Ponzi Revisited

Over a year ago, a story was offered up here comparing today's housing market to a classic Ponzi scheme. Titled "The Biggest Ponzi Scheme Ever?" it arrived at the conclusion that it will not be known whether the label applies until the magnitude of the home price decline is known.

That reasoning still makes sense today.

At the time that the original piece was written in August of 2005, home price declines in the U.S. weren't on many people's radar.

Now that they are here and being talked about rather casually - flat, down five or ten percent, more than 20 percent in some areas - a recent article in Money Magazine about Ponzi schemes may have struck the two million readers of the nation's most popular personal finance magazine in a completely different way than it might have just a year ago.

We'll get to that in a minute.

First, let's once again meet Charles Ponzi.

A turn-of-the-century Italian American who did little to improve the stature of his people in the new world (he looks a little like my grandfather - the clothes are certainly similar), Wikipedia says the schemes named after this man all have the same characteristics.

They are fraudulent operations where returns are paid to new investors out of money raised from subsequent investors, offering high short-term returns but ultimately ending because:

"Once the flow of new investment stops, the scheme is doomed to collapse."

The obvious difference between Mr. Ponzi's scheme and the nation's teetering housing market is that new real estate investment is not likely to ever stop, simply because people will always need a place to live. Many will continue to buy real estate as long as there are lenders willing to extend loans - regardless of the price.

The applicability of the term Ponzi scheme to today's housing market really just boils down the magnitude of the home price declines and how you define the word "collapse".

Surely some homeowners whose homes lose hundreds of thousands of dollars in value would deem this a collapse, even though home prices do not lay on the floor in a jumbled heap.

One man's correction (1985 homebuyer) is another man's collapse (2005 homebuyer).

The Story that Prompted this Story

But back to the Money Magazine story, it was striking to read about a present day classic Ponzi scheme and notice all the parts of the article that could be cut-and-pasted to describe today's real estate market.

So, that's what was done.

Here are a few excerpts from the story Hello Suckers! appearing in the November print edition. Just try and guess what it is they're talking about.

Yet two years ago, the Clermont, Fla. resort-community salesman did something that made him feel like just the sort of idiot who buys into these pitches. He took $108,000 and poured it into an "opportunity" that turned out to be a Ponzi scheme.

He lost every penny.

"I'm reasonably financially savvy. I knew better than to get involved, but I did," says Niggeling, his voice full of regret. "I still can't believe I got scammed."
...
To protect yourself from becoming the next statistic, your first step is this: Get over the idea that you're too smart to be conned. Certainly it helps to know the earmarks of common swindles so that alarms go off when one crosses your path.

But even more important, you need to recognize how vulnerable your own all-too-human psychology can make you. Fraud experts and psychologists (and, unfortunately, con artists) have long known that people are not nearly as good at detecting liars as they think.

And however much you may pride yourself on your powers of reason, understand that you are wired to make critical money decisions emotionally, and with biases you may not recognize. One way or another, every financial scam exploits that fact.
...
According to research done by Emory University neuroscientist Gregory Berns, when we go along with peers, activity in a part of the brain that thinks analytically may decrease, presumably reducing our skepticism. And when we go against consensus, there's a reaction in the part of the brain usually triggered by fear.

So we're afraid to go against the crowd, even when confronted with plain evidence.

If that doesn't give an underwater condo-flipper reason to pause, what would?

The broader context of the above excerpt is that of a classic "investment" ponzi scheme where there is little of substance underlying the investment. New money coming in is used to pay abnormal returns to previous investors, word spreads, and the game continues until no more "suckers" can be found.

Then the whole thing collapses.

OK, admittedly, that description of a classic "investment" ponzi scheme didn't sound too much different than what has been happening in many housing markets around the country today.

Now for the Whole Story

Maybe it would be best to just relate the story as it appears in Money - it's becoming difficult to observe any distinctions up until the point of the "collapse".

Like any reasonable person, John Niggeling, 56, deletes e-mails from African dictators offering him a share of their fortunes. He ignores print ads promising thousands of dollars a week working from home. Postcards declaring that he's won some lottery go straight into the trash.

Yet two years ago, the Clermont, Fla. resort-community salesman did something that made him feel like just the sort of idiot who buys into these pitches. He took $108,000 and poured it into an "opportunity" that turned out to be a Ponzi scheme.

He lost every penny.

"I'm reasonably financially savvy. I knew better than to get involved, but I did," says Niggeling, his voice full of regret. "I still can't believe I got scammed."
...
Three years ago, John Niggeling's nephew David told him about Learn Waterhouse, a company that promised investors a 10% monthly return, supposedly earned by trading debt from an elite group of "prime" banks overseas. To Niggeling the returns sounded too good to be true. But for every question he had - how did Learn Waterhouse make money? Was it legal? Who else was investing? - his nephew had an answer. David kept after him.

"When he told me that a prominent local attorney was involved, I was hooked," says Niggeling.

In the summer of 2004, he took $25,000 out of his IRA and put it into Learn Waterhouse. Within weeks he received a check for $2,200. Encouraged, he invested another $83,000. A month later the Securities and Exchange Commission froze Learn Waterhouse's assets and alleged that its promoters had defrauded 1,700 investors out of $24.5 million. The investigation is ongoing.

Niggeling, who will likely never see his money again, no longer speaks to his nephew. (David admits connecting his uncle to the scam but says that he too was a victim; the attorney representing the head of Learn Waterhouse declined to comment.)

According to SEC claims, the Learn Waterhouse deal was structured as a Ponzi scheme. In scams of this ilk, early investors appear to reap promised returns; in reality they're only getting money put in by later investors, but those early results make the scam look like a genuine bonanza.

The alleged front for Learn Waterhouse's operation was another classic hustle, the so-called prime-bank scam. There's no such thing as a prime bank, but most marks don't learn that until too late. All they hear are some of the sexiest buzzwords in the fraudster pitch book: international investment, elite banks, "guaranteed" returns.

But what really sold Niggeling was the hard sell by his nephew. Affinity fraud, as regulators call it, is among the most effective scams going and the hardest to prevent. Typically the con artist infiltrates a social group like a church or professional club, then persuades his new friends to enroll in his scheme. Like Niggeling's nephew, the members of that inner circle become an unwitting sales network, spreading word to family and friends.

Yikes!

That real Ponzi scheme sounds almost exactly like many regional housing markets over the last few years.

Even the ten percent per month gain isn't too far off the mark if you consider how many homes have been purchased with little or no money down in recent years. The gains didn't come in the form of a check (unless you were flipping condos), but rather in hearing how much so-and-so got for their home down the street.

If you factor in a ten percent downpayment on the purchase of a half million dollar California home in 2002, a home that proceeded to rise in value $10,000 a month (yes, cocktail party chatter circa 2003-2005), you're doing better than Mr. Niggeling ever did. And this appreciation went on not for months, but for years.

It seems we'll have to wait and see what happens with home prices before final judgment is passed.

And, then it's a matter of how you define "collapse".