Every spring I teach securities law to law students and until this year it has always felt somewhat odd to lecture about Ponzi schemes. After all, didn’t this kind of fraud disappear with childhood polio in America?
We thought we had in the SEC and federal and state regulations the toughest legal regime in the world, worth its weight in a lower cost of capital to thousands of companies that sell their shares here and to millions of investors worldwide who park their cash in our financial markets.
As it turns out the concept of the Ponzi scheme is far from dated and, according to Pimco’s Bill Gross, it lies at the heart of understanding the current mess we are in. Gross is one of those commentators about whom it can credibly be said, when he speaks, you owe it to yourself to stop what you are doing and listen.
His argument is that the basics of a Ponzi scheme are what explain the explosion of fictitious capital that is now crashing down around us. The core operating principle of a Ponzi scheme is that the operators of the scheme 1) lure investors into an investment with promises of above market returns; and 2) because the funds they receive are not, in fact, invested in anything that can in fact generate those above average returns must lure in new investors to pay off the old investors.
About the nature of our credit driven economy today Gross writes:
Under the policy-endorsed cover of technology and somewhat faux increases in financial productivity, we became a nation that specialized in the making of paper instead of things, and it fell to Wall Street to invent ever more clever ways to securitize assets, and the job of Main Street to “equitize” or, in reality, to borrow more and more money off of them. What was not well recognized was that these policies were hollowing, self-destructive, and ultimately destined to be exposed for what they always were: Ponzi schemes, whose ultimate payoffs were dependent on the inclusion of more and more players and the production of more and more paper. Bernie Madoff? As with every financial and economic crisis, he will probably go down as this generation’s fall guy – the Samuel Insull, the Jeffrey Skilling, of 2008.
But Madoff’s scheme has a host of culpable look-alikes and one has only to begin with the mortgage market to understand the similarities. Option ARMs or Pick-A-Pay home loans allowed homeowners to make monthly payments that were so small they did not even cover their interest charges. Two million mortgagees either chose or were sold this Ponzi/Madoff form of skullduggery, believing that home prices never go down and that shoppers never drop. One can add to this the trillions in home equity/second mortgage loans that extracted “savings” in order to promote current instead of future consumption, and one begins to realize that Bernie Madoff and our cartoon’s Wimpy had company all these years.
While no one but his closest family members will cry when Madoff is led off to federal prison in an orange jumpsuit, as he surely will the dilatory behavior of our failing SEC notwithstanding, it is Gross’ point that he is only a slightly misshapen example of the entire period in which we have been living.
This argument is not a complete explanation of the crisis. That would require an understanding of the underlying changes in productivity that have helped make very large swathes of our economy socially worthless thus feeding the need to keep fictitious credit afloat lest entire chunks of the economy collapse. Such is the nature of late capitalism. But Gross puts his finger on the dynamic within that machinery that finds a way to keep paper claims to wealth floating like a massive hot potato from investor to investor, from country to country, from year to year.
And now it is the state itself, Gross believes, that must enter the picture to reflate the collapsing world of credit. That is Gross’ blindspot – he is looking, desperately, for a way out. Like all great traders, when he speaks you should listen but you should also understand that he is “talking his book” – his only fiduciary obligation is to his clients, who invest in the credit instruments he finds for them. Thus, he hopes the Government can spend its way through this crisis. He may be right, but it is a big bet.