I’ve written quite a bit about Peter Schiff here on the blog, and finally got around to including one of his video blogs.  In it, you’ll hear Schiff address a couple of issues that I believe escape true public scrutiny, given the way these stories are shaped by the media.

With respect to gas prices, we’re now being subjected to the usual refrain that greedy oil companies are once again fleecing us at the pump.  But this infantile argument begs an easy counterattack if one were to think about it for a mere minute or two.  For example, when gas prices were falling, was that due to oil companies generosity?  I mean, c’mon -- if rising prices are due to their greed, then falling prices must be due to their generosity.  So how come we didn’t hear about the “generous” oil companies from 2009-11?  Bottom line is, the people touting this line of reasoning (or substitute it with the “blame Iran/Wall St greed/etc” screed) would have been rank-and-file “the-earth-is-flat” cheerleaders centuries ago.

I also enjoyed Schiff’s analysis of Warren Buffett’s crusade to get millionaire’s to pay more taxes (good thing he’s a billionaire so he can avoid too hard a hit).  Would be nice if Buffett was more up front about how he hides 99% of his income from the tax man.

Enjoy.

Earlier this week, Bernie Madoff claimed in an interview that the government was running its own Ponzi scheme, above and beyond the scam he perpetuated on investors until he was caught in late 2008.

No matter what you think of Madoff -- scam artist, billion-dollar swindler, destroyer of his own family -- there’s one problem: 

He’s right.

Most of you will recall Madoff as the money manager for many celebrities and other wealthy investors, who promised steady, above average returns, and delivered on that promise for nearly the entirety of his tenure -- until the 2008 financial crisis.  His investors had marveled at his ability to provide consistent, high single digit/low double digit returns, while the overall market endured  more dramatic up and down swings.  His steadiness was the draw.

The problem arose when the markets began tanking in the fall of 2008.  Madoff’s investors, under the pressure of mounting losses in their other investments, attempted to withdraw their funds from his custody, since he was the only fund delivering positive returns.  But there was a hitch: they were trying to withdraw their funds nearly simultaneously.  

You see, during “normal” times, Madoff didn’t have to worry about people making too many withdrawals, because his fund’s “performance” was stellar -- so who’d want to pull out?  But the 2008 crisis created many more withdrawal requests than Madoff had ever handled before.  Since he was using the money pool of all his investors to pay out to the occasional investor requesting a withdrawal, he didn’t have enough funds to pay off everyone who came calling all at the same time.  At last, the withdrawals exceeded the available funds.  

So why was Madoff correct this week when he said the government is essentially in the same business?  Well, before we look closer at that, we have to take a step back and view the situation with complete objectivity, and suspend the rhetoric that often surrounds charged issues such as the government’s culpability for our fiscal predicament.  

We have to look at the facts.

So, we should start with the definition of a Ponzi scheme; according to Wikipedia, a Ponzi scheme is as follows:

“[A] fraudulent investment operation that pays returns to separate investors, not from any actual profit earned by the organization, but from their own money or money paid by subsequent investors. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent.”

Now compare that to Social Security, the largest of all government programs and expenditures:

-- Returns are paid to the “separate investors:” retirees, surviving spouses, and disabled individuals  

-- Wage earners (the “subsequent investors”) pay into the fund in the form of a tax on their wages

-- There is no actual profit earned by the fund.  (In fact, Social Security funds are repurposed and used for other expenditures while being replaced by an IOU, technically leaving the fund bankrupt.)

-- Investors are compelled to “join” the fund, through the entitlement of a consistent return of funds from the point of retirement/widowhood/disability, until their death.

The government stewardship of Social Security gives it a veneer of legitimacy, but when we look closely at how it actually operates, there is no material difference between it and a Ponzi scheme.

And so it’s for this reason that Madoff was right.  Perhaps we can learn something from him.

I’m getting the distinct feeling that the lessons of the 2008 financial crisis are rapidly being forgotten.  The stock market is roaring.  Wall Street bonuses are as big as ever.  The administration is hailing a new “partnership with business.”  The mounting debt crisis is being treated as not much more than a nuisance.  Thus I was inspired to write this post, which looks back at one of the numerous aspects of the crisis and how it came to pass.  Perhaps by revisiting these topics we can keep the 2008 experience in our collective consciousness.  

The credit default swap (CDS) played a significant role in the 2008 crisis.  Aside from a  couple of brief “60 Minutes” segments on them in late 2008 and mid-2009, I've seen and heard little on why these instruments were so crucial to worsening what had already become a bad situation.  Allow me to share a few points on CDS’s here.

In the run up to the crisis, investors were experiencing an increasing appetite for yield.  Treasury bonds and other similar investments were yielding very low returns, compared to the mortgage backed securities (MBS) that were rising in popularity.  MBS’s brought higher yields, but with those yields came greater risks due to the possibility of mortgage default.  

So, when investors purchased MBS’s, oftentimes they purchased a CDS with it.  The CDS acted as a kind of insurance against any potential default with the MBS.  If such a default arose, the firm selling the CDS would make the investor whole by essentially paying the par value of the bonds in question.  In return for this protection, the CDS buyer was obligated to make quarterly premium payments to the seller.

Sounds great right?  Sure...until an examination of the wreckage of the 2008 crisis turned up CDS’s as one of the toxic instruments that exacerbated the whole affair.

To use an analogy, the CDS was the accelerant to the MBS fire.

So why did this instrument wreak so much havoc?  Well, the key goes back to the concept of insurance.  If a financial product is labeled “insurance,” it’s regulated by the government and is subject to various laws and policies. Namely, the firm issuing the insurance must retain sufficient financial resources to pay the insurance policy back in the event it’s called due.  The most common example of this would be life insurance policies: life insurance companies must retain the ability to a reasonable extent to pay off any claims resulting from the policies it issues.  If they couldn't do so, what would be the point of anyone buying insurance in the first place?

Contrast a traditional insurance product to the CDS; notice there is no mention of insurance in the CDS terminology.  By avoiding the distinction, issuers of CDS’s were able to sell them without having to keep sufficient funds in reserve to pay them off in the event a slew of them came due at approximately the same time...which is exactly what happened circa fall 2008 and beyond.

A bevy of CDS-holders thought they were in good shape when their MBS investments cratered during the housing meltdown, assuming the CDS protection would kick in, only to find out they’d been swindled on that trade as well.  The CDS sellers couldn’t cover all the claims, and the resulting losses were simply piled on top of the MBS wreckage.

There are probably several takeaways here, but the one I’d focus on is that financial regulations are often not the answer to our problems.  While some of them have their place, determined individuals will find ways around regulations.  Unsuspecting investors who aren’t familiar with the nuances behind these products will be led into making poor decisions on whether to invest in them or not.  In fact, the existence of the aforementioned insurance regulation probably lulled many investors into purchasing CDS’s, since they assumed that the “insurance” they were buying on the MBS would be guaranteed to them.

When we operate under the caveat emptor principle -- “buyer beware” -- all buyers are essentially forced to be more discriminating about what they do with their money, and all sellers are forced to either meet the minimum standard of integrity when they interact with these buyers, or quickly face losing their reputation in the marketplace for being an honest vendor.

Whether CDS activity becomes more or less effectively regulated after the recent reforms instituted on Wall Street remains to be seen.  But in my opinion, it won't matter.  As long as the current framework of the financial system remains the same, products like CDS’s will come and go, eluding the regulations until the damage is already done.