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percy-l - Re: [percy-l] Percy-L Digest, Vol 59, Issue 2

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Subject: Percy-L: Literary, Religious, Scientific, and Philosophical Discussion of Walker Percy

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  • From: Wade Riddick <wriddick AT>
  • To: "Percy-L: Literary and Philosophical Discussion" <percy-l AT>
  • Subject: Re: [percy-l] Percy-L Digest, Vol 59, Issue 2
  • Date: Wed, 5 Nov 2008 20:48:15 -0600

U have a problem with the reference to our present financial woes as a Ponzi Scheme. It has often been referred to that way in the media and as a writer on Ponzi Schemes in general, what's wrong at the moment does not strike me as being that. Both the classic Ponzi Scheme and the present horror are frauds but they are of a quite different nature as frauds -- unless that is I don't quite understand the reference in Mr Riddick's post. Please explain.

Here at Napalm Investments, we handle a lot of hot subprime work: C.D.O.'s, A.R.M.'s, C.Y.A.'s. Step into my den and I'll explain our portfolio...

I've talked to a couple of certified fraud examiners for a few years now about CDO's (asset-backed collateralized debt obligations). They're pretty much identical to the daisy chains that S&Ls used in the 1980's to hide their bad debt from regulators in a classic pump and dump stock scheme. The key in a Ponzi scheme is to keep bringing in new money from new investors to pay off old investors just enough to convince them the scheme is working. In this case, adjustable rate mortgages were crucial to the operation of the con.

Basically, you had unregulated mortgage brokers who didn't verify the ability of the borrower to pay because they never intended to hold the loan to maturity themselves. They frequently bribed home appraisers to overvalue the property in question and they either bribed or relied on incompetent accountants at the bond ratings agencies to value the mortgage before it went into the CDO. As they did with Enron bonds, these accountants couldn't or wouldn't independently examine the true value of the home or the ability of the borrower to repay (their true credit quality). Worse, where they could make black and white judgments from available information, they failed miserably. They would judge mortgage A and B as equivalently risky if A and B were identical except in A the guy put 20% down and in B they guy borrowed the entire cash downpayment. Clearly B is riskier because the more money you borrow, the greater the risk of default - all other things being equal. So this is how they disguised the bad paper so they could sell it to the suckers.

But companies were sometimes victims and participants. Companies who bought these CDOs would often break them up into their individual components and rotate in and out their own bad debts they wanted to hide. When interest rates started going up - as everyone knew they would - the house of cards collapsed.

So is it a classic Ponzi scheme? As long as you had growth in the market for these screwy mortgages, the network did fine. New money was coming in to cover up the sunlight starting to shine through the crumbling debt bomb. Then the balloon payments kicked in and interest rates went up - which the ratings agencies knew could happen but avoided analyzing. Anybody who got caught holding the bag when that happened got singed.

Try not to think in terms of one institution conning another. Instead, try to think of it as one gang of criminals taking over a bank here and there, trading on the good corporate reputations to sell overpriced junk debt with underpriced risks, generating huge temporary profits based on the lies, taking huge cash bonuses (or company stock they then dumped) for those profits and then bailing out. At Countrywide, executives often harassed, overturned and/or fired any internal risk control officers who tried to restrain their lending. The fees for selling the packaged mortgages were simply too great. At AIG's special investment products division, a Drexel retread borrowed capital internally at a tremendously underpriced rate and stuck the money into high-yielding, high-risk CDO's which temporarily generated high returns before exploding. The rest of the company was so happy, they didn't ask any questions. The 300 odd employees averaged a million in bonuses a year before the outfit collapsed and took the rest of AIG with it.

Plenty of participants were just gullible and dumb. Con artists always need true believers (the "deregulatory" faithful in Republican parlance). But plenty of core operators knew exactly what was going on and they're getting paid on the front end of the scheme *and* on the back end through the government bailout which is funneling money to failing banks and will probably be used to help bad managers buy perfectly good regional banks who didn't do all of this crap.

I grew up watching my father prosecute cases like this, which is why I knew four years ago - and explained on another list - that AIG would collapse because the problems that dented their returns during the Enron scam had never been corrected by Bush/Greenspan. In fact, Bush loved Enron so much they expanded the scope of deregulated derivatives instead of reigning them in in the wake of Enron's implosion. A few weeks ago a nice innocent looking California gal in Congress who was patronized by Greenspan back then on the issue grilled him on exactly that until he was, frankly, professionally humiliated and she looked like an investment genius.

Louisiana's insurance industry is rife with problems like this. Companies, for instance, hide assets from regulators and convince them they have more assets on the books than they do so they can underwrite more policies than they really can. They launder the money into separate companies and then rely on the LIGA (Louisiana Insurance Guarantee Fund) to pay off client policies when the insurer goes bust. The S&Ls relied on FDIC deposit insurance (in economics this is called moral hazard). The scheme relies on underqualified, naive, sometimes actively malicious, government civil servants to run interference and break the law in favor of the crooks without fear of the consequences. You see a lot of sociopaths and bullies. And dumb voters.

I wrote a lengthier examination of the market meltdown including the CDS problem for another list if you're interested (I would send it privately, of course). In short, we have come very, very, very close to a tremendous economic depression. We may still get there. The amount of fraud was literally staggering.

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