Friday, December 10, 2010

Financial Fraud, Ponzi Schemes, and Legitimate Economic Policies: Misunderstandings of, and Overreactions to, the Financial Crisis and the Great Recession

Via FindLaw (T/Y SimoleonSense).

The type of fraud that permeated the global financial system prior to 2008 -- and that still exists, to a distressing degree -- was thus a rather simple type of deception. Ratings agencies, in return for handsome fees, gave top marks to financial instruments that were worthless. Mortgage originators put people who were eligible for regular loans into high-priced, subprime loans. This led to catastrophe, for which we are all still paying.
One of the favorite buzzwords in financial circles over the last few years has been the "Ponzi scheme." Every manner of financial transactions and policies has lately been described as a Ponzi scheme, by which the speaker often appears to mean nothing more than "something that I don't like." This is unfortunate, because it has become far too easy simply to hurl this insult, without understanding the difference between legitimate financial transactions and the real problem of fraud.
One straightforward definition of a Ponzi scheme is "an investment swindle in which early investors are paid with sums obtained from later ones in order to create the illusion of profitability." Named after an early-20 th-Century swindler, such a scheme is fraudulent because there is no set of circumstances under which its organizers can honor all of their promises to all of their investors. In a Ponzi scheme -- also known as a pyramid scheme -- each tier of investors is paid by bringing in yet another tier of investors (larger in number), who in turn must be paid off by bringing in even more suckers. With a finite population of potential investors, this scheme is unsustainable. It is certainly a unique type of fraud, and it remains illegal.

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