Ponzi-conomy

When it comes to the financial crisis, everyone carries some blame. Realizing that is the first step toward recovery.

The symmetry is not obvious at first, but last year’s economic cataclysm and Bernie Madoff’s Ponzi scheme are near-perfect bookends for 2008. One began with a housing boom built on easy credit and flimsy mortgages, which infected the financial system through Wall Street’s securitization machine and then spread globally to investors eager for the higher returns that pools of American mortgages and their exotic progeny offered. The other began with an obscure Wall Street market-maker deciding to moonlight by managing other people’s money, at first for his country-club and civic-minded friends, and later for wealthy people around the world. He promised results he could not deliver, so he made up numbers out of whole cloth.

Both were fueled by low interest rates that led eager investors–be they European aristocrats or investment banks or American pension funds–to seek out fatter returns. They also both drew heavily on Charles Ponzi’s special skill as an asset manager–taking fresh funds from new victims to pay off existing ones. We know this is true in the case of Madoff because prosecutors say he has admitted as much. But the housing market, too, was the functional equivalent of a Ponzi scheme: Easy credit sucked in a steady stream of new buyers, many of whom got absurd “ninja” loans–no income, no job, no assets. Wall Street firms packaged these mortgages into bonds, credit ratings agencies slapped on a triple-A stamp, and investors bought them. It was all built on air, but as long as home prices kept rising–or as long as more suckers were drawn in–the housing Ponzi scheme kept rolling along.

In a thoroughly ironic twist, one Ponzi scheme undid the other. The housing bust exposed Madoff’s fraud when wealthy clients demanded their money back so they could pay off other debts that had gone sour or to meet margin calls. Flooded with $7 billion in redemption demands, he couldn’t keep up the ruse any longer and confessed to his brother and sons.

But more than anything else, the 2008 twin towers of financial disaster were made possible because, over the last decade, the United States government–Democrats and Republicans alike–tolerated, even encouraged, unregulated markets (securitization, credit default swaps), unregistered asset managers (hedge funds, private equity firms, or anyone with fewer than 15 investors, in Madoff’s case), and overly credulous gatekeepers (credit rating agencies, corporate boards, the Securities and Exchange Commission).

As the Obama Administration rolls up its sleeves to do the hard work of repairing the broken financial system, it is important to understand this as the über-lesson of 2008. Much as we can each name our favorite financial executive or deregulation-minded lawmaker as the evil mastermind, much as we can each finger our favorite runaway institution for providing the timber, and much as we can invoke our favorite dastardly financial instrument for lending the spark, a smart watchdog or two could have stopped them all.

It’s easy to look back on it all and ask: What were we thinking? But it made perfect sense. As George Soros, the hedge fund founder and philosopher, points out in The New Paradigm for Financial Markets, people acted rationally in the housing bubble’s buildup stages. Interest rates were so low that capital, for all intents, was free. “When money is free,” he writes, “the rational lender will keep on lending until there is no one else to lend to…And when the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one expects to occupy.” But if the housing bubble wasn’t irrational, it sure was destructive. It was the job of regulators and other gatekeepers to spot this behavior.

In his latest book, The Return of Depression Economics and the Crisis of 2008, Paul Krugman, the 2008 economics Nobel prize winner, comes close to understanding this, though his book is more an updated 1999 tome on the Asian and Latin American crises than a full exploration–more like dashed-off thoughts in an epilogue–of 2008’s meltdown. The Madoff scandal had not even struck by the time he completed it.

Nevertheless, it’s an insightful read. The Asian and Latin financial crises were rehearsals for the global economic bust we are living through now, writes Krugman, a Princeton professor and New York Times columnist. While in the 1990s, growing international capital flows set the stage for devastating currency crises, the same globalized financial system allowed the spread of mortgage-backed securities to infect banks and investors around the globe, he writes. The credit crunch that grew out of the housing calamity then froze the rest of the world’s lenders, using the same viral pathway.

Krugman stops short of blaming the globalized financial system itself as the villain, though he drops several hints that it’s where he would like to pin blame. He is more on target, however, in awarding special opprobrium for the shadow banking system–the commercial banks, investment banks, insurance giants, and hedge funds that created, traded, and held trillions of dollars’ worth of unfathomable securities.

• 1
• 2
• 3
• 4

Post a Comment