A few years back, I read the book, Ponzi’s Scheme: The True Story of a Financial Legend, by Mitchell Zuckoff. The book detailed the life of the ubiquitous Charles Ponzi, inventor of the first successful pyramid scheme. This scheme enabled Mr. Ponzi to get rich quick through what would be tantamount today to currency arbitrage. The crux of the scheme involved buying and selling International Postal Coupons (IPC) at a low price in Italy, taking the coupons to the U.S., selling them in the U.S. for a greater price, and re-investing in more of these coupons.
Ponzi attracted these investors by promising them 50% return on investment in 45 days or double their money in 90 days. In order to get even more people involved in the scheme (thus creating higher payouts for himself), Ponzi ended up buying so many IPCs that the object itself became devalued. As people became self-aware of the relative uselessness of so many IPCs, they demanded their money back. Unfortunately, the outpacing moneyback demand caused the base of the pyramid to crumble and eventually collapse. Ponzi’s complex scheme of arbitrage created an atmosphere of trading that was so euphoric, it lost its grounding.
Ever since I read this book and started to read more about the global financial marketplace and stock markets, I’ve been trying to pose a theory of my own: the financial system is nothing less than a Ponzi scheme that we’re all buying into. This past week, the subprime mortgage crisis seemed to validate my theory. Replete with a breakdown of my basic understanding of financial markets, here’s how I see it:
When I was in London, I started to broach the idea to my Ruskin roommate, Charles (not Ponzi). His response was that the marketplace is filled with such complex financial instruments that it would be difficult for one industry to bring down the market. This complexity meant that risk was spread out even farther with less direct impact on markets as a whole. What would happen in one industry would be less likely to touch another industry. Even though this conversation was only three months ago, it was an answer I was willing to buy into, since it was the only one that seemed to show that my theory wasn’t entirely developed. However, the past week seemed to disprove his answer, instead highlighting the poignancy of my own theory.
Subprime mortgages are mortgages that are offered with introductory interest rates that are lower than the prime rate — usually 300 basis points above the Federal Reserve rate. Typically after the first six months to a year (depending on the terms of mortgage), the interest rate skyrockets to exorbitant percentages that are often variable and much larger than to those offered to regular borrowers. But who would be taken advantage of like this?
Some subprime mortgages can often be described as a type of ninja loan (No Income, No Job, no Assets). After all, we all need some place to live, no? Typically, the subprime borrower has a lower credit rating and is given a “second chance” by the lending bank. In the eyes of the bank, there is a trade off by lending to people with unverifiable income or poor credit: the high-yield interest return on the lending risk.
What happens though, when even some of these borrowers can’t afford to pay when the interest rates rise to well above prime? As the chart shows, with almost $600bn of subprime loans (35% of total mortgages) originated in the U.S. last year alone — when the mortgages aren’t paid and they go into default, the bank gets left with a house and no return.
Let’s switch tracks for a second and introduce another financial concept here: the idea of Asset-Backed Securities (ABS) or Mortgage-Backed Securities (MBS). For a financial institution, debt is viewed as an asset. Not only is it getting back the principal investment, but it is also getting a return on investment (interest). When a bank loans money for a mortgage, it knows that it will be receiving these monies back or else, based on the stipulations of the mortgage agreement, the homeowner will foreclose on the house. Rather than keep these mortgages on the balance sheets, the Financial Institutions repackage all the mortgages into MBS, where these securities can be freely traded on the open market. It’s a simple, yet very complex financial instrument that, once traded, starts to make the mortgages themselves seem useless.
The problem is, the mortgages are not useless. Much like with Ponzi’s IPCs, there has to be some sort of value underneath the derivative. If people cannot pay these subprime mortgages (or any mortgages, for that matter), there is no true backing to the instrument. Thus, unless paid for, the hedge funds and banks that trade MBS are really trading something without much value. When it is admitted that there is no actual money backing the securities – no liquidity – everything starts to catch up and the pyramid falls.
This became most obvious last week when several hedge funds – including some from large investment banks such as BNP Paribas, Bear Stearns, and Goldman Sachs – admitted to large losses stemming from the subprime mortgage crisis. The liquidity backing these securities just wasn’t there. The complex scheme of ABS and MBS created an atmosphere of trading that was so euphoric, it lost its grounding. The trading of billions of dollars of these securities even infiltrated other market exchanges.
Unlike the Ponzi investors however, the Federal Reserve Board (as well as Bank of Japan, Bank of England, and European Central Bank) was able to attempt loss-stabilisation by directly injecting this “lost” liquidity into the market. However, with an interest in maintaining interest-rates and inflation targeting, the Fed’s choice to flood the market with billions of dollars of liquidity raises the question of What happens next? Government didn’t offer bailouts to Ponzi investors.
So… is the financial system just a Ponzi scheme that we’re all buying into?
I’m not a financial analyst, but my critical analysis would seem to suggest that it is. The level of complexity that financial instruments starts to devalue liquidity, however it is liquidity that drives the entire world markets. Inability to back assets with liquidity makes them even more susceptible to risk. Risk isn’t merely spread out because of complexity, but is ultimately intertwined with everything else that drives the markets (lower overall investor confidence, for instance). When everyone wants their money doubled in 90 days and finds the money isn’t there, everyone gets burnt. I don’t think there’s anything complex about it: if my theory is even partially correct, when the full extent of damage is revealed, this whole crisis could be bigger than we all thought. They might as well have been selling IPCs.
The battle is over, Rupert Murdoch has won. Not only has Mr Murdoch won, he has also done it with little effort. His efforts to buy the revered American financial newspaper, the Wall Street Journal have ended with a family realizing its destiny and mismanagement of its own firm. As Louis Ureneck was quoted in 
