Picking Up Nickels in Front of a Steamroller

Suppose a casino offered the following bet.  You roll six fair dice.  If anything but all sixes shows up, you get $20.  But if all sixes show up, you lose a million dollars.  There are a number of practical problems with this game.  The casino would demand a million dollar deposit in advance, and the odds are way too sensitive to imperfections in the dice and to player skill at not throwing sixes.  But this is a thought experiment designed to shed light on real world financial events.

Initially, few people would play this game, because losing a million dollars is too scary.  But if you watched someone playing, even all day, you’d likely never see a loss.  You’d just see the player collecting $20 every 10 seconds or so building up to many thousands of dollars.  The fear of missing out (FOMO) would set in for some and tempt them to play.

Over the long haul, the casino expects to pay out $933,120 for every million dollars it wins.  So playing this game is good for the casino but a bad idea for the player.  However, it’s easy to forget about the losses if you only see everyone winning $20 every play.  Games like this are referred to as “picking up nickels in front of a steamroller.”  The $20 payoffs are the nickels, and the million-dollar losses are when you get flattened by the steamroller.

The yen carry trade

So what does this have to do with real life?  There are many “games” in real life that resemble this hypothetical game more than people would like to admit.  When interest rates were much lower in Japan than they were in the U.S., it seemed profitable to borrow yen at a low interest rate, convert it to U.S. dollars, and collect high interest on U.S. dollar deposits.

This sounds quite profitable, so why did I say it only “seemed profitable”?  Well, all was well as long as interest rates and the exchange rate between yen and U.S. dollars were stable.  However, a rise in the value of the yen and higher Japanese interest rates (the steamroller) could more than wipe out any profits from the interest rate spread (the nickels).

Unlike the hypothetical dice game where the potential loss of a million dollars is prominent, it’s less obvious with the yen carry trade.  You might convince yourself that the value of the yen and Japanese interest rates would change slowly enough that you could exit your positions profitably.  However, many others would be trying to unwind their positions at the same time, each one trying to be among the first to get out.

Excessive leverage

Rather than just invest a fraction of your wages in stock markets, you could borrow extra money to invest more.  The stock markets may gyrate, but they keep rising.  If you can just wait out the gyrations, you’ll be sure to eventually make more money (the nickels) than if you didn’t borrow.

The problem is that if you borrow too much, and your creditors see that you’re in danger of becoming insolvent, they may demand their money back or impose high interest rates that eliminate your profits.  A sudden stock market crash (steamroller) could wipe you out before you get a chance to wait out the market decline.  Modest leverage can be reasonable, but it takes some skill to determine how much you can borrow safely.

The great financial crisis

Many Wall Street firms made apparent profits selling insurance against mortgage defaults in the form of exotic financial instruments like credit default swaps (CDSs) and collateralized debt obligations (CDOs).  In this case, the nickels were the insurance premiums they collected, and the steamroller was the wave of mortgage defaults across the U.S.

It’s tempting to say that everyone involved was naive or incompetent, but employees of a firm have different interests than the firm itself does.  While the party was ongoing, the apparent profits piled up, and employees collected their share in the form of huge bonuses.  When the steamroller crushed their firms, these employees didn’t have to return their bonuses.  It was like playing the dice game with someone else’s money.  The employees would take a cut of each $20 win, and let others deal with the million dollar loss.

Long-Term Capital Management

The LTCM hedge fund employed Nobel Prize winners to beat the markets, and it seemed to work for a few years.  They used complex models of how markets work to squeeze out profits (the nickels).  Unfortunately for them and their investors, markets eventually stopped working the way the models expected (the steamroller) for long enough to wipe out past profits.

Conclusion

There are many financial schemes in the real world that resemble picking up visible nickels in front of an obscured steamroller.  If you think you've found a way to beat the markets, try to figure out where the steamroller is.