LESSONS LEARNED #8: “Of course Social Security will fail; that’s what Ponzi Schemes do.” –Old Pithy

Posted by PITHOCRATES - April 8th, 2010

IT’S ONE OF the oldest scams in the book.  The Ponzi scheme.  It takes some creative lying.  Or a cold heart that can stab trusted friends in the back.  Like Bernie Madoff did.

When it comes to investing large sums of money, people would rather do so with someone they know and trust.  And so it is in the Jewish community.  Madoff’s investment funds were very profitable.  And hard to get into.  So when he worked his Jewish circles, the response was favorable.  Everyone wanted in.

Madoff targeted Jewish charities.  Not for the philanthropy in his heart, but for something characteristic about charities who invest.  Charities work on the interest earned on the principal of their investments.  The principal is parked and rarely withdrawn.  And this is ideal for a Ponzi scheme. 

With all that ‘parked’ money it was easy to sustain the lie.  It was easy to write small checks; the payouts for the returns on investment were only a fraction of the total fund.  When an individual wanted to withdraw his money, it was easy to write that check, too.  Those big investments could sustain the fraud for years without worry.  Madoff was happy.  The investors were happy.

MADOFF CONFOUNDED ANALYSTS who could not understand how he could be so consistently profitable, even when other investment funds were showing losses in bad economic times.  Of course, when you have nothing invested, it is easy to avoid market fluctuations.  As long as your pile of money doesn’t run out.

But with the financial crisis kicked off by the subprime mortgage crisis in 2008, that pile of money did run out.  Madoff’s investors were losing money elsewhere and needed to withdraw their money from his fund to cover those losses.  And when people start withdrawing their principal from a Ponzi scheme the house of cards comes crashing down.

And that’s what happened.  Madoff went to jail.  This is usually how a Ponzi scheme ends.  In case you’re thinking about trying this.  First crash.  Then jail.  It’s just a matter of time.  Eventually people start pulling out their principal.  For whatever reason.  Even if you got about as perfect a group of investors as possible.  As in Madoff’s case.  If you don’t believe me, you can ask Bernie.  During visiting hours.

AND SPEAKING OF the subprime mortgage crisis, there were elements in that crisis that were very Ponzie-like.  At the heart of this crisis was affordable housing for people with sh*tty credit. 

HUD was pressuring lenders to loan to people who could not qualify for loans.  Advocacy groups representing various ethnic groups and nationalities sued.  But no advocacy representing those who had no chance in hell of repaying a loan sued.  Funny, for the banks did discriminate against these people.

Anyway, new laws and regulatory pressure as well as lawsuits (and threats of lawsuits) eventually forced lenders to lend to the unqualified.  Then Fannie Mae and Freddie Mac bought the risky, subprime loans.  Problem solved.  All of them.  Right?

Wrong.  They used some creative financing to approve the unqualified.  The one thing to really come back and bite us in the ass was the Adjustable Rate Mortgage (ARM).  You can’t afford to make recurring mortgage payments?  Okay, no problem.  We’ll just make those payments smaller.  We’ll use an ARM which gives you a lower interest rate as well as a lower payment.  You just refinance later when rates go up.  After you’ve built up some equity in your home.

I’m approved?!?  Great!  Thank you!  Refinance?  What?

They may not have understood that part but they signed on the dotted line.  Interest rates at the time were very low.  As were their monthly payment.  They could just squeak by.  Everything was cool.  Until the interest rates went up.

ALL THIS PRESSURE to loan money to the unqualified and the low interest rates caused a housing boom.  The boom became a bubble.  Then the bubble burst.  House values fell.  Interest rates went up.  Then the interest rate on AMRs went up. 

With a lower house value, a new mortgage would have lower collateral (i.e., the house).  So even if they could qualify, they couldn’t borrow enough to pay off the original mortgage.  So they were stuck with a mortgage payment they could no longer afford.  And they couldn’t refinance.  Their only choice was to default.  And default they did.  Lots of them.  Perhaps most of them.  And the subprime mortgage industry imploded.

Why is this like a Ponzi scheme?  Well, looking back at it with hindsight, there was no other possible outcome of these governmental policies.  When you force institutions to loan money to people who don’t qualify for a loan chances are that they will default.  If two people ask you for a loan and one had good credit and the other did not, who are you going to loan your money too?  If it’s your money you’re going to be very careful.  If it’s not your money, you going to do what is politically expedient and give the money to people who will vote for you.

THE SUBPRIME MORTGAGE crisis resulted from governmental policies in place to raise political capital.  The unqualified got the houses so government got the political capital.  Fannie Mae and Freddie Mac were buying those subprime mortgages, repackaging them and reselling them.  They were making money and could make political contributions.  Everybody was getting something.  Before the house of cards fell, that is.

And all of this was based on the lie that people who couldn’t qualify to buy a house could somehow buy a house.  In other words, it was a fraudulent investment.  Like a Ponzi scheme, it would work as long as there was a net cash flow into the system.  A rising interest rate, though, changed all that. 

SWINDLERS OFTEN GET tripped up by things beyond their control.  The subprime mortgage crisis was the undoing of Bernie Madoff.  A rising interest rate was the undoing of the subprime mortgage scheme.  And a declining population growth rate will be the undoing of Social Security.  In time.  Because, in time, all Ponzi schemes fail.



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