The Logic of Ponzi Finance

08/19/2011 11:09 am ET | Updated Oct 19, 2011
  • Micah Hauptman Financial Services Counsel, Consumer Federation of America

This post was co-authored by Dr. Eric Tymoigne and Micah Hauptman.

When you think of Ponzi schemes, fraudsters like Bernie Madoff come to mind. However,
Ponzi schemes are not always the result of a few crooks; they can also be a common practice used by society to create a short term economic growth spurt. But such a growth spurt is destined for failure. The mortgage finance industry and all that it affected -- at the heart of the financial crisis -- functioned as one such Ponzi scheme.

The core of Ponzi finance is not fraud; it is a scheme that rests on making payments on a financial contract by refinancing or selling assets based on the expectation that those assets' prices will rise indefinitely. But, in a Ponzi scheme, for asset prices to rise, there must be a continuing flow of new investors to boost demand. This financial scheme is not self-sustaining and when the flow of participation ends -- or to continue the analogy, new suckers stop buying in, the system crashes.

As the saying goes, "the bigger they are, the harder the fall," the longer a Ponzi scheme lasts and the deeper its impact, the greater the fallout is when it crashes.

This is because all of the unsound debt that accumulated when asset prices increased must be unwound; this can occur often painfully, as we have witnessed. Consequently, the temporary gains that are realized on the upside of a Ponzi scheme are wiped out in a flashflood on the downside.

During the housing bubble, a massive Ponzi finance scheme temporarily improved homeownership. Everyone played a role: bankers, homeowners, politicians and regulators all chose to ignore reality and believe that borrowing based on expected increases in house values was legitimate. After all, "house prices always go up."

Under this financial smokescreen, the mortgage finance industry granted loans on the basis of rising home prices rather than capacity to pay based on creditworthiness and income. Mortgage originators assured borrowers that because house prices would rise in perpetuity, houses were safe investments that would increase homeowners' equity. If borrowers were ever unable to pay their loans, they could merely refinance or sell their house at a profit. Everyone would win.

As more and more homebuyers were enticed into the market, demand was artificially boosted and house prices were inflated. Although mortgage originators quickly exhausted the limited supply of qualified borrowers, that didn't impede them. The money was just too good. They realized they could continue to generate new mortgage loans by becoming more creative with whom they loaned money to, and how those loans were configured.

Households of all income levels were enticed to take so called "low-cost" mortgages, mortgages that required low initial payments, but ballooned to unaffordable levels after a few years. This practice affected prime and subprime borrowers alike. Bankers also figured out ways to lure current borrowers with fixed rate mortgages to switch to the "low-cost" varieties. These types of mortgages skyrocketed in the mid-2000s. While they constituted less than five percent of mortgage origination between 2000 and 2002, they exploded to over twenty percent between 2003 and 2006 (and were over twenty-five percent by 2005).

While many of these mortgages were based on deliberate, seemingly well-informed choices by borrowers and lenders, they still contributed to the Ponzi finance scheme. When the low-cost mortgage ballooned, the borrower's payments became unmanageable. Refinancing or selling were the only ways to escape the debt burdens, but these options were only viable when the housing market was growing.

The mortgage finance Ponzi scheme was further aggravated by widespread predatory mortgage lending practices, in which "low-doc" or "no-doc" loans were approved, and borrowers' income and ability to pay were not verified. The worst example was the "NINJA loans," where an individual with No Income, No Job, and no Assets could miraculously qualify for a mortgage. Additionally, instances of fraud or "liar" loans grew, as mortgage brokers, appraisers, and borrowers misrepresented income, assets, and debts.

The Ponzi mortgage finance disaster was fully in motion. The bubble burst and the flooding downside of the scheme began.

Unable to pay inflated mortgages that cost more than their houses, borrowers could no longer refinance or sell to service their payments. Consequently, they defaulted in record numbers, the housing market crashed, and the Ponzi finance system ground to a screeching halt.

Many people have suffered as a result of this Ponzi finance scheme. The temporary gains that were realized in the housing boom were indeed, only temporary. And we are currently dealing with the devastating effects of the system unwinding. We must repair the damage that was done and guarantee that another similar catastrophe does not occur. A return to stricter lending standards, a stronger enforcement system, and a restoration of properly placed incentives will go a long way toward preventing another Ponzi finance scam from wreaking havoc on our financial system.

This post was co-authored by Dr. Eric Tymoigne and Micah Hauptman. Dr. Tymoigne is a Professor of Economics at Lewis and Clark College in Portland, Oregon, and Research Associate at the Levy Economics Institute of Bard College. For further reading, please visit the Levy Institute's website at