## Monday, February 23, 2009

### The Real Ponzi Scheme

The emergence of the Bernie Madoff financial flim-flam has people pointing to “Ponzi schemes” once again, especially as we now know Madoff made no genuine bond or stock purchases. However, when they try to use the term against Social Security, suggesting it is a “government Ponzi scheme’ they are comparing chalk and cheese.

The reason is that the 1935 Social Security law was out front in terms of how it would be funded: from current workers to current beneficiaries. (See also Michael A. Hiltzik’s ‘The Plot Against Social Security’). This is understood from the get go.

Now, forget the Madoff ruse and think of Wall Street in general, and specifically stock investments. It can be shown that they are the complete embodiment of a classical Ponzi scheme.

Consider: Company XYZ goes public and issues 10 million shares of stock to 2 million people, for \$50 a share. The market capitalization here is therefore \$500 million. The 2 million shareholders own variable amounts-shares, but all are priced at the stock issuance rate of \$5.

Now, one particular person - Joe Schmoe - has bought 100 shares of XYZ, and so at the outset he owns \$5,000 worth. Each month he buys a further 5 shares a month via “dollar cost averaging” and so invests \$250 a month, or \$3,000 a year..

After ten years, he’s plowed \$30,000 in, and owns 596 more shares, with the share price of XYZ going up to \$250 the last month of the 10th year.

After this final month, his total paper worth is 696 x \$250 = \$174,000.

This again is his paper worth, while he has actually put in \$35,000.

So also, each XYZ investor has reaped 4.97 x more than the actual money invested. The total paper wealth has thus increased to:

4.97 x \$500 million = \$2, 485, 000, 000

The question becomes: What happens if ALL 2 million investors sense a crash coming and want to cash out their shares on the same day? How much would each receive on average?

This average cashout can easily be computed and works out to just \$1,243 each.

This simple computation discloses that stocks and their managers prevail only by betting stock holders will not all redeem shares on the exact same day. For them to do so would be disastrous, because the company’s actual market capitalization would not support such a payout. There is simply not enough money to give all share holders what their paper profits indicate. If this isn’t a “Ponzi scheme’ I don’t know what is!

What this spread means, in concrete terms, is that when stock prices rapidly inflate most of what appears on paper is phantom money, not real money. By the same token, most of what disappears in a market crash is phantom money.

Joe Schmoe similarly, may be elated at beholding a \$174,000 balance after his 10th year of holding XYZ stock, but he needs to understand that the bulk of this:

\$174,000 - \$35,000 = \$139, 000

is phantom money.

By the same token, if the following month the share prices collapses back to \$5, Joe has not lost \$139, 250 but only the money he actually put in up to THAT point, or \$35,250.

In a recent PARADE column (Feb. 22), Marilyn vos Savant - the magazine’s resident genius - dealt with a question related to this, which asked about investors recently losing a large amount of money and where did it go?

Her correct answer was “much of the lost money never existed”.

As we see from the illustration I gave, this is exactly true. The bulk of Joe’s money was certainly not his to lose. It merely existed temporarily in virtual or paper space. It had been subjected to what we call "asset inflation" via uptick in share price, not having more actual money.

Now, if he had the prescience and boldness to act in time, it is true he would have collected it (minus capital gains taxes). But the chances of this were actually very slim: about ½ of 1 percent of investors do a maximally profitable cashout, without any benefit of advance knowledge.

The bottom line here is that if all shareholders demanded their paper worth at the highest share price, they’d likely not get it, since it would bankrupt most companies. The real Ponzi scheme here is Wall Street’s stock scheme.

Despite this, one still sees egregious advice being given to little guys, such as ‘Keeping Your Financial Plans Afloat’ in the current U.S. News and World Report (march, p. 65) wherein it is noted that financial advisers still recommend that retirees “maintain a significant proportion exposure to stocks” But what would one assume a FA to say? Not to do so? He would soon be out of work!

The article is honest enough to go on to say:

But investors who followed this advice are now suffering the steepest losses

Indeed, and this will continue to happen for YEARS – perhaps even decades, as long as they remain in the market. The reason (as I noted in a previous article from last year) is that \$55 trillion in credit default swaps locked in banks has still to unwind. Those who are realists believe this unwinding will continue asset deflation for a long time. Those Pollyannas who anticipate a quick “capitulation” and back toward the 10,000 DOW days of yore are in for a brutal shock as their nest eggs shrink to nothing.

The further advice (or warning) in the U.S. News piece to the effect that “Still, avoiding the stock market completely means you nest egg may not stay ahead of inflation” is not a reason to place 50% or more in stocks, or even 20%. What one must do, rather, as Vicki Robins and Joe Dominguez noted (in ‘Your Money or Your Life’) is to re-evaluate one’s spending and drop those items which are the most inflation prone in so far as possible. But risking major loss to a market Ponzi scheme is no better than playing the craps tables in Vegas.

The other interesting article in the U.S. News special finance issue was by Katy Marquardt, ‘Time to Buy Stocks or a House’ wherein she notes how people are still being advised to pass over home mortgage payouts for stock investment. According to one finance hotshot, Richard Moody – chief economist at Mission Residential:

“you always hear that owning a home is the best way to build wealth but in terms of returns it’s not that great an investment”

However, as we already saw, returns are mostly imaginary (on paper) anyway. Only a tiny percentage of stock investors actually manage to reap the high returns. Most ‘buy and HOLD’ and get incinerated later by crashes, corrections and bear markets in the process. Whereupon they must proceed to “square one”, work longer, and start all over. When will they ever learn? Maybe never.

And besides, in the stock Ponzi scheme there isn’t enough money to pay out all investors in the event they all wanted to cash out at once. So it is mostly flim-flam sold to those susceptible to the ploys, pleas and PR of finance hacks.

Fortunately, Marquardt gives the exactly appropriate response to Moody’s drumbeating:

Stocks seem like a simpler choice, but buying a house guarantees a huge return for me – even if it’s not financial”.

But who cares, given the financial returns of stocks are mostly smoke and mirrors for the few. (Or people, like Warren Buffet, who can afford to be wrong on when they guess the market’s capitulation to occur. Bottom line, what Buffet does or not with his billions is totally irrelevant to what investors with tiny sums of precious nest eggs and savings do.)

One final parting shot to take is at Pat Toomey, CEO of club for Growth in the same issue (p. 18, ‘Use the Free Market’) . This fool once again embraces and recommends private accounts to save Social Security and “entitlements” (a right wing buzz word if ever there was one) once and for all. But it is false, a false solution. The current market crash, with no end in sight and the DOW melting lower each day, shows personal accounts are not viable. A better solution is for the FICA income limit to be raised past \$250,000 as Obama proposed during his campaign.

Toomey is even more whacked in the head when, instead of Medicare for oldsters, he alternatively proposes “accumulated savings used to purchase a health care policy at retirement”

Yes, Mr. Toomey, and please tell me WHO is going to provide such a policy to any but the most healthy and wealthy seniors? As it is, most 62- 64 year old people can’t beg, borrow or steal a policy even if they have the money. The insurance companies aren’t inclined to insure anyone over 55. If you think an over-65 person will have an easier time, you are dreaming, live on another planet, or …..detached from all modes of existing health care reality in this country.