Econ 101 at the Poker Table

This story originally ran on Jan. 3, 2003. It remains ostensibly true.

True story. Well, true to the best of my recollection. Geez, it was college, after all.

I always thought our regular freshman-year poker game would make a great economic study. But absent the ability to actually do a great economic study, I decided to describe the game and its components to you.

Very little about the participants was ordinary. Usually, six guys played. Five had fathers with job descriptions ranging from "chief executive officer" to "oil minister." One player was even a prince -- a prince who loved Metallica, wore black T-shirts, and had a stereo system loud enough for Yankee Stadium. A good mix, if you liked Metallica. Not so much, if you didn't.

These guys weren't wealthy. They were wealth.

I'll call the sixth guy Eric, but not because that's his name or anything. Unfortunately, Eric had two strikes against him. First, he came from a working-class family from south Boston, and he was only in school by the good graces of heavy financial aid. Eric was also not very good at poker.

In my opinion, strike three would be Eric's lack of good judgment in getting involved in such a game, when his margin of error was so small... but this isn't about me.

The games were generally dollar ante, mostly Omaha or Texas Hold'em -- good casino-style poker. Generally, the guys had one or two pots a night with thousands of dollars in them. Chicken feed for the son of an oil minister. Blood money for Eric. Generally speaking, on these occasions, Eric gave a great deal of "blood" to someone else at the table.

Now, here's what's interesting about these games. The "buy in" was generally in the form of personal checks. They had stacks of them, in varying amounts. At the end of the night, the losers would just endorse a few checks to the winners, and the next week, they'd start anew. After a while, these checks could have upwards of 10 endorsements on the back, but they'd still cash just fine.

Eric's checks were in this mix, as well -- a lot of them. At one point, he had more than $6,000 in uncashed checks spread among the other five players. As you can imagine, even for guys to whom money is no object, they much preferred to hold checks from one another than Eric's nearly guaranteed rubber variety.

And so they came up with a simple, ingenious solution. They began offering an exchange rate on any currency backed by Eric's checking account. They called them "Eric Notes." At the beginning of each night, the five got together, totalled up the amount of money owed by Eric, and then discounted accordingly, depending on the perceived risk that the actual checks backing the Eric Notes were worthless. Any additional money Eric wished to play with would also be discounted at the same amount. The exchange rate got pretty high -- as high as 10 Eric Notes equaling a buck. So if a player bought in using a check for $1,000 and another Eric-denominated check for $1,000, he'd get back a total of $1,100.

As you'd expect, the more Eric played, the worse things got. He didn't have an endless supply of money, and the money he did use to buy in was discounted. He'd write a check for a grand and only get back $100 worth of purchasing power. On the big pot hands, he was hamstrung, even if he knew how to play them. It was the gambling version of a death spiral, and eventually, the other players decided he couldn't play anymore until he paid some of his debts down.

Plenty of investing lessons come to mind. Most would say No. 1 is: "Don't write checks your butt can't cash." But I think there's a greater one: "Make sure you don't have a gambling problem before you start to invest. Or play poker."

There's a lot going on here. At the outset, Eric's debt helped him. He only had a few bucks in his checking account, but the fact that someone was holding uncashed checks from him allowed him to leverage his precious dollars into substantially more at the table. In the business world, debt is used this way. Companies and people get loans to pay for something without spending precious cash. But debt also destroys. As Eric got deeper into debt, his cost of capital exploded. That's murder on a company or a person.

The players treated each check like a bond. Because they perceived no risk that the checks of the sons of fortune would bounce, they sold those checks back and forth at face value. Eric's checks, on the other hand, had a high degree of risk involved. Treating them as A-rated instruments, on par with the other checks, made no sense.

And so they discounted accordingly, using a simple method -- bartering. How much in face-value checks from Eric would each accept, and at what rate? The person who bid lowest got Eric's checks and set the exchange rate accordingly. In exchange for the added risk, for the consideration of, say, $500 in table winnings, the player could cash the check for the full amount. At the highest exchange rate, that's five grand. After all, the banks knew nothing of Eric Notes, but they knew checks and their face-value amounts just fine.

So surrounding this ordinary poker game was a series of checks and balances (pardon the double entendre). What started as a group of guys getting together for some (high stakes) fun evolved into a miniature economy.

You might wonder what happened to Eric? Well, it took him a while, but he worked and paid back every penny he owed. He may have had questionable judgment with money -- as well as with whether to stay on three sixes against someone who's been folding all night and is suddenly betting aggressively -- but he knew an obligation when he saw it, and he honored it.

Fool on!

Bill Mann (TMFOtter) has a poker face best described as "expressive."The Motley Fool has a disclosure policy.


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