Ponzi Scheme or Free Market?

Originally published on March 3, 2009, at politicsunlocked.com

A pyramid scheme or “Ponzi scheme” (named after legendary swindler Charles Ponzi) is the name given to a bit of financial trickery in which early investors are rewarded with big returns from money put in by later investors. The promise of big returns lures more and more people to keep adding to the pot, until the public is spooked, the market for funds tapped, or the game shut down by authorities. At that point, the later contributors, who greatly outnumber the early participants thanks to publicity and word of mouth (hence “pyramid”), are left empty-handed, as the funds have already been paid out to the first investors who generated buzz and paid off the scheme’s instigators.

Stock market

Compare this with the stock market, where investors bid against other investors for shares in companies. The more people are willing to pay for shares of a company, the higher the price, according to supply and demand. The company uses the investment funds as capital to finance their operations, and successful businesses reward stockholders with dividends, higher share prices, or simply confidence that the business will grow and the stock will increase in value. In a successful business, even if shareholders abandon the stock, one could retain shares — albeit with little value — until a later time where the stock might again come into favor.

Real estate

Real estate is similar in that people purchase land at a price based on supply and demand. The price goes up if many people want to buy and are willing to pay more in order to have what’s being sold. Price goes down when there is less demand, but if you own the land, you really own it and it has some value as a home or as land to be developed.

Added leverage

Unfortunately, it’s not that simple. In recent years, stock prices have gone up so fast, and real estate values have increased so much, that many people wanted to invest even after they had no more money to invest. But interest rates were lower than the profit they believed they could make, so they borrowed money and invested it in stock and real estate. This is called leveraging, and it’s perfectly legal: borrow money, buy stock or real estate, sell stock or real estate, pay back interest, keep the profit.

An individual who had ten thousand dollars to invest might borrow another ten or twenty or hundred thousand and invest the total. If they doubled their money in a year, they would have sixty thousand dollars, minus the thousand they had to pay in interest to borrow the funds for one year. Institutions did this with millions of dollars; one million to invest might be added to ten million or thirty million borrowed.

Then something happened. Was it the price of oil sucking the profits out of companies large and small? Was the limit of leverage as everyone willing to borrow heavily to invest had already done so and there were no more people lining up to play the game? Was it fear of the growing deficit (2006), the flailing war effort in Iraq (2007), or the pending presidential election exacerbating tension and uncertainty (2008)? Risks went up and the expectation of reward fell. The real estate market slowed; the stock market topped.

People began to sell, to take their profits.

Prices started to fall, and economic clouds darkened. People who borrowed money to invest were still paying interest. They had to make the calculation. Was the fast run-up in prices going to continue? Would a gradual gain in prices outpace the cost of the funds that they borrowed? Was it worth the risk? The answer was likely “no.”

“Deleveraging”

As prices fell, the stock and real estate prices fell below the purchase price for many investors. Now they were taking a loss on their borrowed funds. Paying back the bank became more difficult. Banks started to find that the risk of default was going up.

Ponzi scheme or free market? The bank’s fault or the investors? Where is all this going?

These days, financial experts are looking for the bottom. At what point is the speculation gone, the deleveraging complete, and the more authentic supply and demand for productive use of land and capital remaining?