Bad Attitudes

Many people are unaware of the vital role that attitudes play in a society built on credit. For instance, with the fractional-reserve based lending model that exists in the U.S and elsewhere, banks' loans and other obligations outstanding typically exceed cash on hand by a wide margin, meaning supposedly safe institutions are technically insolvent--often from day one. It is only depositors' willingness to believe that they will have ready access to their money when they want it or need it that keeps the system afloat.

However, once enough people start thinking otherwise, that can set the stage for a major crisis. In "Ponzificating,"The Economist explores the question of whether the modern day financial system as a whole is "a confidence trick."

Charles Ponzi was a likeable man. That helped him persuade American investors in 1920 that he could deliver returns of 50% in just 45 days by exploiting a loophole in the pricing of international postal coupons. In a way, he was advertising an early version of an arbitrage fund.

In reality, the loophole could not be practically exploited. So Ponzi exploited his customers instead. He could deliver returns only by taking money from new investors to give to his early backers. But although he died in poverty, the Italian immigrant achieved immortality of a sort: fraudulent moneymaking operations are often known as Ponzi schemes.

In the world of finance, describing something as a Ponzi scheme is a standard form of abuse. This insult has been bandied around a lot of late. Financial-sector profits have grown far faster than GDP over the past 25 years; everyone has become richer by lending money to everyone else. Household debt is running at about 100% of GDP in America and higher still in Britain. Credit derivatives are soaring in value and payment-in-kind notes (which pay interest with more debt, rather than cash) are in vogue. Last month Tim Lee, a strategist at pi Economics, described the whole financial system as “the equivalent of a gigantic Ponzi scheme.”

In one sense, of course, he is right. Many elements of the system are Ponzi-like in that they depend on confidence—they would collapse if all investors demanded their stakes back—or they rely on new backers to keep them going. Pay-as-you-go pension systems, for example, depend on there being enough workers to fund promises made to retired employees.

The health of the commercial banking system depends on the assumption that, at any time, most depositors will keep their money in the bank. That allows banks to borrow short and lend long; earning higher rates on loans to business. When depositors panic and start to withdraw their money, the result is usually an economic catastrophe.

Ponzi's original scheme was fraudulent from the start. But even if he had found some exploitable anomaly in the financial system, his rationale was flawed. Because he offered such a high rate of return over such a short period, claims on the “Bank of Ponzi” would quickly have reached ridiculous levels.

So perhaps there are good and bad Ponzi schemes. Good schemes will do more than funnel money from latecomers to early takers, allowing the foremost to prosper at the expense of the hindmost. And they will not allow claims to increase too fast. That was the big mistake of John Law, the pioneer of paper money in early 18th-century France. Law's system eventually collapsed, but he did have the insight that the creation of credit might increase trade, and thus general welfare.

But how to tell when a scheme has gone too far? Hyman Minsky, an American economist, distinguished three kinds of borrowers. Hedged debtors can safely meet all debt payments from their cashflows. Speculative borrowers can meet current interest payments from cashflows but need to “roll over” their debt in order to pay back the principal. And Ponzi borrowers can pay neither interest nor principal from cashflows but rely on rising asset prices to keep going.

The American housing market seems to be suffering from the unravelling of a Ponzi-type system. Subprime loans were offered on generous terms that, implicitly or explicitly, depended on rising house prices. The banks that made these loans bundled them up and sold them in the credit markets to investors, eager for high yields. This was supposed to make the financial system more secure by dispersing risk more widely.

But look what is happening now. The buyers of these loans are asking the original mortgage-writers to buy them back. But these homelenders do not have the money to do so. The confidence that sustained their balance sheets has evaporated, leaving many in dire trouble.

Might the problem be more widespread than housing? The latest stockmarket wobbles suggest investors are asking themselves the same question. Financial-sector debt has risen from virtually zero 50 years ago to 100% of American GDP today, and Europe's financial corporations have helped to accelerate the money supply.

George Magnus, a strategist at UBS, has just written a research note entitled “Have we arrived at a Minsky moment?” His big worry is of a contraction in credit supply. As lending standards tighten, consumer demand could suffer, possibly prompting a recession in the United States. No one knows when the credit cycle will end, he says. But the pyramid is beginning to look a bit top-heavy.

Indeed, once enough people figure out that the Goldilocks economy and other elements of today's American dream are nothing more than a fairy tale, they may start questioning a great many other assumptions.

Comments

[Schahrzad Berkland]

I'm almost done reading your book. It's a wake-up call, and I will add it to my Recommended Books list on my website. I've been preparing for a bear market since last spring by moving to cash (partially US dollar), gold/silver, and inverse index funds.

Do you see any risks in swap agreements used by inverse funds?

[Michael Panzner]

Yes, though it is hard to gauge the degree of risk that exists at a particular fund without knowing more about counterparties, transaction structures, back-up provisions, back office procedures and systems, accounting methods, etc. That being said, I believe that as time goes by the risk of being blindsided by any given firm's exposure to any type of derivative, including swap agreements, will increase significantly.

[Edward Charles Ponzi Jr]

"Many elements of the system are Ponzi-like in that they depend on confidence—they would collapse if all investors demanded their stakes back—or they rely on new backers to keep them going."

Mr. Ponzi's definition of a Ponzi scheme: *you service debt with additional borrowing*

(no need to worry there)