Bernard Madoff meet Charles Ponzi

Earning enough for retirement requires a long term commitment and regular saving. As an alternative, America has a variety of get rich quick schemes, the most famous of which belongs to Charles Ponzi. His scheme dates from 1920 and even though his was not the first, and definitely not the last, he continues to be an American icon for get rich schemes.

Ponzi’s modus operandi called for three separate transactionsin two countries to buy stamps at a low price to resell at a higher price. By international agreement a foreign national could send a letter to an American using their foreign stamp and for the price of a foreign stamp also buy a Postal Reply Coupon to enclose with their mailing. The American receiving the letter could exchange the postal reply coupon for an American stamp to make a return mailing.

Ponzi noticed that he could have a foreign national send him letters with postal reply coupons: the first transaction. Then he could exchange the coupon for an American stamp: the second transaction. Then he could re-sell the American stamp to an American: the third transaction.

He claimed he could earn a 400 percent return, which was technically correct. American stamps were two cents. If you buy a foreign stamp for a half cent and resell it for two cents you have a 400 percent return. However, it is lots of work to earn 1.5 cents. Earning just a dollar requires 66 of the above mentioned three transaction cycles.

Never mind though, Mr. Ponzi formed the Securities Exchange Company and began luring “investors” by selling vouchers for $1,000, which had a written promise to pay investors $1,500 in 90 days.

Beginning in February 1920 investors started buying the vouchers. At first only a few, but the pace picked up in just a few months. As the early vouchers came due Mr. Ponzi made payoffs with the money from new investors.

It was the early payoffs that brought in more investors until by July 1920 reports indicate he had sold hundreds of thousands of dollars in vouchers. The scheme collapsed after 6 or 7 months because continued payoffs require ever increasing investors to keep up.

Money paid was described as income, but payoffs were actually a distribution of other people’s money. In popular lore, any investment that pays early investors from the capital of latter investors is a Ponzi scheme.

This fall’s bad news in the sub-prime mortgage market was a failure of people who were reckless and irresponsible. The current news about Bernard Madoff is worse because his Ponzi scheme, like all Ponzi schemes, requires fraud.

Charles Ponzi’s investors look foolish expecting a 400 percent return from postal coupons. Mr. Madoff had better disguise, but the Securities Exchange Commission was notified of irregularities, which they did investigate. A serious investigation will detect the payout of capital funds. We will hope their failed detection was just incompetence, but Mr. Madoff, gives the strongest message yet this fall that America needs better regulation of financial markets.

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T-Bills

Back on September 25th the Wall Street Journal published an article about nervous investors who were buying low yield, short term U.S. Treasury Bills as safe securities. [Demand for Short-Term Treasury Debt Puts a Crimp in World-Wide Supply, wsj, 9/25/08]

I remembered that because I just read another article about nervous investors buying government securities at low yields, under 1 percent. This time it is the Washington Post writing about the low yield U.S. Treasury bonds and declaring that "it’s terrible news for the economy, which relies on people’s willingness to invest and lend money." [Flight to U.S. Treasury Bonds Bad News for Economy, Wash Post, 12/2/08]

Others in the financial world are quoted. One said “The simplest way to think about this is that nobody wants to hold any risky assets.” Another said, "You can cut rates all you want, but if nobody wants to take risk, no matter how attractive an investment seems to be, no one will put up the capital for it."

But wait a minute. Buying government bonds is investing and lending money. Consider the wreckage of the last few months after a decade of mortgage lenders making billions of sub prime mortgage loans. Investment houses like Bear-Stearns and Lehman Brothers risked billions of America’s loanable funds, our savings, speculating with sub prime mortgages, but our savings did nothing except give them a chance to resell financial assets at a higher price.

Our savings could have helped fund our massive Federal deficit. Instead we owe foreign nationals who bought U.S. Treasury Bills and Bonds while Americans were on a speculative spree buying up risky assets that have failed by the billion. We want our savings to fund the production of long lived assets and valuable services. The private sector has failed to do that lately.

Government bonds earned 4 to 5 percent interest for the last 10 years. If we had invested more in the government and government had used our savings and rebuilt New Orleans we would have something to show for it and thousands of jobs in the process.

The past decade has proved in the most decisive fashion that American’s are ready to take risks and to lend and invest money, but there is nothing that makes private lending and private debt better that public lending and public debt. It all depends on the assets we buy. Remember one rule: it is not who invests, but in what.

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Credit Deployment

A recent headline from Wednesday, November 26th in the Washington Post reads “U.S. Moves to Revive Consumer Spending.” The first line of the article tells readers “The government said yesterday that it will deploy up to $800 billion to make it cheaper for Americans to get a home mortgage, take out a car loan or borrow money through a credit card . . .”

The word “deploy” has never been a financial term in my memory. Troops get deployed, but money is typically saved or spent. Dollars need to be spent rather than deployed to revive the economy so the article’s quote of the word deploy tells us the government knows Americans are short of more solid sources of money to spend: wages, salaries and savings. Instead they apparently hope consumers will return to their usual excess and borrow.

Spending our way to prosperity was the policy of Franklin Roosevelt in the 1930’s and every president since, but a policy that deploys dollars for consumer loans differs from previous expansionary policies.

Will it work? As a saver I believe there are many other savers like me who have matched percentage payments into defined contribution pension plans and 401(k) plans as well as other purchases of CD’s, stocks and bonds. This fall’s stock market and interest rate drops have caused a massive decline in purchasing power for this group.

As savers in a good economy we were the least likely to use consumer loans, or abuse consumer credit. In a bad economy, it is hard to think savers will be the ones most likely to resort to consumer borrowing. We are the group more able to postpone discretionary purchases like cars, clothes, electronics and vacations.

For the many others who defaulted on sub prime loans and continue to struggle to pay credit card balances it is hard to believe the government’s plan will find them ready and able to borrow more and spend us out of recession.

Recession appears likely with Gross Domestic Product down last quarter (3 Months) and revised figures due shortly. When our government stops talking about consumer loans and starts discussing tax policy and the Federal Budget, there will be good reason for hope. If all they want to do is "deploy" consumer credit, expect another quarter of decline.

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Credit Ratings

Many savers with a 401(k) or other investment account are probably familiar with the Standard & Poors, Moody’s or other credit rating firms. Monthly statements usually include their ratings alongside a list of assets.

Lately though the credit rating firms have admitted to Congress [Washington Post, Credit-Rating Firms Grilled Over Conflicts, October 23, 2008] their ratings have been tainted by conflict of interest. Moody’s and Standard & Poors are paid by the firms they rate. The article quoted a memo written at Standard & Poors by someone who said "Let’s hope we are all wealthy and retired by the time this house of cards falters."

Long before I read that anonymous statement I wondered about credit ratings and whether they are good guides for savers and investors. Credit rating firms use past performance to rate future risk.

Forecasting the conditions in markets years ahead is hard enough but the current wave of defaults on mortgage backed securities has spread to other firms in a domino effect. The good management and triple A rating at one firm can be affected by defaults at other firms. Ratings cannot be given in isolation from the solvency of the larger financial system.

Since a bond is an enforceable contract just like a home mortgage, it is worth asking whether a failure to pay interest and principal on time is the important financial risk. As long as a defaulting institution remains after a default, then late payments can be recovered later.

For example, corporate bond holders risk losing interest and principal in a default, but a corporation can literally disappear in a bankruptcy. Cities, counties and states do not disappear. Even if they go into default they continue to have taxing authority to meet their legal pledge of full faith and credit to pay their bond obligations.

Furthermore, city and county governments are created and governed by state legislation, which makes state government responsible for city and country bond payments in the event of their default.

Following this logic, even small municipalities should have higher credit ratings than private sector corporations. Size and name recognition should not matter in credit ratings and the difference of market interest rates between government and corporate bonds may not reflect actual differences of risk. Remember too non-federal government bonds and bond funds are not taxed as part of income.

The article did not tell readers if Congress wants to impose professional standards, or what if anything it intends to do about this newly reported conflict of interest. In the mean time, remember governments are likely to be around to pay their bills.

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Circuit City Jobs

Circuit City is back in the news [Washington Post, November 6, 2008] with plans to close 155 stores and layoff thousands in bankruptcy reorganization. I say back in the news because there was an article about Circuit City in the Washington Post back on March 29, 2007 titled “Circuit City Cuts 3,400 ‘Overpaid’ Workers.”

The cuts came out of 40,000 in store jobs, or 9 percent of the company’s in store workforce. The firings were not related to job performance the company announced, but came as part of an effort to cut costs and improve the bottom line.

They were going to save on labor costs we learn later in the article by firing their “overpaid” staff and rehiring new sales people at lower wages. That may sound like a way to save money, but now, 18 months later, there is good reason to doubt they saved any money.

Circuit City is part of retail trade in a sector called Electronics and Appliance Stores where salesmanship is important. Circuit City buyers may need to learn about complicated electronic products and how they work before they make up their mind. Retail Salespersons do selling, which means explaining and demonstrating products, answering questions, knowing warranty terms or other product information.

In other retail sectors like gasoline stations and grocery stores, selling and salesmanship are not as important. People know if their gas tank is empty and they buy their pasta and potatoes from a cashier, not a salesperson. Explaining and selling takes time, skill and experience and so more and better paid retail sales jobs are needed at electronic and appliance stores than gasoline stations or grocery stores.

The need for salesmanship is partly reflected in staffing where retail salespersons and their supervisors make up more than 40 percent of retail jobs. Staffing at gasoline stations contrasts with electronics and appliance stores where more than 60 percent of jobs are cashier, but virtually none are retail salespersons.

The Washington Post article back in March 2007 informed readers that Circuit City dismissed their sales staff earning wages over of $15.50 an hour, or their most experienced and longest tenured sales staff.

We can be sure Circuit City management saved on wages, but wage savings are not cost savings unless they lower costs per dollar of sales. Ignoring productivity tells us that Circuit City management did not know the meaning of overpaid, or even how to save.

True, the economy is doing poorly now, which is probably part of Circuit City problems, but as the saying goes, “They were penny wise and pound foolish.”

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Mr. Greenspan Talks

The caption in the Washington Post reads “Greenspan Says He Was Wrong on Regulation.” [WP, Oct. 24, 2008] The former Federal Reserve Board Chairman told Congressional Committee members the “… crisis has shaken his very understanding of how markets work, and agreed that certain financial derivatives should be regulated – an idea he long resisted.”

After his opening comments to the committee Mr. Greenspan argues against regulation and warns Congress that regulation is a threat to economic growth, despite the collapse of derivatives markets this fall.

Greenspan worships free markets so much he forgets that free markets and regulation work together all the time. Take physicians. Physicians are regulated because they have to go to medical school and get a license before they practice medicine. Across America biology students dissect frogs, but without that licensing regulation any one of them could decide they know anatomy so well they can be surgeons, ready to do surgery on you and me.

Regulating doctors lets us be confident they are competent to be physicians; without regulation many would suffer before word got out and free markets acted to eliminate incompetent physicians.

Free markets need equal opportunity and they operate best when we know what we are getting. Regulations requiring equal opportunity, disclosure, honesty and integrity aide and promote the smooth operation of financial markets just as they do in physicians markets.

Remember banks and all financial intermediaries operate with one purpose: to attract the funds of net savers so the savings can be returned to the spending stream by loans to net borrowers. For many years savings accounts, certificates of deposit, stocks, bonds and mutual funds have served the millions in America who save.

Unless Mr. Greenspan will explain what unregulated derivatives can do for America’s economy, which are beyond the established and regulated methods of saving and investing, then we can feel justified that he is arguing against disclosure, honesty, and integrity essential in financial markets.

After the collapse of derivatives markets, and then financial markets, further opposition to regulatory standards gets close to defending secrecy and deception. We would like to think better of Mr. Greenspan, but given his testimony he is making it hard.

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1929 meet 2008

There are many comparisons in recent newspapers between the crash of 1929 and the crisis of 2008. The media of today has not settled on a consistent title for America’s current events but “Crisis” appears to be the most common caption among the newspapers I see.

Many books and articles have been published on the stock market crash of 1929, but one book in particular stands out as short, only 197 pages, readable and relevant for today’s debacle. It is The Great Crash, by John Kenneth Galbraith.

After using newspaper and other accounts he describes what happened in journalistic fashion with a final chapter titled Causes and Consequence. The first cause on his numbered list is “The Bad Distribution of Income.”

Allow me a brief quote.

In 1929 the rich were indubitably rich. … The proportion of personal income received in the form of interest, dividends and rent – the income broadly speaking of the well-to-do – was about twice as great as in the years following the Second World War.

This high unequal distribution of income meant that the economy was dependent on a high level of investment or a high level of luxury spending or both. The rich cannot buy great quantities of bread. If they are to dispose of what they receive it must be on luxuries or by way of investment in new plants and new projects.

Mr. Galbraith was writing 50 years ago about events of nearly 80 years ago, but it is helpful for man of his distinction to confirm what is the underlying cause of America’s crash of 2008: the bad distribution of income.

The growing inequality of income is well documented in the Federal government’s publication of the Current Population Survey. In their table of Selected Measures of Household Income Dispersion the highest 10 Percent of household income continue to gain income share year by year on the bottom 10 percent, but also the bottom 20, 50 and 80 percent of households.

The wealthy pay the same price for bread, eggs and milk as everybody else which is why they have extra money to speculate in Wall Street’s new and exotic investment derivatives: hedge funds, collateralized debt obligations, mortgage and asset backed securities, principal only strips, credit default swaps and so on.

In the mean time heavily taxed wages are going up slowly, but not as fast as prices, a reality documented by the Bureau of Labor Statistics. More of us are reaching credit card limits and home equity loan limits. Refinancing mortgages for cash, or lower interest rates, did provide a boast to buying power, but these too are running low.

A mass society needs mass participation, which the unequal distribution of income limits. The crisis of 2008 tells us the wealthy have failed to return their savings and tax cuts back into the economy in a constructive way to create long lived assets and jobs. They have failed themselves and the country. It is time for the wealthy to pay more tax.

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