Wednesday, September 17, 2008

The Pyramid Scheme

On Monday night on the TV program “Charlie Rose”, the economist Nouriel Roubini said of the current financial crisis:

The only light at the end of the tunnel is the one of the incoming train wreck”

A few hours after this statement, one of the world’s largest companies, AIG, was nationalized by the U.S. government. The bankruptcy of Lehman Brothers was the biggest bankruptcy in history. This morning, it seems that Morgan Stanley is also facing only two options - bankruptcy or merger. The amount of money being spent on this crisis by the U.S. government is now nearing 1 trillion dollars, and this comes at a time when the U.S. government has enormous debts and deficits itself, while very little tax money is coming in on the federal and state level. The Fed keeps lowering interest rates, which will inevitably lead to more inflation, while U.S. workers’ wages have been declining for decades. Hundreds of thousands of people have already lost their jobs in the wake of this crisis, and those unfortunate people have no social safety net to fall back on, as their counterparts in the rest of the western world do, resulting simply in poverty and suffering.

It is very difficult to grasp the true problems behind this crisis, but I believe that it can be summed up the following way:


“Financial innovation” is what it has been called over the last 10 years, and that has involved things such as sub-prime mortgages, CDO:s and CDO:s squared. I’m not even going to go into what these things mean exactly, but they are very complex financial products that have the same basic problem: they cannot be valued. It is very important to value assets correctly for the entire economy. If you are going to buy a stock or a mutual fund, you must know what it is comprised of; what the money is buying. How else are you going to be able to figure out whether it’s a good or a bad idea to buy it? These products called CDO:s (Collateralized Debt Obligations), are very much like forged jewelry. They are made to look like something they’re not.

What Lehman Brothers, Bear Sterns and many other institutions which will soon fail did, was to make it seem as if their products were solid investments, when in fact the investment depended on the repayment of hundreds of thousands of sub-prime mortgages. In other words, if some poor unfortunate person in Cleveland was unable to pay his or her mortgage, the investment that someone had made in Lehman Brothers became less worth. To realize the magnitude of this, you must know that, up until recently, that person could get a mortgage with: no job, no savings, no ID, no nothing! Would you lend someone like that 200,000 dollars? If not, you should also not invest any money in a Lehman Brothers mutual fund…

Meanwhile, it looked on the surface as if Lehman Brothers was doing great, because they had a so-called triple-A credit rating. On Wall Street this means that the company is doing very well. The agencies who was responsible for the rating (Moody’s, S&P) was supposed to go over all the investments that Lehman Brothers had. They did not. The agencies have said (to the New York Times) that there was no way that they could spend the time it would take to go through all these mortgages that made up a Lehman Brothers mutual fund, and hence they did not do it. So what good is the rating? Well, not good at all. What good is a grade from a teacher when it comes out that the teacher never reads the students’ essays or corrects their tests? In addition, Lehman Brothers (and all other companies who have ratings) are paying the ratings agencies in order to get the rating. What good is a grade from a teacher to whom you have paid money to receive the grade? As you can see, this is all a big joke, and worse yet, a bona-fide scheme. This is the structure of the pyramid:



[Pension Funds] [Hedge Funds]

[Individuals] [Individuals] [Individuals]

More specifically, the current situation is a result of a giant, classic pyramid scheme, where the people at the top benefit, then pull out, and the whole thing crumbles. Only this time, the pyramid is built on the foundation of the entire U.S. financial system. Again turning to Lehman Brothers as an example: in a pyramid scheme, the people at the top are selling some kind of questionable product. In this example it’s a Lehman Brothers mutual fund. Everybody starts getting into it because it seems that easy money can be made quickly. Money then pours in from, for example, banks, hedge funds, private individuals and those individuals’ pension funds. Some money trickles down the pyramid, but most of it stays at the top, in this case in the form of dividends, profits and bonuses for those at the very top at Lehman Brothers. The top individuals cannot sell their own stocks in the company, however, because that would alert the public of the scheme. When the pyramid crumbles, all those who are not at the top are left with nothing, which is what happened on Monday this week.

In order to keep the scheme going, profits needed to grow each year. That was helped by the housing market, where the price of housing kept going up, but Lehman Brothers was able to amplify and further inflate their profits by investing much, much more money that they had borrowed from other institutions. Now, investing money that you have borrowed is very risky, because if you lose the investment you’re still stuck with the loan plus interest. This happened to Lehman Brothers on a massive scale - they had 30 times more borrowed money invested than they had in assets.

In all pyramid schemes, people eventually find out that it’s fraudulent. In the case of Lehman, that happened last week. Everyone realized that what Lehman was selling was worthless, and everything came crashing down. The implications of this are vast, because people are slowly starting to realize that the scheme has spread throughout the economy, and throughout the world. Wall Street is desperately trying to hide this fact at present, and is trying to come up with a million reasons why everyone should keep investing in the stock market. Believe me: things are much worse than people in the financial industry are trying to tell you. If they admitted how bad things really were, we would immediately have a stock market crash. I think that will come pretty soon anyway, but as of now, Wall street investors are trying to sell as little as possible, and “hold steady” so that panic will not spread. It’s a miracle that we haven’t had a stock market crash yet, and it’s all due to the smoke and mirrors that Wall Street is putting up.

In New York City, the belief in Wall Street is very much like a religion. This past winter, I succumbed to a cigarette outside of a bowling alley in Manhattan. A man came up to me and asked for a light, and he told me he worked for Bear Sterns. I asked him what he thought of the financial crisis, and he responded with a phrase that I have heard countless times before and after this encounter. He told me:

- Everything will be fine.

When there is no rational reason to believe in something, the mind instinctively turns to faith. That is, after all, the essence of faith as an occurrence. The “everything will be fine” phrase has become the “amen” of the slowly disappearing ranks of Wall Street workers that until so recently dominated the cultural landscape of Manhattan.

1 comment:

steve said...

This is a very helpful description. Thanks for taking the time to write it.