Interesting article in Slate Magazine today, “We’re Down $700 Billion. Let’s Go Double or Nothing! How the financial markets fell for a 400-year-old sucker bet,” written by Jordan Ellenberg, warns that the prospect of a bail out may have contributed to reckless behavior on Wall Street.

Ellenberg is Associate Professor of Mathematics at The University of Wisconsin.  He has a Ph.D from Harvard. As a teenager Ellenberg became known as a math prodigy, winning many math competitions. When he was 17 (in 1988) The National Enquirer featured him in an articled entitled,  “America’s Top Math Whiz Kid.”  He writes a regular column for Slate.

Jordan Ellenberg

Ellenberg explains the math of his thinking in detail in the article and says that Wall Street’s recent behavior resembles a betting strategy that involves doubling one’s bet, until you win — a strategy that comes down through history and is called “the matingale.”  He writes, “Here’s how to make money flipping a coin. Bet 100 bucks on heads. If you win, you walk away $100 richer. If you lose, no problem; on the next flip, bet $200 on heads, and if you win this time, take your $100 profit and quit. If you lose, you’re down $300 on the day; so you double down again and bet $400. The coin can’t come up tails forever! Eventually, you’ve got to win your $100 back.

“This doubling game offers something for nothing—certain profits, with no risk. You can see why it’s so appealing to gamblers. But five more minutes of thought reveals that the martingale can lead to disaster. The coin will come up heads eventually—but “eventually” might be too late. Most of the time, one of the first few flips will land heads and you’ll come out on top. But suppose you get 10 tails in a row. Just like that, you’re out $204,700. The next step is to bet $204,800—if you’ve got it. If you’re out of cash, the game is over, and you’re going home 200 grand lighter. …

“But wait a minute, maybe somebody will loan you the $200,000 you need to stay in the game. After all, you’ve got a great track record; up until this moment, you’ve always ended up ahead! If people keep staking you money, you can just keep betting until, eventually, you win big time.”

Ellenberg continues, “The carefully synthesized financial instruments now seeping toxically from the hulls of Lehman Bros. and Washington Mutual are vastly more complicated than the martingale. But they suffer the same fundamental flaw: They claim to create returns out of nothing, with no attendant risk. That’s not just suspicious. In many cases, it’s mathematically impossible.”

Ellenberg concludes his article by saying, “This is what makes some people queasy about the federal bailout of the banks. It just might be that the prospect of a bailout—which could make a total collapse no worse for the banks than a garden-variety bear market—could have helped cause the martingale boom. There seems to be little question that the country needs the bailout now. But unless some real pain for the martingalers is built in, we’d better be ready for a return to maverick finance down the road.”

The bail out bill passed by the Senate adds $149 Billion to the original $700 Billion package.  It is hoped that these additions will attract “Yes” votes in the House, but, it may cause some fiscally conservative House members, who previously had approved the $700 Billion bail out, to switch their vote to “No.”
The Senate package includes:

• Repeal for a year of the Alternative Minimum Tax (first drafted to make sure that the superrich pay some income taxes, but now set to hit more than 22 million additional Americans if Congress does not act); This repeal would spare 24 million households from a $62 billion alternative minimum tax.
• Extend $17 billion in benefits to companies that produce alternative energy.
• Disaster relief (for Hurricane Ike).
• Temporary increase the limit on federal insurance for bank deposits to $250,000 from $100,000.
• A new property tax deduction of up to $1,000 for homeowners who do not currently itemize deductions on their federal income taxes. (Advocates say 30 million people would be eligible for the benefit.)
• Deductions for tuition and education expenses, and deductions for sales tax in states that do not have an income tax.
• A clean-energy tax package; and tax-break extensions, such as the popular research-and-development tax credit.
• Deductions for sales tax in states that do not have an income tax.
• Film and TV programs receive a $344 million tax break.
• Motorsports racing track facilities get a tax break of $140 million.
• Restaurateurs and retailers get a $5.8 billion break for restaurant and retail improvements.
• Indian reservations get a $624 million break to accelerate depreciation on business property.
• Washington, D.C., receives $132 million of tax incentives to attract investment to the District, and
• A mental health parity bill.

The Democrats “Blue Dog Coalition,” a fiscally conservative group, has previously blocked legislation to repeal the Alternative Minimum Tax (AMT), because the proposed legislation did not have provision to pay for the repeal.  The Senate version of the bail out tacks this same AMT legislation to the bail out package.

Paul Blumenthal on the Sunlight Foundation blog writes, “In classic congressional fashion, the Senate has decided to use a crisis piece of legislation as a way to push through a massive package of other priorities forcing an inter-chamber factional battle to come to a head.”

According to The Hill, Of the Blue Dogs’ 49 members, 23 voted for the bill Monday.  Because of the added $149 Billion in the Senate version — with no provision to offset any of this expense — the support of these Blue Dog Democrats in now in question.

The New York Times reports that Charles B. Rangel, Democrat of New York and the chairman of the Ways and Means Committee, said the Senate was setting a bad precedent by trying to impose its tax legislation on the House.  Rangel is quoted as saying, “The Senate leadership took an unprecedented gamble when they attached a package of tax extenders to the emergency financial rescue legislation”