Double or Nothing: How Wall Street is Destroying Itself [Zerohedge]

There’s nothing controversial about the claim— reported on bySlateBloomberg and Harvard Magazine — that in the last 20 years Wall Street has moved away from an investment-led model, to a gambling-led model.

This was exemplified by the failure of LTCM which blew up unsuccessfully making huge interest rate bets for tiny profits, or “picking up nickels in front of a streamroller”, and by Jon Corzine’s MF Global doing practically the same thing with European debt (while at the same time stealing from clients).

As Nassim Taleb described in The Black Swan these kinds of trades — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and of course if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral.

 

This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

The key difference between modern business models, and the traditional roulette betting system is that today the focus is on betting multiple times on a single outcome. By this method (and given enough capital) it is in theory possible to win whichever way an event goes. If things are going your way, it is possible to insure your position by betting against your initial bet, and so produce a position that profits no matter what the eventual outcome. If things are not going your way, it is possible to throw larger and larger chunks of capital into a position or counter-position again and again and again —mirroring the Martingale strategy — to try to compensate for earlier bets that have gone awry (this, of course, is so often the downfall of rogue traders like Nick Leeson and Kweku Adoboli).

 

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How to Prevent Other Financial Crises [Taleb]

By Nassim Nicholas Taleb and George A. Martin

This article argues that the crisis of 2007–2008 happened because of an explosive  combination of agency problems, moral hazard, and “scientism”—the illusion that  ostensibly scientific techniques would manage risks and predict rare events in spite  of the stark empirical and theoretical realities that suggested otherwise. The authors  analyze the varied behaviors, ideas and effects that in combination created a financial
meltdown, and discuss the players responsible for the consequences. In formulating a  set of expectations for future financial management, they suggest that financial agents  need more “skin in the game” to prevent irresponsible risk-taking from continuing.

Let us start with our conclusion, which is also a simple policy recommendation, and one that is not just easy to implement but has been part of  history until recent days. We believe that “less is more” in complex systems—
that simple heuristics and protocols are necessary for complex problems as  elaborate rules often lead to  “multiplicative branching” of  side effects that cumulatively  may have first order effects.  So instead of relying on thousands of meandering pages of  regulation, we should enforce  a basic principle of “skin in  the game” when it comes to  financial oversight:  “The captain goes down  with the ship; every captain  and every ship.”
In other words, nobody  should be in a position to  have the upside without sharing the downside, particularly  when others may be harmed. While this principle seems simple, we have  moved away from it in the finance world, particularly when it comes to  financial organizations that have been deemed “too big to fail.”

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