Ponzi Schemes, Bubbles, and Banks | Dollars & Sense

Ponzi Schemes, Bubbles, and Banks | Dollars & Sense: "What is the difference between a Ponzi scheme and the way the banks and other investors operated during the housing bubble?"

As badly as our banking system operated in recent years, the housing bubble was not a Ponzi scheme. In some respects, however, it was even worse than a Ponzi scheme!
A Ponzi scheme is based on fraud. The operators of the scheme deceive the participants, telling them that their money is being used to make real or financial investments that have a high return. In fact, no such investments are made, and the operators of the scheme are simply paying high returns to the early participants with the funds put in by the later participants. A Ponzi scheme has to grow—and grow rapidly—in order to stay viable. When its growth slows, the early participants can no longer be paid the returns they expect. At this point, the operators disappear with what’s left of the participants’ funds—unless the authorities step in and arrest them, which is what happened with Charles Ponzi in 1920 and Bernard Madoff this year.
Fraud certainly was very important in the housing bubble of recent years. But the housing bubble—like bubbles generally—did not depend on fraud, and most of its development was there for everyone to see. With the principal problems out in the open and with the authorities not only ignoring those problems but contributing to their development, one might say that the situation with the housing bubble was worse than a Ponzi scheme. And Madoff bilked his marks out of only $50 billion, while trillions were lost in the housing bubble.
Bubbles involve actual investments in real or financial assets—housing in the years since 2000, high-tech stocks in the 1990s, and Dutch tulips in the 17th century. People invest believing that the price of the assets will continue to rise; as long as people keep investing, the price does rise. While some early speculators can make out very well, this speculation will not last indefinitely. Once prices start to fall, panic sets in and the later investors lose.
A bubble is similar to a Ponzi scheme: early participants can do well while later ones incur losses; it is based on false expectations; and it ultimately falls apart. But there need be no fraudulent operator at the center of a bubble. Also, while a Ponzi scheme depends on people giving their money to someone else to invest (e.g., Madoff), people made their own housing investments—though mortgage companies and banks made large fees for handling these investments.
Often, government plays a role in bubbles. The housing bubble was in part generated by the Federal Reserve maintaining low interest rates. Easy money meant readily obtainable loans and, at least in the short run, low monthly payments. Also, Fed Chairman Alan Greenspan denied the housing bubble’s existence—not fraud exactly, but deception that kept the bubble going. (Greenspan, whose view was ideologically driven, got support in his bubble denial from the academic work of the man who was to be his successor, Ben Bernanke.)
In addition, government regulatory agencies turned a blind eye to the highly risky practices of financial firms, practices that both encouraged the development of the bubble and made the impact all the worse when it burst. Moreover, the private rating agencies (e.g., Moody’s and Standard and Poor’s) were complicit. Dependent on the financial institutions for their fees, they gave excessively good ratings to these risky investments. Perhaps not fraud in the legal sense, but certainly misleading.
During the 1990s, the government made tax law changes that contributed to the emergence of the housing bubble. With the Taxpayer Relief Act of 1997, a couple could gain up to $500,000 selling their home without any capital gains tax liability (half that for a single person). Previously, capital gains taxes could be avoided only if the proceeds were used to buy another home or if the seller was over 55 (and a couple could then avoid taxes only on the first $250,000). So buying and then selling houses became a more profitable operation.
And, yes, substantial fraud was involved. For example, mortgage companies and banks used deceit to get people to take on mortgages when there was no possibility that the borrowers would be able to meet the payments. Not only was this fraud, but this fraud depended on government authorities ignoring their regulatory responsibilities.
So, no, a bubble and a Ponzi scheme are not the same. But they have elements in common. Usually, however, the losers in a Ponzi scheme are simply the direct investors, the schemer’s marks. A bubble like the housing bubble can wreak havoc on all of us.
Arthur MacEwan

THE PONZI PARADIGM

PKArchive:

Charles Ponzi wasn't the first to try it, but he has joined Dr. Bowdler and Captain Boycott among those whose names will forever be terms of abuse. And the classic scam that bears his name -- using money from new investors to pay off old investors, creating the illusion of a successful business -- shows no sign of losing its effectiveness.

Robert Shiller's terrific new book, "Irrational Exuberance," contains a brief primer on how to concoct a Ponzi scheme. The first step is to come up with a plausible-sounding but complicated profit opportunity, one that is difficult to evaluate. Ponzi's purported business involved international postage reply coupons. In a more recent example, Albanian scammers convinced investors that they had a profitable money-laundering business.

From that point on it's all a matter of timing and publicity. An initial group of investors must be pulled in, large enough to attract attention but not too large; then a larger second group, whose investments can be used to pay off the first, a still larger third group, and so on. If all goes well, stories about how much early investors have made will spread, attracting ever more people, and the continuing success of the company will silence or drown out the skeptics.

In the United States, regulators -- who know very well just how effective such scams often are -- do their best to stop them before they get started. So you might think that Ponzi schemes are mainly a historical curiosity. But Mr. Shiller is not interested in history for its own sake; he uses Ponzi schemes as a model for something much more important. Imagine, just hypothetically, that a new set of technologies -- technologies that are really, truly, deeply fabulous -- has just emerged. And suppose also that a number of companies have been created to exploit these new technologies, in the entirely honest -- but very hard to assess -- belief that they will eventually be able to earn huge profits. For the time being they earn little if any money; even if they make an accounting profit, they must continually raise more cash to pay for equipment, acquisitions and so on. Still, as the evidence for a true technological revolution mounts, the prices of their stocks keep rising, producing huge capital gains for early investors. And this attracts ever more investors, pushing the prices still higher.

If the process goes on long enough -- and there is no reason it cannot go on for years -- the doubters will start to look like fools, and the bears will go into hibernation. Everyone (well, almost everyone) may be completely sincere; nonetheless, in effect you get a Ponzi scheme without a Ponzi, a scam with no scammer.

Given the title of Mr. Shiller's book, you can guess the punch line. He makes a powerful case that the soaring stock market of recent years is a huge, accidental Ponzi scheme in progress, one that will come to a very bad end. The book actually focuses on the market broadly defined (most numbers are for the S.&P. 500), but it reads even better as a tale of the tech stocks. It's a book that I hope many people will read; but I doubt that many will be persuaded.

You see, right now bears have an extra credibility problem. Not long ago many people were skeptical not only about the prospects for today's technology companies but about the importance of the technology itself. (I plead guilty.) And every new statistic showing soaring productivity and earnings growth shows how wrong they were. As a matter of logic you can concede the reality of a technological revolution, even while asserting that the valuations of many technology companies are crazy; but who will listen?

It's also true that savvy investors (at least they seem savvy) are following the Levi Strauss strategy: Let others get caught up in the gold rush, we'll sell them the supplies. It is quite possible that the valuations of companies that sell Internet infrastructure make sense even if those of the dot-coms do not.

Still, as you watch those who missed out on the first few thousand points of the Nasdaq's rise feverishly try to make up for lost time, you have to wonder. Will people 80 years from now talk, without quite knowing where the term comes from, about being bezosified or qualcommed?

Originally published in The New York Times, 3.12.00

Note that as luck would have it, the Nasdaq Composite Index peaked at almost exactly the time this was published and plummeted within a month. It's timing looks very wise in retrospect.