Bernie's Ponzi Scheme

When Bernard Madoff was arrested, he reportedly told FBI agents that his eponymous investment advisory firm had bilked investors out of $50 billion and was a "giant Ponzi scheme." So what is a Ponzi scheme? Ponzi schemes are illegal programs to make money by enticing potential "investors" with high expected rates of return which are funded by recruiting more particpants to invest. A pyramid scheme is the classic example. The first wave of participants is paid off with money obtained from the second wave of participants and so forth. Inevitably, the pyramid collapses under its own weight as it becomes exponentially more difficult to recruit enough new participants to pay off earlier ones. A very small group of early participants make the promised return while the rest lose everything. Simply put, it is a redistribution of wealth from new participants to earlier participants. Charles Ponzi was a 1920s swindler who took investors with the scheme that bears his name.

Lending Standards in the Subprime Mortgage Market

The combination of historically low interest and active government to extend credit who could walk and talk, the subprime mortgage market experienced rapid growth during the period 2000-2006. A recent International Monetary Fund study by Dell'Ariccia, Igan and Laeven present some compelling findings about the fuel of this growth. Subprime mortgage originations tripled over this period reaching $600 billion in 2006. As a percentage of all mortgage originations, subprime increased from 9% to 20% over this period. In 2006, the size of the subprime market was approximately $1.3 trillion. They also examine the relationship between credit standards and mortgage lending growth. The following conclusions emerge from their analysis: (1) lending standards declined more in areas where the growth in lending was highest; (2) lower leanding were associated with areas that experienced faster house price appreciation; (3) lending standards declined in areas where large and aggressive lenders entered the market; (4) lending standards declined more in regions where a larger proportion of the lender's loan portfolio is sold to third parties (e.g., securitization); and (5) the deterioration of lending standards was more pronounced in the subprime mortgage market.

Should We Bailout the Automakers?

Do I have a deal for you! Suppose I fly you to Las Vegas in a Gulfstream 650 with all the comforts of home. You gamble for a week. Anything you win you get to keep and I will make up of losses. Do you think these terms are going to affect your behavior? I wonder... Government bailouts alter the incentives to take risk in the same way. When firms take risks and perform poorly, they should fail and be forced into bankruptcy. Bankruptcy is not tantamount to death. Think of bankruptcy as change. The assets are still there. The employees are still there. Bankruptcy is a vehicle to transform corporations from one form into another. Bailouts will only delay the change that will happen eventually any way and it will cost the taxpayers a bundle in the process. The Greek philosopher Hermicles said "Through change one finds purpose." Now is the time for the US automakers to find their purpose.

The Fixed-income Experience

This blog will showcase the musings of a bona fide fixed-income junkie. With the greatest financial crisis of our generation in full swing, this seems like the perfect time to start. In the words of the late Dr. Hunter S. Thompson,"Buy the ticket. Take the ride."