Category Archives: Finance Capital

Our Ponzi Economy

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.

What are these bankers thinking?

It appears that former Goldman Sachs executive John Thain forgot the lessons of teamwork and humility that were a part of the Goldman culture when he moved to Merrill Lynch. With the allegations that he spent $1.2 million on re-furbishing his personal office, he looks more like the felon Dennis Kozlowski of Tyco fame who once spent thousands of shareholders money on a dog-shaped umbrella stand!

With taxpayers spending hundreds of billions to rescue the banking system, outrage is surely justified.

But outrage is not policy….and it is policy that this crisis needs. It is becoming increasingly clear that we need to nationalize the banks to insure that the necessary reforms take place under the scrutiny of the public. In fact, that may be the only way to avoid the collapse of the system: if we try to buy the bad bank assets then it could cause a re-pricing downward of remaining assets. It also means the government gets the lemons while the banks keep the profitable assets.

Nationalization is only the first step – the second has to be a new system of governance including public trustees placed on the boards of our key banks so that we can insure that savings are allocated safely to those areas of the economy that need the money and can invest it wisely to create jobs and develop new useful technologies.

While discussion of nationalization has now surfaced in the pages of the Financial Times and today in the New York Times, one fears that the Geithner/Volker/Summers team will move too slowly to discard failed models.

Fed induces crisis of legitimacy?

Stanford economist and former Fed member John Taylor nails the central dilemma presented by the Fed’s aggressive intervention into the financial crisis: legitimation. 
The viability of capitalism, which generates volatility and inequality as a matter of course, depends heavily on the notion of “consent by the governed.” Absent that revolution or chaos fill the vacuum. Taylor notes that the massive buy-in by the Fed has meant, whether intentional or not (certainly not), that the federal government is now making industrial policy choices. 
This is really no different than the “pick the winner” policies that are at the heart of the east Asian model. Thus, the Fed begs the question, who does the picking? 
Presumably the governed…but where are they in the process?

Fed has abandoned monetary policy, critic says
| Reuters

GM in bankruptcy

This overview of the impact of a GM bankruptcy gives some insight into the complexity that all parties will face.
Left unclear is where the UAW negotiated VEBA debt stands. The VEBA was supposed to be bankruptcy remote but instead it is becoming an ATM for GM to help increase its leverage against creditors.
Of course, the UAW and GM failed to provide UAW workers any disclosure of the risk that bankruptcy entailed for the VEBA when GM workers needed that information – during the contract ratification vote.

GM in bankruptcy (The Deal Newsweekly)

Forget Madoff, SEC Ignored GM/UAW Bailout Risk


Earlier this year, I filed a complaint with the Securities and Exchange Commission on behalf of autoworkers pointing out that GM and the UAW had failed utterly to warn GM employees of the risk of bankruptcy and its impact on the proposed VEBA health care plan.

The VEBA was supposed to be “bankruptcy remote” – secure against bankruptcy risk but it turns out that it is being used to help GM survive bankruptcy.

The SEC complaint was based on my research note, Proposed GM/UAW VEBA: House of Cards.

Sure enough GM is now, in essence, in bankruptcy.
And GM workers and retirees still do not know what will happen to their jobs, their pensions or their health insurance.
That is what the SEC exists for – to protect investors and GM sold the UAW a $4.5 billion convertible note without disclosing the risk of bankruptcy. If the UAW had understood what I laid out in the research note, they likely would have taken a different approach to bargaining last year.
Senator Corker, from Nissan, is proposing now that the cash flows into the VEBA be turned into even more worthless paper, GM stock. Of course, no evidence exists that existing GM bondholders will agree to this. In any case, the auto workers have ALREADY taken a huge hit – the convertible bond is now worth far less than its original face value.
Bankruptcy, whether prepackaged or not, whether or not with a bridge loan from the U.S. Government, is not the way to go. As I proposed in A Way Out for the Auto Industry the way forward is creation a new Public Trust Company that could issue long term low interest bonds to purchase the assets of the Big Three and manage them in the public interest.