December 26, 2008--All Ponzi All the Time

While we continue to be absorbed in trying to understand and unpack the truth behind the ponzi scheme perpetrated by Bernard Madoff, there has been a much larger, more ruinous ponzi scheme that continues to victimize the American public.

Madoff’s involved “only” a relatively few wealthy individuals and institutions and cost them “only” $50 billion. The one still plaguing the larger public is the adjustable rate mortgage scam--the basic way of securing home mortgages for at least a decade and more responsible for the worldwide recession than any other financial instrument.

ARMs too are a ponzi scheme.

Let me explain.

You buy a house that costs $200,000 and take out a no-down -payment mortgage for the full purchase price. To help you pay the monthlies, rather than paying the actual prevailing mortgage interest rate, you pay less. Of course this means that the “unpaid” interest accrues and you do not at all reduce the principal—you pay just the interest and, at that, less than it should be.

This of course sounds fiscally crazy—by opting for an ARM each month you go deeper and deeper into debt. So why would anyone want to do this?

Because you, with the bank’s encouragement, assume that real estate values will increase at a rate faster than the mounting interest debt. When your $200,000 house is worth $250,000 or $300,000, from that growth in value, you have a paper asset of $50,000 or $100,000. More than enough, if you refinance, to pay off the interest that accumulated while the value of the house was rising.

Sounds good.

And it was good so long as real estate values seemingly and inexorably kept rising. But when they began to decline, everything, as in a ponzi scheme, began to implode.

Like the classic Madoff-style ponzi scheme (which should now probably be renamed the Madoff Scheme), the ARM scheme required an endless infusion of new capital.

In Madoff’s case this meant he needed to keep signing up new suckers in order to pay off the ones who got in early. When he could no longer do so his fraudulent pyramid collapsed on itself and the people who had been taken in.

In regard to ARMs, when housing values went south the new money needed, in this case from the previously rising values of the homes, there was no money to keep it propped up.

All of this, we now are sadly learning, occurred with the blessing of the Bush administration, the asleep-at-the-switch regulators, and of course the lenders.

If you want a vivid case-in-point, look at yesterday’s New York Times article linked below that recounts the rise of Marion and Herbert Sandler of the former World Savings Bank, who made their billions by coming up with a scam of their own—the “Pick-A-Pay” adjustable rate mortgage.

Of course they deny doing anything wrong. In fact, they claim, as philanthropists in the non-banking part of their lives, what they did allowed low-income folks to buy houses.

What they don’t say is that many who bought homes this way are now losing them by the millions—especially the lower-income people to whom they have allegedly been so caring.

Well, I can tell you about some of their philanthropic work in education—there is a less there than meets the eye. I know them both quite well, and one day at a meeting at the Ford Foundation Herb told me that they intended to give to charity all of their vast wealth. Those of us in the education field are still waiting.