In a World of Nested Ponzi Schemes – Can we all Plead Insanity?

The latest twist in Bernard Madoff’s $50-billion dollar ponzi scheme sideshow is the rumor that Bernie’s legal team will have him plead insanity, claiming that he had some kind of mental break or suffers from a serious psychological disorder.  Given the age of  Madoff’s operation, my guess is that he started out with good intentions and slowly drifted into ponzi mode to maintain his self image as a respected and admired investment advisor – the guy you could only get to via invitation.  Only in the perfect redemption storm of 2008 would Bernie’s grand self delusion finally come to an end.
As Warren Buffet is fond of saying, “when the tide goes out we see who is swimming naked”.  In 2008, much was revealed and it seems that Bernard Madoff was just one of the smaller dolls in a world of nested ponzi schemes.  I sometimes feel as if we are collectively working our way out of the center of a Russian matryoshka or set nesting dolls.

At the core we have Madoff and probably a score of other financial wizards that the lowered tides have yet to reveal.  Next we have Wall Street itself, a casino of questionable securitized debt and 100’s of trillions of dollars of derivative side bets hypothetically backstopped by over-leveraged counter parties.  Then we have the U.S. economy — a debtor nation house of cards inhabited by consumers at the end of their credit line.
Coming to the rescue is the U.S. Government teetering on the edge of default.  Our massive debt funded by foreign purchasers of U.S. Treasuries is a ponzi scheme on its last legs.  In 2007, public debt in the U.S. was $10.6 trillion dollars or 77% of GDP.  In 2008, the percentage of debt to GDP has grown to over 100% and that excludes the liabilities of Medicaid, Medicare, and Social Security.  Given our current debt to GDP ratio the U.S. would not even qualify for admission to the EU.
However the final doll in our matryoshka of ponzi schemes is the belief that our world population and economy can grow forever in the closed ecological system of planet earth, and yet central banks and governments around the world are desperately trying to “jump start” the economy and get us back into growth mode.
So I wonder — will we all end up pleading insanity — and to whom?

Only after the last tree has been cut down.
Only after the last river has been poisoned.
Only after the last fish has been caught.
Only then will you find that money cannot be eaten.
Cree Indian Prophecy

From Nouriel Roubini of the RGE Monitor on March 11, 2009:

A reporter contacted  today with the following question:

“I am a reporter and I am doing a story on Bernard Madoff’s life after pleading guilty. As part of this I was wondering if you could comment on what significance he will have in the history of this period. Will he represent more than a scamster who stole a lot of money from a lot of people? As Bernie Ebbers and Ken Lay came to embody corporate greed and deceit, what will Madoff symbolize? I would really appreciate your insights on this”.

Here is my answer fleshed out in full:

Americans lived in a Made-off and Ponzi bubble economy for a decade or even longer. Madoff is the mirror of the American economy and of its overleveraged agents: a house of cards of leverage over leverage by households, financial firms and corporations that has now gone bust.

When you put zero down on your home and you thus have no equity in your home your leverage is literally infinite and you are playing a Ponzi game.

And the bank that lent you with zero down, a NINJA (no income, no jobs and assets) liar loan that was interest only for a while with negative amortization and an initial teaser rate was also playing a Ponzi game.

And private equity firms that did over a $1 trillion of LBOs in the last few years with debt to earnings ratio of 10 or above were also Ponzi firms playing a Ponzi game.

A government that will issue trillions of dollars of new debt to pay for this severe recession and to socialize private losses may risk to become a Ponzi government if – in the medium term – does not return to fiscal discipline and debt sustainability.

A country that has – for over 25 years – spent more than income and thus run an endless string of current account deficit and has thus become the largest net foreign debtor in the world (with net foreign liabilities that are likely to be over $3 trillion by the end of this year) is also a Ponzi country that may eventually default on its foreign debt if it does not – over time – tighten its belt and start running smaller current account deficits and actual trade surpluses.

Whenever you persistently consume more than your income year after year (a household with negative savings, a government with budget deficit, a firm or financial institution with persistent losses, a country with a current account deficit) you are playing a Ponzi game; in the jargon of formal economics you are not satisfying your long run intertemporal budget constraint as you borrow to finance the interest rate on your previous debt and you are thus following an unsustainable debt dynamics (discounted value of your debt growing without limit in NPV terms as the debt grows faster than the interest rate on it) that eventually leads to outright insolvency.

According to Minsky and according to economic theory Ponzi agents (households, firms, banks) are those who need to borrow more to repay both principal and interest on their previous debt; i.e. Minsky’s “Ponzi borrowers” cannot service neither interest or principal payments on their debts. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.

By this standard media US households whose debt relative to income went from 65 percent 15 years ago to 100 percent in 2000 to 135 percent today were playing a Ponzi game.

And an economy where the total debt to GDP ratio (of households, financial firms and corporations) is now 350 percent was a Made-Off Ponzi economy. And now that home values have fallen 20% and they will fall another 20% before they bottom out and now that equity prices have fallen over 50% (and may fall further) using homes as an ATM machine and borrowing against it to finance Ponzi consumption is not feasible any more. The party is over for households, banks and non-bank highly leveraged corporations.

The bursting of the housing bubble and of the equity bubble and hedge funds bubble and private equity bubble showed that most of the “wealth” that supported the massive leverage and overspending of agents in the economy was a fake bubble-driven wealth; now that these bubble have burst it is clear that the emperor had no clothes and that we are the naked emperor. A rising bubble tide was hiding the fact that most Americans and their banks were swimming naked; and the bursting of the bubble is the low tide that shows who was naked.

Madoff may now spend the rest of his life in prison. The US household and financial and non financial firms and government may spend the next generation in debtor’s prison having to tighten their belts to pay for the losses inflicted by a decade or more of reckless leverage, over consumption and risk taking.
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