Monday, December 29, 2008

One giant Ponzi Scheme

For the last couple months i've been thinking about the spiraling downfall of the American economy as based on the loosening of credit standards. In a conversation with my father, he reminded me that historically, banks only made business and corporate loans. For the majority of the American experience, if you wanted to buy a house, you talked to the person that owned the land and made some kind of deal that you could build a house on his land and make payments to buy that parcel of land. If the house already existed, we would in modern terms call this a rent-to-own agreement.

But somehow, someone got the idea that it would be a good thing if people owned their own homes, and Uncle Sam got in the act of creating Freddie Mac and Fannie Mae to help 'average' Americans get enough credit to purchase their own homes. Sometime around the eighties, two things happened that i think laid down the infrastructure of our current downfall. First, lending institutions started lending to a lot more homeowners. Second, the widespread application of the 401(k).

The growth of the 401(k) meant that there were tens of thousands of more new investors in the stock market. This steady influx of money for the next two or three decades fueled the average increase of the price of a stock. The growth of access to consumer credit for home ownership enabled people to purchase houses that were formerly unattainable, not just too expensive. As more and more people got home loans, prices for those homes steadily rose [above historical norms - but that's speculation on my part].

So what's happening, is that people are investing their money and 401(k) are putting money into an inflated product simply because the market price is higher. The same thing for home ownership. But with homeownership its worse.

With home ownership, even though historically prices have been rising (for the reason i mentioned above plus inflation), there is a modicum of risk that you'll owe more than you're worth. This isn't a problem with stocks because you buy stocks outright. Back to homeownership . . .

Now, if you default on your home loan, both you are out of a home, and the bank is out of both its money and its profits. So by giving more people the ability to borrow from banks, this puts them at greater and greater risk the more loans they have. Hence our bubble.

So what was happening in the mortgage industry is that banks would make unsubstantiated loans (see this NYT article). But they weren't left holding the bag because they then sold these loans to investors (whose company smaller investors invested in).

Now, the structure of a Ponzi scheme is that i tell one guy to give me ten dollars and i'll give him twenty next week. then i get two more people to give me ten, and i pay the first guy off. That first guy then re-invests, and gets his friends to invest too. Then i pay off the second group with the new money and the re-investment. Now, what happens is that I then have more and more people coming in to get their guaranteed returns. And the cycle perpetuates until i get less people coming to pay the people already in.

So, we hear of this with the Madoff scandal, which rocked to the tune of 50Billion large (well, small these days). The reason Madoff made off with so much money is that he didn't do the doubling in a week. He paid relatively stead premiums let's say once a month. So if you get a guaranteed return of 12% a year despite what the market does, and over the course of ten years this is guaranteed money, of course you'll tell your friends and associates. That was the wonderment of his Ponzi scheme, the slow but steady returns.

Some folk, including myself, realize or say that the Social Security system has the same structure, and that's why there's what we call an 'unfunded mandate'. But more or less on that later.

Now, though this scheme was working flawlessly for Madoff for his twenty or whatever years in business. I'm saying that that's child's play. I'm saying that the bailout is really a response to a larger uninentional Ponzi scheme. This larger unintentional Ponzi scheme was a direct result of the loosening of available credit using automated software. This automated software that allowed banks to process hundreds of times more loans than before, making 'competition' against the next guy not finding the good borrowers but lending to more and more people. So the housing bubble was perpetrated on selling the higher priced house to the next schlep that comes along. The sorry thing was that the next schlep didn't have to certify that they made enough money to pay the bills, but only that they had half-way decent credit?!

Another thing that accelerated the increase in housing prices was that the couple of schleps in the middle borrowed against and pulled equity out of their houses to pay down unsecured credit card debt (who the hell would trade unsecured credit for secured credit? just stop paying the suckers). So these consumer/homeowners were robbing Peter to Pay paul, and making Timothy foot the bill.

So the confluence of the increase in available credit, automated loan-processing software, laxer lending standards, unsecured credit

The Housing collapse is evidence of the greatest Ponzi scheme ever perpetrated.
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