Thursday, March 06, 2008

When Pyramid Schemes--a.k.a. Housing--Go Bad

Let's say there's a new pyramid scheme hitting town and J.Q. Citizen is itching to join the immensely profitable fun. But dang it, he doesn't have any money to speculate with. If only somebody would loan him some capital to play with....


A pyramid scheme, also known as a Ponzi Scheme after "financial innovator" Charles Ponzi, exploits the "something for nothing" greed inherent in human nature. A handful of speculators are persuaded to invest some capital, which is then distributed to a larger circle of new speculators as "profit." The "pyramid" of enticing new investors by distributing the previous speculators' money as tremendous "profits" continues ever higher until the pool of new speculators is exhausted.


At that point the pyramid collapses and the last "layer" of speculators--the latest and largest--discovers their "investment" is worthless, as the pool of "greater fools" has been drained.
Amazingly, J.Q. is approached by someone willing to lend him $500 to join the pyramid scheme--and they only want $3 a month! J.Q. is incredulous--after all, earlier speculators have doubled their investment, and are hurrying to put their ever-increasing "equity" back to work in new speculation--it's a "no lose" proposition. Here is a lender who doesn't even demand J.Q. put up any of his own cash, and yet all the profits will flow to J.Q.


Talk about an easy decision. J.Q. borrows the $500, sets aside $20 to pay the monthly interest of $3 and then immediately buys into the scheme. Sure enough, he quickly "earns" a big profit, which emboldens him to borrow another $500. Imagine getting to leverage $1,000 for only $6 a month! It's like a printing press for free money.


The profits are so amazing that J.Q. "doubles down" and borrows another $1,000 and "invests" it. The monthly payments are only $24 and he's making way more than that with the borrowed $2,000. In fact, he's making so much easy dough that he peels off $500 for some spending money. To his astonishment, the lender is still willing to loan him another $500 for the same $3 a month in interest. Where the lender is getting all this cash is unknown, but it's the greatest "no brainer" deal J.Q. has ever seen.


The profits start slowing, and J.Q. becomes slightly nervous. There are rumors of people getting out, and then rumors of people not being able to pull their money out. J.Q. finally joins the horde rushing to cash out but it's too late: there are no buyers. J.Q. is busted, and with a heavy heart he informs the lender he can't make the monthly interest payments any longer--he's broke.
The lender is none too pleased, but as the saying goes, "you can't get blood out of a turnip," and J.Q. reckons that it was a pretty dumb move to loan him all that money even though he never put up a dime of his own money.


Then J.Q. sees on TV that his lender has approached the government to cover the money which the lender lost lending to speculators in the pyramid scheme. This doesn't seem quite right to J.Q. After all, nobody forced them to loan $500 for $3 a month. They were idiots to loan all that money for so little return and no guarantees.


Add three zeros to these numbers and you have the Housing Bubble in its purest essence. Lenders were lining up to give J.Q. $500,000 "no document, no down payment" mortgages for only $3,000 a month. With home prices shooting up by 10%, 20% or even 50% every year, who would be dumb enough not to take the money and "invest" it?


And who would be dumb enough to risk such huge sums for so little return? Lenders who could sell off the loans as "safe investments," that's who. And who would be dumb enough to buy the risky debt for such pathetic returns? It turns out lots of institutions lined up to do so, despite the blatant obviousness of the pyramid scheme and the risks of loaning money to people who had none of their own money in the game.


Now the lenders and the fools who bought the risky debt are demanding the "gummit" step in and buy the bad loans via the FHA or Fannie Mae or whatever, anything, just do it, man, we're getting killed out here.


Interesting, isn't it, how little sympathy there is for J.Q. losing his shirt via speculating with OPM (other people's money) in the housing bubble, and how little animosity is being generated as the "big boys" who staked J.Q. his gambling wad with OPM demand that the government cover their own gambling losses.


What is the difference between J.Q. and the lenders who staked his gamble? Weren't they both speculating in the same pyramid scheme? If J.Q. is expected to suck it up and take his losses, then shouldn't the lenders and the fools who bought the risky loans also take their lumps?


Those of us who valued real estate based on time-tested business fundamentals such as rental-income-to-value ratios and the like showed that the housing bubble (and now the commercial real estate market) was a pyramid scheme based on the expansion of the pool of speculators to include millions of people who would, under common-sense lending risk analysis, be unable to borrow vast sums of leveraged capital.


Now the pyramid scheme has collapsed, as it inevitably would once the pool of "greater fools" (oops, I mean home buyers/speculators) was emptied. Everyone who could buy in bought in, and that left only sellers suddenly anxious to "cash out." It is the nature of pyramid schemes to end this way, and the monstrous size of the housing/real estate bubble pyramid scheme is the only difference between it and any previous scheme.


Those who chose not to speculate should not be paying for the losses of those who did. Isn't that simple enough?


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