Wizards of Money Part 19: "The Education Sweepstakes"

Audio Version

TABLE OF CONTENTS
Introduction
1. The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First Century Risk Management
2. The Skills for Playing in a Market Economy
3. The State of State Finances
4. Economic Development and Slot Machines
5. The Lotto Sweepstakes Sweeping the States
6. The Other Mae Family – Sallie, Nellie et al.
7. The Ultimate Risk Bearers

This is the Wizards of Money, your money and financial management series…but with a twist. My name is Smithy and I’m a Wizard Watcher in the Land of Oz. This is the 19^th edition of the Wizards of Money and it is entitled “The Education Sweepstakes”.

Introduction

In this, the nineteenth edition of the Wizards of Money, we are going to take a look at the funding of education and the rise of the slot machine. With more federal dollars being diverted to overseas conquests and the US states experiencing a severe budget crisis, some things have to suffer. And one of these somethings happens to be education. "Never mind", say some states, let’s just get those lotto balls rolling and slot machines ringing.

Insert: Casino/Slots/Governors Meddly (1minute)

Compulsory primary and secondary education in the United States is funded mainly by state and local governments. Higher education is funded through a combination of state and federal aid programs, rich parents, and overwhelmingly by the educated getting into a whole lot of debt. And for those shut out of funding options in the civilian markets, education funding and job training have become the primary reasons why people join the US military.

The squeeze on state and local budgets, compounded by the diversion of federal spending to war and homeland security, seems to be turning the education system into a great big game of chance – the “Education Sweepstakes”. If you don’t come to the market with accumulated wealth, even something as simple as getting good healthcare is a bit like winning the lottery, and so is getting a good education. Small wonder then, that the lotteries and casinos the states are expanding to plug their budget holes are attracting more and more of those who can least afford to play.

Without a good education, it is much harder to face the daily battle with the trickster who lies at the heart of both capitalism and the slot machines – RISK. The shifting nature of government spending is turning the economists’ favorite theoretical relationship between risk and return on its head. For the markets to work efficiently, an investor should only get high returns if they are taking on lots of risk, and conversely they should expect low returns where risk is minimal. But increasingly, certain market players can get huge returns by taking hardly any risk, simply by playing against others facing huge risks for low or negative returns. Now government bodies, in their desperation, seem to be making this problem worse. Sometimes they’re even the ones running off with the public’s money!

Insert: "Mass Cash" Song

The constant marketing of gambling and lotteries, whether it be over the internet, the television, the radio or at the local store is the stuff of "genies and magic lamps, rooted in hopes, dreams and suspicions", so said a report on gambling commissioned by the government as the last century came to a close. In this edition of the Wizards of Money, we'll speak to one of the authors of this report, as well as an investment banker in Maryland about the slot machine business, and a professor at the University of Nevada in Las Vegas.   

But first, speaking of that rascal called risk, let’s delve into the history of risk and why the business of risk management is so important.

1.      The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First Century Risk Management

Ask yourself "What is the defining feature that lies at the heart of capitalism?" To that question many people would probably answer “profits”. But it may be more correct to say that it is “RISK”. Profits are compensation for taking risk. In a capitalist economy, individuals with accumulated capital either spend it on something real or invest it, which really means lending it to some economic venture. When you invest your money, you are putting your capital at risk for you might lose some or all of it. Investors are compensated for this risk-taking by the potential for profits. This potential for return provides the incentive for risk-taking, and it is this risk-taking that has lead to phenomenal economic growth in market economies. 

One of the downsides of this system is that individuals are required to bear many of the risks of daily living themselves – the risks of devastating events like unemployment, sickness, accident and loss of housing. In our current economy, some if this is alleviated through government safety nets and the insurance markets, where risks can be transferred, but for a price. As government safety nets shrink and more people find adequate insurance coverage prohibitively expensive, it becomes increasingly important for individuals to develop their own contingency plans. In a market economy then, each player would do very well to understand how to manage his or her risks, and how to take calculated risks.

Amazingly, many people do not pay much attention to this ever-changing, ever-elusive beast who runs so much of our lives. Risk is sneaky – it likes to influence everything, but let something else take the credit (or the blame!) for it. For thousands of years, much to its delight, Risk evaded human scrutiny as the humans worshipped the sun, then the gods, then a single god, and, of course, the two permanent occupiers of the human mind - fate and destiny.

But over the past thousand years various tools developed to measure risk and for humans to take some control of this wild beast. These capabilities are ultimately what lead to our capital markets, and our modern monetary system and it’s financing of the industrial and then technological revolutions.

Developments in Mathematics and developments in finance have been inseparable since the days when merchants would use an abacus to calculate their trading gains.

But perhaps the real turning point occurred somewhere along the halls of Baghdad about a thousand years ago. While Europe was still bumbling through the Dark Ages, an Arab mathematician named Al-Khowarizmi laid the foundations for the basic arithmetic and algebra we use today, upon which most subsequent mathematical theory would later be based. And part of his motivation was quite simply practical - to facilitate trading. Imagine how things would have progressed if, instead of this development, the world had stayed on the old Roman and Greek numbering systems, adding them up with an abacus or pebbles in the sand!

It must have been at this point that risk was getting nervous that soon, not only would it be noticed, but the humans might try and use it to their advantage.

As Europe woke up from its dark era and the renassaince began, the Europeans built on these developments from the Arab Mathematicians and the equipment for dealing with risk and the mathematics of finance began to develop. Initially, probability theory was born mainly as a result of wealthy men’s fascination with games of chance. Accounting theory developed in Italy and facilitated the flow of capital into business ventures. Then the mathematics behind insurance (or actuarial science) began to develop to help manage the risks of overseas trade and financing vehicles such as annuities issued by the English government to finance their budget deficits. Over the centuries the mathematics behind trade and finance has developed as a tool to help investors take calculated risks and get capital to flow in the direction of economic development, rather than catastrophic loss. Finally, the late twentieth century saw the ultimate formalization of the practice of “risk management”, and today there are tools to help us manage the risk/return trade-off for just about any risk we can imagine.

Risk has been caught and tamed for economic growth. (At least up till now. There’s no telling what’s around the corner!).

2. The Skills for Playing in a Market Economy

For a market economy to be somewhat fair in providing opportunity, all market players must know how to play and must be able to make sensible risk-return trade-off decisions. Where you have large segments of society that participate but never really learn how to play, then they will be preyed upon by the more knowledgeable players.

“Even more important than money itself is information about money”, so said a past CEO of Citigroup a few years ago. Just as in a sports game it’s important for each player to know the rules of the market game and to learn some skills and strategies to get to their desired outcome. Also of paramount importance is to have some information on how other players are going to play the game.

Deregulation in both the financial and gaming sectors over the past few decades has created a situation where the more sophisticated players can play directly against those that never even learned the rules of the game, let alone strategy. And so over the past two decades we have seen the rapid rise of things such as predatory lending, credit cards, and the focus of this Wizards episode - lotteries, slot machines and casinos. All of these create a transfer of wealth from the poorer to the richer, based on the knowledge gaps between the two groups, and at a time when government safety nets at the federal, state and local levels are in pretty bad shape.

Capitalist economies have tried to prepare people for a life in the market economy through their education systems. They have also tried, in varying degrees, to provide a safety net for those who do not have the ability to withstand the risks of disability, illness, unemployment and so forth, to prevent them from being shut out of the economy.

But the government funding for this safety net for handling risk and for the education system is shrinking as states face budget crises and as federal spending is increasingly diverted to war and homeland security. And more and more it seems that the funding gaps are to be funded by the winnings of this market game played by the skilled players against the less educated players, just as the latter becomes more tempted towards games of pure chance to change their situation.

Insert: Peron Lottery Song (0.5 minutes)

3. The State of State Finances

As you may have heard, most US states now face something of a budget crisis totaling almost $100 billion dollars in the coming year. Making matters worse, the Bush Administration, wanting to create more room in the Federal Budget for war expenses, is imposing greater financial burdens on the states.

Unlike the Federal Government, the states are bound by their own constitutions to “balance the budget”, meaning that they must bring in enough revenues through taxes and other means to match their expenses.

As we all know from arranging our own personal finances, to make these two sides match, states must raise revenues or cut expenses, or both.

Here’s Jeff Hooke, an investment banker in the state of Maryland discussing how that state is going about tackling its budget crisis:

Insert: Jeff Hooke 1 (2.5 minutes)

4. Economic Development and Slot Machines

The states must be looking upon slots as a gift from heaven. And so too are the private interests that run the slots. Nowhere is the risk-return relationship more upside-down than in the slot machine business.

So enticing is the Slot Machine – it’s the perfect candidate for a tax you have when you’re not having a tax. They have become so charming! .. Insert Regis Slot Machine ()… and so cute! Insert Addams Family Slot Machine ().

And the closer you put the slots to large urban and suburban populations, the more dollars the slots generate. Jeff Hooke helps us understand the economics of the slot machine business:

Insert: Jeff Hooke 2 (7 minutes)

Bill Thompson, a professor from the state whose primary export is slot machines, helps us understand the impact of the gaming business on local communities:

Insert: Bill Thompson Vegas1 (3 minutes)

And while the huge returns from the low-risk slot business are attracting those with degrees from the Ivy leagues and lots of capital to invest at one end, at the other end we have the slot player who, on average, will, of course, lose money. That is, their expected financial return is negative. The so-called "House Edge" on slot machines ranges from about 5% to 15% in some cases.
This House Edge is the proportion of money that you will lose, on average, if you keep pumping dollars into the slot machine. It’s the pure profit cleared by the slot machine for its owners. Here’s the Maryland investment banker Jeff Hooke, talking about this guest at the other end of the slot machine.

Insert: Jeff Hooke 3 (1 minute)

And Bill Thompson talks about national trends in this area Insert: Bill Thompson Vegas 2 (6 minutes)

No question, slots are bad bet if you're the one putting the dollars in. But the worst odds of all and the most regressive tax of all, meaning that it’s a much higher tax for the poor than the rich, is, of course, the State Lottery system.

Insert: CA Lottery Full + Song (1minute)

5. The Lotto Sweepstakes Sweeping the States

The history of lotteries is an interesting one and perhaps longer and more volatile than you might be thinking.

Recorded history shows that lotteries date back at least to the time of Julius Caesar. Around 100 BC the Chinese created Keno, and more than a thousand years later Europe came out of the Dark Ages and monarchies and governments set the trend of using lotteries to fund government spending.

Believe it or not, in the 1600s the English kings ran lotteries in London to help fund early colonies in America. Later, lotteries were used by the founding fathers of America to fund the Revolutionary War. In 1776, in France, Louis XV appears to have started the trend for states to have a monopoly on lotteries for reducing state deficits.

In the 1700s and 1800s, in the absence of an income tax system and a Federal Reserve System, lotteries were a standard source of revenue for public and private spending. Fifty colleges and 300 schools were constructed with the help of lottery proceeds, including even Harvard, Yale and Princeton.

But these lotteries, unregulated as they were, were a breeding ground for corruption and fraud. State and federal governments decided to shut them down. By the end of the nineteenth century lotteries were banned in most states, not to be seen again for many decades to come.

During the 1960s and 1970s lotteries began sneaking their way back onto the scene and lottery sales reached about $1 billion by 1976.

In the late 1980s multi-state lotteries emerged and today 38 states have lotteries and total US lottery sales are now at about $40 billion and growing fast. The majority of these states use the bulk of their lottery proceeds to fund education.

No doubt about it, your expected return from playing the lottery is very negative. First the House Edge – or the amount that goes into state coffers - is a whopping 50%, the largest House Edge of any chance game. And your odds of winning the mega-millions prize are lower than the possibility that Martians with land on your doorstep tomorrow. Of course, you wouldn’t know this if you listened to the States advertising their lottery wares…

Insert: WA State Lotto

Here's Bill Thompson on Lottery Advertising and the Education Sweepstakes:

Bill Thomson Vegas 4 (2 minutes)

In 1999 the National Gambling Impact Study Commission put in place by the US Government, commissioned a study on Lotteries entitled "State Lotteries at the turn of the Century". A section of that report reads as follows "Promoting lotteries does more than persuade the pubic that playing is a good investment. At one level the sales job may be viewed as values education, teaching that gambling is a benign or even virtuous activity that offers a desirable escape from the dreariness of work and the confines of limited means. Not only does lottery advertising endorse gambling per se, it may also endorse the dream of easy wealth that motivates most gambling. Many ads are unabashedly materialistic with winners basking in luxury and lives transformed. Yet this is not the materialism of hard work and perseverance but rather of genies and magic lamps, rooted in hopes, dreams and suspicions".

Ironically it is the state governments, who we elect to represent us, who are responsible for feeding this message of myths and magic back to us.

I spoke to Philip Cook at Duke University, one of the authors of the National Gaming Impact Study Commission Lottery Study about the capital flows of the lottery..

Insert: Cook1 (6 minutes)

Then there is another question about lotteries and gaming in general, and that is whether cuts in the social safety nets will actually drive people further into the gambling trap. Here's Philip Cook again…

Insert: Cook2 (4 minutes)

6. The Other Mae Family – Sallie, Nellie et al.

If you've watched any of the business and finance shows on TV lately, and seen the "quick picks" of the wealthier players, you'll certainly notice that the gaming sector has become popular amongst the stock picks.

And there is another big favorite that's emerged from the state budget crisis. And that's the student loan market players - that is, the originators of student loans, and those that buy and sell student loans in the secondary market and bundle them up into neat financial securities through the securitization process, as we talked about in Wizards Part 15.

In most states the first expense item on the budget chopping block has been college education, passing more and more tuition costs onto students themselves. Consequently, the student loan business is booming. And here the major player is Sallie Mae, close friend and relative of Fannie Mae, Ginnie Mae, Freddie Mac, Farmer Mac and that whole clan. And she's yet another one of those semi-government, semi-private so called "Government Sponsored Entities" we discussed in Wizards Part 15. Similar to what other members of her family do in the home loan market, Sallie Mae originates and buys a huge proportion of student loans. Banks and other financial institutions are also major players in the student loan market.

Through the Federal Family Education Loan Program, private investors get nice government guarantees on the capital they invest in student loans. Here again is another example of the risk-return trade-off being all upside-down. For no risk, private investors in these guaranteed loans can get a guaranteed return, while the student taking out the loan bears the risk that they wont get a job with a high enough salary to repay their skyrocketing tuition costs.

7. The Ultimate Risk Bearers

As bad as all this is, when it comes to getting a good education, the ultimate risks are born by those who, for whatever reason, don't have access to education funding in the civilian financial markets. A number of studies in recent years have demonstrated that the majority of people entering the military do so for the benefits of education funding and job training. But they go for this promising return by taking on the ultimate risk.

That's all for the Wizards of Money Part 19. Note that the Wizards of Money has a web site at www.wizardsofmoney.org where you can access the text, audio and references for all WOM episodes.