May242010

Go Ponzi, young debtor! Managing finances the California way

Borrowers bow down before their lenders. Borrowers give up control of their own lives when they take on debt as their time and effort go toward paying for the past rather than investing for the future. Borrowing is a weakness, a crushing weight, a debilitating pile of paper detailing a life of servitude in exchange for a borrower’s entitlements.

Of course, most borrowers don’t see it that way. They feel powerful. Borrowers believe they are rich because someone was willing to loan them money. The more money people borrow, the stronger they feel and the weaker they get. Ponzi Schemes of debt are the highest form of borrower sophistication and financial management. These structures take borrowers to the heights of borrower power and the depths of borrower weakness.

you_will_serve_me

 

What is a Ponzi Scheme?

The first Ponzi Scheme was the brainchild of Charles Ponzi from whom we get the name. From Wikipedia:

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

The term “Ponzi scheme” is a widely known description of any scam that pays early investors returns from the investments of later investors. He promised clients a 50% profit within 45 days, or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeeming them at face value in the United States as a form of arbitrage. Ponzi was probably inspired by the scheme of William F. Miller, a Brooklyn bookkeeper who in 1899 used the same scheme to take in $1 million.

Ponzi Schemes remind us that greed is not good and that unfettered capitalism leads not to unlimited prosperity but to the creation of dangerous paper tigers.

Ponzi Schemes of debt

A Ponzi Scheme is any investment where the returns come not from the investment but from the capital contributions of new investors. If you change the terms slightly, a Ponzi Scheme is also any debt where the payment of debt comes not from wage income but from borrowed money from new lenders.boiling_debt_oil

The Ponzi Scheme embedded in the housing bubble was relatively easy to spot from a lending perspective if lenders had bothered to look. Serial refinancing is a clear sign a borrower has gone Ponzi. A prudent lender would not extend credit to a borrower who increases their debt every year. That is an implosion waiting to happen. However, during the housing bubble, lenders did not care. They thought the risk was passed to someone else, so they turned a blind eye to the obvious and gave out free money.

Even now lenders seek to enable Ponzi borrowing. Lenders try to bring borrowers to a boiling point where the borrower is churned with fees and drained with interest. Borrowers learn to tread water in this boiling froth partially submerged for their entire working lives. It is hell on earth, in my opinion.

Going Ponzi

Going Ponzi often happens in stages. Ponzi is a slow seducer offering tempting pleasures; the devil in disguise. Each step into the trap of Ponzi offers rewards, but like the La Brea tar pits attracted predators to trapped prey, Ponzi puts a death grip on all who enter.

My revulsion toward debt comes from personal experience. I know the evils of debt first-hand.

I remember my first introduction to Ponzi. A brash young man in my real estate development program in college was a born entrepreneur. He mowed lawns for an entire summer to pay for an option contract on a piece of land for a small deal. He was the one who first suggested to me that I take the cash-advance checks from one credit card to pay another. I was floored. I was in my mid 20s, and it didn’t occur to me that I could do that. Since it came from an guy I perceived to be a finance genius, I thought it was a great and sophisticated financial management tool. But I didn’t jump in right away.

I remember my first taste of Ponzi. I was finishing my education when I embarked on a doomed entrepreneurial adventure. There was a six-month period where I was working many hours without pay as entrepreneurs do, and I didn’t work enough paying hours to cover my costs. When I considered my dilemma, the correct decision was to work more paying hours, but the decision I made was to go Ponzi.American_Dumbass

I remember my first comfort of Ponzi. That first month after going Ponzi, my stress level dropped significantly. I suddenly had all the money I needed to focus my efforts on starting a new business. Hell, I quit that stupid job at the computer lab. I had thousands of dollars before I reached my credit limit, and I wasn’t falling behind that quickly; besides, I was going to be rich soon. I was very peaceful.

I remember my first feeling of the sophistication of Ponzi. After a few months of juggling credit card bills, I came across the advanced technique of low-interest balance transfers. Since I was now accumulating and storing debt like I used to accumulate and store savings, I needed some new tools. Storing my debt on low-interest credit cards seemed like wise financial management. It was wise. I was a genius. I was as sophisticated as those cool people on TV who pull out their American Dumbass cards.

I remember my first worry about Ponzi. As the pile of debt grew, I began to feel the weight of Ponzi. When I first saw the event horizon of the abyss — the credit limit — a small twinge of regret and worry signaled my upcoming doom. It was a minor worry — easy to ignore. A quick glance at the remaining credit limits on the six other credit cards showed me I had nothing to worry about.

I remember feeling pwned by Ponzi. For many years, I learned to dance with Ponzi. My debt service was a manageable amount of my income, but it was a significant percentage that needed to go out each month. What made matters worse, there wasn’t much room in the budget to pay off the debt in a reasonable timeframe — or so I thought. I really didn’t want to give up my entitlements. Since paying off Ponzi seemed hopeless and painful, like many others, I chose to dance in the debt meat grinder.

I remember choosing not to live Ponzi. At some level, I knew I was carrying a crushing weight, but denial prevented me from doing anything about it. A small voice inside of me cried out, “enough.” I set my intention on purging Ponzi debt from my life. The decisions that followed both big and small were guided by my intention, and they lead me to a life without Ponzi debt.

I remember the freedom releasing Ponzi. I wish I had a great story of personal sacrifice, but I don’t. I received outside help, and thanks to the housing bubble, I found good paying work that enabled me to pay off a few remaining debts. Fortunately, I was disciplined enough from my fear of Ponzi to stop using credit at all. It is a healthy fear I carry with me to this day. Once I had purged Ponzi debt from my life, I freed up all of my income. I was losing no energy to the past. It is a wonderful feeling of freedom I enjoy to this day.

The Ponzi limit

Debts are supposed to be paid off. People forget that simple fact and take on debt as if it is something to be endlessly serviced. Those that embrace the debt-service mentality try to surf on the edge of the abyss.

Treading financial water occurs is when the amount a borrower pays toward principal on debt is matched by taking on new debt. When the amount of new debt exceeds the amount debt was paid down, particularly if debt was used to pay debt, the borrower is Ponzi borrowing. There is a point beyond which a borrower cannot pay down debts without continued borrowing, a point where the debt service exceeds the ability to income to support it. This is the dilemma of insolvency, and the brink of insolvency is the Ponzi limit.borrower_oblivion

Unfortunately, the Ponzi limit is fluid. Many borrowers creep up on the Ponzi limit without knowing it. Lenders often extend credit to borrowers beyond their ability to service it putting the sum of all credit lines beyond the Ponzi limit. Once borrowers cross this unseen threshold, lenders begin to raise the borrower’s interest rates and force them to Ponzi borrow in order to make ends meet. At that point, the borrower is insolvent, but ongoing Ponzi borrowing can mask that for a time.

Once borrowers have gone Ponzi, there is no hope — they can’t borrow their way out of debt, and they can’t afford to earn and pay their way out either. It is only a matter of time before insolvency leads to delinquency and forgiveness of debt usually through a bankruptcy.

The problem with the Great Housing Bubble is insolvency. Lenders underwrote too many loans for too much money. Borrowers everywhere are insolvent, and the main mechanism for curing real estate debt insolvency — foreclosure — is being shunned by our government, lenders and borrowers alike. Thus our government encourages useless loan modifications programs and lenders allow delinquent borrowers to squat. These are not solutions to the problem; these are avoidance mechanisms to prevent dealing with the problem. The debt must be purged.

The fate of Ponzis

The Ponzis have two options once they are insolvent: (1) find another borrower who will loan them money, or (2) experience the The Unceremonious Fall from Entitlement as their lifestyle expenses are reduced to their income level regardless of their needs and wants.

Ponzi borrowing is not sustainable. Once borrowers cross the Ponzi limit, they will financially implode, and any lenders who extend credit to those borrowers will lose their money. Since lenders have so much money tied up in the Ponzis right now, they are working to expand the Ponzi scheme by getting the government involved as the bagholder for the bank’s Ponzi loans. The government and the central bank are the lenders and bagholders of last resort. It isn’t very likely private lenders will step forward to extend Ponzi loans any time soon. That leaves only one option for the Ponzis….

Unless Ponzis are given more debt, they will all succumb to the weight of their obligations. As each one exhausts their credit lines, bank losses will mount, and pressures on capital reserves will increase. Lenders will remain cautious and zombie-like. Since the spending of the Ponzis has become such a large part of our local and national economy, we may experience a long period of deflation similar to Japan as the Ponzis collapse. As I see it, we will not experience a robust economic recovery as long as the Ponzis keep their debts and banks keep pretending these Ponzis will pay them back.