Friday, December 19, 2008

Ponzi Scheme and Mortgage Meltdown

From Wikipedia: "A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business. It is named after Charles Ponzi.[1] The term "Ponzi scheme" is used primarily in the United States, while other English-speaking countries do not distinguish in colloquial speech between this scheme and other forms of pyramid scheme."

From what I can tell, this is precisely what was going on in the mortgage market from ~2000 to 2006ish. The people involved in these loans to potential homeowners were only able to make money because of the new money coming in from subsequent investors. Meaning, the only reason the scheme was functioning and generating returns for investors was because of the fresh blood coming into the market next week, willing to pay more for the same house that just sold for $30,000 less only one week ago. That kind of high turnover/short turn-around time was basically an over-glorified Ponzi Scheme. Think about it, what have these financial institutions been saying all along? We just knew the price of homes would never go down, so we'd just say, Don't worry, you can just refinance, or sell the home in a few months. So, the homeowner finds some new person entering the market (at the bottom of the pyramid), who has to pay out the most (thus far), they cash out, the bank cashes out, and New York cashes out. Meanwhile, the investment hasn't actually made anything in the process. Now read what Krugman has to say about the New York bankers and their bonuses. 

From Krugman's Op-Ed in the NYTimes: "Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses."

I think that I finally understand this whole mess. Yeah sure, it's interesting to consider how this spread to the money and credit markets, and yeah it's interesting to ask why the gov't didn't step in and prevent this from happening, but's just another scam like anything else.

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