AIG Casino and Financial Services Company

My wife and I often argue about whether investing in equities is the same as going to a casino and pumping dimes into a slot machine. Now when it comes to slot machines and dimes, my wife has first hand experience. On our first trip to Las Vegas together we stopped at the first casino we came to, she put a dime into a slot machine and on the first pull collected $100. “That’s a better return than on any equity investment we’ve made,” she’ll point out thirty years later. I’ve given her the business school pitch on markets countless times and have explained that we’re value investors and occasional traders, but that we’re not gambling with our retirement.

The other day we were watching the latest AIG news. After I explained credit default swaps (CDS) to her, she asked me she asked me about the difference between AIG and a casino or a bookie. “So these hedge funds are betting these debt holders are going to default? That sure sounds like gambling to me.” She has a point. AIG was bookmaking, but instead of taking bets on sporting events, they were taking bets on financial events. Unfortunately, they didn’t do a good job managing their book. They had too many one-sided long-odds bets that they had to pay. When I say long odds, I mean really long odds, somewhere in the 200-to-1 range. For comparison, the odds that Freddie Couples is going to win the Masters this year are 100-to-1.

Most of you are probably familiar with the story of the MIT Blackjack Team. Students and former students from MIT and Harvard formed a team of highly skilled card counters. The team offered a prospectus to raise capital ("stake") and reportedly made an annualized return of more than 250%. Most of them were eventually caught and politely barred from playing 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 outcome, removing incentives to create Martingales and protecting investors from themselves, but does not propose many solutions.

The approach that we should take to overhaul that the financial system needs to be one of simplification and rationalization. Every time we’ve ended up in a financial crisis, there has been an “innovative” financial scheme behind it. Junk bonds, leveraged buy-outs, mortgage backed securities and credit default swaps are a few that Dukach points out. CDS’s are a perfect example to consider. An investor can purchase a CDS regardless of whether he owns the underlying debt or not. One can make the case that if the underlying note is held by the investor, that the CDS is a form of insurance. But if the investor doesn’t hold the note, isn’t the CDS equivalent to a casino wager?

In Obama’s press conference today at the G20 meeting he questioned the economic value of derivatives and their role in the current crisis and the need for balancing free market economics with regulations. I agree conceptually and would start with passing a simple rule: all derivative instruments require that the buyer or seller, as appropriate, hold the underlying asset and that there can only be one contract per asset. The purpose of hedges should be to hedge, not to wager. That’s why we have casinos and bookies. By eliminating most derivatives, the financial system and the interdependencies that only Geithner understands are greatly simplified. Not only would that help prevent the type of meltdown we're having, it would also make the financial system easier to regulate and police. 

Wall Street needs to get back to basics and let the casinos handle the gambling.