Bernie Madoff took dishonestly about $50 billion from investors through a Ponzi scheme. A 20 times greater amount, about a trillion dollars, has been taken from naïve investors (both bank and non bank) who invested in subprime loans in a way which is as dishonest as the Madoff Ponzi scheme, at least in a moral sense. The only big difference between the two scams is that the Madoff scam we can blame on Madoff, but Subprime is the fault of the system. While no one individual is responsible for the Subprime problem, the general greed for profits led all the bankers to deceive themselves and their investors. Government must be held responsible for not having fundamental regulation to protect its banks and investors from the stupidity of the banks that promoted subprime.
First, let's look at the claim it is dishonest, at least morally. Subprime is a specific type of transaction more generally called CMO's (Collateralized Mortgage Obligations) and CDS (Credit Default Swaps). Subprime depended basically on brokers who did not care whether the borrower could pay his loan because they got paid their commission at closing, on banks that also did not care much whether the borrower could pay since the loan was being sold off, on packagers of loans who cut and sliced the packages of loans so that some could be called AAA rated loans (generally called CMO's). They paid credit rating companies to put triple A ratings which could not possibly be justified with any analysis of the underlying package of loans. Finally, they paid credit insurance companies to give guarantees (Credit Default Swaps) that they would cover any default when the credit insurance companies did not have the financial ability to pay if called on to pay. To make it even better, everyone seems to have had the idea that real estate prices would always go up. Finally, we even had President Bush saying all this was good because we were increasing housing without looking at the inevitable results. This is brilliantly shown on a YouTube video called "The Subprime Primer."
Let's compare the Madoff Ponzi scheme to the Subprime lending to see similarities. The Madoff scheme depended on:
- Exceptional financial results, even though they were unbelievable given serious analysis.
- A public explanation of how these results were obtained, even though experts said it could never work.
- Keeping everyone happy by consistently paying out money to previous investors with new investors' money.
- Having a lot of highly respected people saying this was a great investment.
The subprime followed all four of these rules.
- Financial Results: There was never a history of the returns. Financial institutions and their sales representatives told everyone that this was an exceptional investment. They talked about a piece of paper that is "triple A rated "and "guaranteed by insurance through Credit Default Swaps." While Madoff peddled dishonest results, here banks peddled a dishonest idea without any results.
- Public Explanation of the process: Salesmen only explained these were triple AAA rated investments "structured so that they could not fail." Furthermore, there was an insurance guarantee just in case. When it all fell apart, we naturally got the obvious truth that the so called protection never existed in reality. When the problem was obvious, Merrill Lynch (MER) sold these triple A rated bonds with insurance guarantees for 22 cents on the dollar and most people said the real value for Merrill was only 5 cents on the dollar. Madoff's explanation was no phonier than the banks explanation of the value of Subprime triple A rated with CDS guarantees.
- What kept the fraud going? While Madoff had to pay out early investors, this fraud did not even depend on really paying investors off. The only ones who really collected on this were the bankers who earned bonuses or a percent of the profits (which can be 40% of the transactions' profits) when these subprime loan packages were sold. The finance community had never made so much money on an idea like this. Who was going to say that it would not work? Here is a clear case that the personal greed of the bankers led to their own demise and that of their investors. Probably anyone that wanted to cut back on the system was probably told to shut up. As a former banker, I know the pressures put on people. "X bank is making all that money. What is wrong with you?" If you try to say it is a bad idea, most people get run over by the system. Years ago, former Fed Chairman Greenspan said that he trusted the bankers to protect their own interests. He recently said in congress that he made a terrible mistake in this assumption. And in this simple mistaken assumption, we see a root cause of the problem.
- Professional Opinion: The personal interest of bankers led them to tell all their investors that this is a splendid investment. In this case, the professional bankers did a 20 times greater disservice to themselves and their customers than all of the Madoff salesmen.
In summary, the Subprime issue has been a greater cause of loss for reasons that are very similar to the Madoff Ponzi scheme. While we do not have just one person to blame, as in the case of Madoff, the results of Subprime Scheme were essentially the same as the Madoff Ponzi scheme and the losses were far greater to the public than the Madoff scheme. The $50 billion loss of Madoff pails in front of the $1 trillion loss on subprime and the amounts lost by banks, municipalities, states, schools and other non bank investors is far greater than the Madoff $50 billion. To see a sample of the pain inflicted on innocent investors, see the "Subprime tragedy."
Policy footnote: Four issues result from this sad trillion dollar loss on subprime loans.
- The problem of subprime is bad credit, not a lack of liquidity in the banks. We cannot hope to fix the problems until we deal with the real problem of poor credit. The original hope of TARP was to create more liquidity in banks. This idea died stillborn and no money was spent on this erroneous solution to the problem.
- Now half of the TARP money has been spent on equity investments in the banks, with the hope that the recipient banks will lend the money to needy borrowers. The banks were stupid once with subprime, but they are not going to repeat the problem by lending again in the same terms. As a result, the TARP money is sitting in banks, being used for the purchase of other banks or being used for employee bonuses. In short, $350 billion has been spent without a productive benefit for needy US borrowers. There has been one short term benefit which the pressure of the banks going broke has been reduced, but this is only a temporary benefit.
- US Treasury recognized that Fannie Mae (FNM) and Freddie Mac (FRE) were near bankruptcy. The government intervened, changed the president and strengthened the indirect guarantee of the US government. But then nothing changed in terms of credit policy. Now they have trillions of dollars of assets and liabilities, but no capital. This "new" problem will be exploding at any moment. If you have a credit problem, you need to fix it. You cannot say the old management is bad and then continue to do the same thing.
- A new version of the subprime problem is on the horizon for 2009. While interest rate resets are slowing for existing subprime loans, 2009 will bring major interest rate resets for conventional mortgages for both housing and commercial real estate. There will be a whole new wave of loan failures of very major importance.
The subprime problem is better explained as a type of fraud than the popular version of reasons like liquidity in banks. Until public policy recognizes the true problem, which is fundamentally bad credit, we cannot hope to find practical solutions to our problems. Even pretending subprime is the problem condemns us to not learn from the problem. Bad credit, explained away by people who envision inordinate profits from the sale of these instruments, puts at risk our ability to correct these fundamental problems.
Disclosure: no stock positions.
