in probabilistic terms, the government's proposed $700 billion bailout of U.S. financial markets bears some uncanny similarities to the use of a "martingale" strategy to make money. That is not a good thing.

Gamblers have unsuccessfully tried to win using martingale strategies since at least the late 18th century. Here's how the basic version is supposed to work, applied to roulette as an example…

  1. Start by betting $1. If you win, pocket the $1 winning and bet $1 again.
  2. If you lose, play again, but double your bet to $2. If you win, your total winning is $1, $2 won on the second bet, minus $1 lost on the first. Pocket the $1 winning and begin again, with a $1 bet.
  3. If you lose the $2 bet, play again, doubling your bet to $4. If you win, you will again have won a total of $1, $4 won on the third bet, minus $2 lost on the second bet, minus $1 lost on the first. Pocket the $1 and begin again.
  4. If you lose, at this stage or any stage, double your previous bet and begin again…
WARNING: Do not stop reading this post at this point, run off to a casino, and try this yourself, thinking you've found a way to generate a guaranteed stream of income. It doesn't work.

The problem is that the odds favor a single catastrophic losing streak – "catastrophic" defined as bad enough to swallow your initial stake – eventually wiping out any gains made from building your winnings $1 at a time. Unless you have an infinite amount of money (in which case, why are you bothering to bet?), you will reach a point where you can't make the bet that's necessary to cover your losses.

The signs of martingale-based thinking in the recent history of U.S. financial markets are disquieting. We've seen the government, twice in the past 20 years, appear to make two late-stage bets to cover a run of large losses, first the S&L bailout in the 1980s, now the proposed $700 billion bet to cover losses from the current housing and mortgage crisis. In between, there was the bailout of Long-Term Capital Management in the late 1990s, where some big Wall Street firms -- including names like AIG and Lehman Brothers -- put up big money to rescue a multi-billion dollar hedge fund that suddenly went on a big losing streak. They won that bet, kept playing, and later went on a losing streak that they were unable to cover.

The government's resources for covering market losses are not infinite. Congress can't decide to temporarily suspend the law of large numbers or any other of law of chance and probability. If the government keeps pumping funds into a financial system that requires continual doubling-down in order to stay ahead, isn't it only a matter of time before the government experiences the catastrophic loss that wipes out all of its (er, that would be our) stake?

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>The government's resources for covering market losses are not infinite.

Yes and no. In theory Feds can run up as much dollar-denominated debt as they'd like, and then the Federal Reserve can "repudiate" that debt by running the printing presses a la the Weimar Republic.

The U.S. didn't go off of the gold standard circa 1971 because that standard wasn't working, but because it was - it was impinging the politicians' desire to spend money on the Great Society and traditional pork while still suffering the hangover from LBJ's "guns and butter" policy - but do so without having to raise current taxes to pay their way.

Since 1971 the dollar is a fiat currency backed only by ... unquestioning confidence in the dollar.

Unfortunately Congress - i.e., petty politicians who have become addicted to buying votes to remain in office - is the ultimate repository of that confidence, and has proven unworthy of any confidence.

The dollar is worth a fraction of the buying power it had when the U.S. went off of the gold standard (indeed it has lost something like 90% of its value since the creation of the Federal Reserve) ... there is an unannounced official policy of slow motion devaluation of the dollar and repudiation of the debt.

That devaluation is now accelerating (a/k/a inflation / CPI rising), and both our foreign creditors (we were once a creditor nation, but in recent decades have become a debtor nation), and the general public in America, are just beginning to consider that the dollar emperor may have no clothes.

Posted by: Tom W at September 25, 2008 1:53 PM

Tom is largely correct. By pumping so many created "dollars" into the over all system to prop it up, in effect, what we are doing is trying to do is to inflate ourselves out of a mess. That only serves to delay; not really fix the problem. Weimar is a great historical example.

I absolutely agree that we have to do "something bold," but that doesn't mean we have to act first, and ask questions later.

Anyway, despite anything you've heard today, there was no deal, there is no deal. They are lying. NO DEAL!

The House Republicans are in a great position to essentially force Congress' hand to pass their alternative version of the legislation. The more I've researched the proposed Bush-Dem deal, the more I'm inclined to oppose it. Make no bones about it, the proposal currently being floated is thinly-disguised socialism.

The House GOP has an alternative plan which would provide for very low interest loans, instead of direct government purchase of known bad assets of undetermined value. If you had a company, would you ever buy something that way?

From a purely political point of view, this puts the Dems (and by extension, Obama) in a wonderfully horrible position. The Democrats are the majority in both houses of Congress, so they should have the votes if their leadership thinks this is such a great plan. The Dems are either going to get their people to go along with President Bush's bailout proposal (which is largely "the deal" you've heard about all day), or accept whatever the House GOP proposes in its place to break the deadlock.

That's what I call a win-win. The American people win, the House GOP wins, and Senator McCain wins in effect, by opposing the President, and saddling the Dems as being in cahoots with him -- and we'll probably get the GOP alternative plan passed, too. It's a brilliant strategy.

PS The October Surprise came early!

Posted by: Will at September 26, 2008 1:06 AM

By the way, if the practice were not already temporarily banned, I would have heavily suggested "selling short" on anything and everything in the stock market on Friday! It's going to be a very bumpy day -- all day.

The House Republicans are not going to go along with the present proposal, even if the president gets down on one knee like Paulson did to Pelosi. We have nothing to gain and everything to lose. If this deal is so great, I'm sure we'd be happy to let the Dems take the credit for it -- or they can join us and adopt some version of the GOP alternative plan. Win-win.

PS It's not so bad being in the minority party, is it?

Posted by: Will at September 26, 2008 2:42 AM

PS It's not so bad being in the minority party, is it?

Get used to it.

Posted by: phil at September 26, 2008 6:57 AM

"By the way, if the practice were not already temporarily banned, I would have heavily suggested "selling short" on anything and everything in the stock market on Friday! It's going to be a very bumpy day -- all day."

Congratulations on your market prognostication. You would have only lost 350 Dow points by getting short Friday morning! If you ever meet Chris Cox you better give him a big kiss for saving you from yourself.

Posted by: observer at September 26, 2008 6:12 PM
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