Wikinvest Wire

The Biggest Ponzi Scheme Ever?

Thursday, August 04, 2005

The phrase Ponzi scheme is tossed around quite a bit these days when people talk about the housing bubble. While not truly a Ponzi scheme, the housing bubble has enough similarities with this notorious scam that it is worth taking a look at.

Named after Charles Ponzi, an Italian immigrant at the turn of the last century who became one of America's best known swindlers, this scheme was used effectively by its creator during six months in 1920 to amass millions of dollars in personal wealth. While millions of dollars doesn't sound like much today (perhaps a few mobile homes in Malibu), in 1920, this was a lot of money.

The scheme was eventually found out by Clarence Barron, the founder of Barron's financial paper, when a few simple calculations proved that the business for which Mr. Ponzi was gathering investment money was theoretically impossible. That, plus the fact that Mr. Ponzi invested none of his own money in his venture.

A Ponzi scheme is defined by Wikipedia as:

A fraudulent investment operation that involves paying returns to investors out of the money raised from subsequent investors, rather than from profits generated by any real business. A Ponzi scheme offers high short-term returns in order to entice new investors. The high returns that Ponzi schemes advertise require an ever-increasing flow of money from investors. Once the flow of new investment stops, the scheme is doomed to collapse.
As this relates to today's housing bubble, the part about high short-term returns enticing new investors is certainly true, as is the requirement for an ever-increasing flow of money. We have the world's central banks and still burgeoning finance industry to thank for the ever-increasing supply of money - it is individual home purchasers who make the money flow.

It seems the only characteristic of a Ponzi scheme that doesn't match up neatly with the housing bubble is the part about paying returns to previous investors out of the money raised from new investors, rather than from profits generated by a real business.

When you think about it though, this isn't too far off the mark. Today, existing homeowners are seeing rapid appreciation as a result of money coming into the real estate market from new homeowners, rather than from "naturally" rising home values (i.e., home values driven by such factors as population, wages, rents, etc.).

So, instead of there being no real business to generate profits in a true Ponzi scheme, it is a question of how "unnatural" the rapid rise in home prices is today. This is not nearly as cut-and-dried as the discovery that Clarence Barron made 85 years ago, but as the days go by and more respected analysts and economists weigh in, it increasingly appears that today's real estate market is not very natural at all - some would say today's real estate market is not theoretically possible.

The last sentence in the definition above will surely determine whether the current housing bubble will be thought of as a Ponzi scheme five or ten years hence:
Once the flow of new investment stops, the scheme is doomed to collapse.
At some point, the flow of new investment in real estate will slow down dramatically. Obviously it won't stop completely, because people will always be buying homes - they'll just stop buying them two or three at a time.

If, when this happens, home prices moderate or decline slowly waiting for wages and rents to catch up, then it won't really be fair to call today's housing bubble a Ponzi scheme.

If, on the other hand, home prices do collapse, today's housing bubble will most likely be called The Biggest Ponzi Scheme Ever.


keith said...

I can't wait until the 2008 senate hearings on the bubble and what caused it

"we never saw it coming"

Damian said...

It seems to me that the biggest problem with equating the housing bubble to a Ponzi scheme is that the Ponzi scheme relied on new investors to buy out old investors for what appeared to be the same asset - a share of the investment pool. Effectively people investing their money were only buying part of the investment they thought they were buying, with the rest of their funds going to pay off the earlier investors.

In the housing market, investors are actually getting the asset they bought. What's more, first home buyers are legitimate buyers, and their demand impacts on the value of the house. It is a normal supply and demand scenario, with demand outstripping supply because :
1. More families are dual income, giving them more cash than when they were single income, some of which they spend on housing
2. The baby boomers are a population bubble, leading to increased demand for housing as they came of age, married and had children
3. The baby boomers are the first generation to have readily accessible divorce, so now they need two houses per family
4. Buy-to-let investment is more popular and accessible than ever before

These circumstances have created a kind of quadruple witching-hour for house prices in Australasia, Europe and the United States, causing a massive, and possibly unsustainable demand for housing.

Demand will ease slightly as the baby boomers age, downsize and eventually die, but I doubt there will be a sudden shock unless it is in response to a natural catastrophe like global warming dramatically altering living conditions.

Anonymous said...

Using the term ponzi scheme against the current subprime debacle is not at all on target. A much better term to stick with is bubble - as in tulipmania...

Sure - you have a point, rising bubbles and ponzi schemes share the high return aspect. But - that's about it...

Enjoy your blog comments - found them via the WSJ.

Anonymous said...

It's funny how all this ish turned out to be true. The US government stood by while Wall St. got drunk and provided incentives for these risky subprime loans, CDO's and CDS'. The US government has failed us.

ARC said...

There is a film to be released soon on this topic. Check out the trailer here:

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