Monday, February 1, 2016

liquidity, solvency, and Ponzi schemes

I think I've noted here that fractional-reserve banking will fit most natural definitions of "Ponzi scheme" — "We have 125 $100 deposits, of which 26 or more will certainly be withdrawn in the next 10 years, but we're going to make a 10-year loan for $10,000, and it's okay because we'll get money from new depositors with which to pay the old depositors." Sure. — and it occurs to me that there's some smaller degree of this in a lot of other contexts. The working cash a business keeps on hand is typically not a huge multiple of the rate at which it acquires new supplies, and often a business will count on being able to collect on some of its receivables in order to pay some of its payables; simply sitting on enough cash to pay all "current" liabilities is bad practice, at least when it earns a much lower interest rate than the company's cost of capital, and yet there is something of a Ponzi feel even to that.

I might note right now that many classic Ponzi schemes are "actual" fraud, in that the person promoting it knows that there is no value being generated within the scheme and that the "investors" have no legitimate likelihood, at least on average, of making money; for more sophisticated designs (or dumber promoters), the promoter may actually believe that there is a social benefit to it, and where there is some actual economic activity, such as in "multi-level marketing" schemes in which the participants do actually do some sales but make most of their money (if any) from recruiting new marketers who pay a "franchise fee" to join the scheme, it can be quite hard to tell what legitimate expectations the class of marketers might have.  With much fraud, stupidity is a defense — by which I mean that as long as you sincerely believe the claims you're making, you aren't guilty of fraud.[1]  Ponzi schemes, however, are constructively fraudulent; if you're found to have been promoting an illegal Ponzi scheme, it doesn't matter whether you believed in it.  The multi-level marketing schemes in particular are fairly controversial, with some courts deciding some schemes are illegal pyramid schemes and other courts deciding other schemes are not.  None of the courts particularly investigates, in any case, whether the promoters are particularly competent at basic arithmetic.

A lot of the Ponzi-like set-ups that are clearly on the good side of the law, though, have in common that the Ponzi character is one of liquidity-mismatch rather than a solvency issue; there is some public consensus that these sorts of practices are being used by entities that almost always have assets on hand that, in some intermediate or long-term sense, are worth more than the liabilities.  If the stream of new cash were to come to a sudden stop and the firm unable to pay cash on a timely basis to claimants to whom it was due, it would not be because the firm was "insolvent", but because it was unable to quickly or efficiently sell assets.  Distinguishing between "illiquidity" and "insolvency" is a famously fraught problem, especially for financial or other firms with a lot of short-term liabilities;[2] saying that my Ponzi problem is perhaps answerable in terms of solvency versus liquidity is not, in practice, a solution to the problem, but a hopefully enlightening observation that it's related to another not-entirely-solved problem.

[1]New Jersey consumer fraud laws actually do not have this provision; even perfectly good faith inaccuracies leave you liable not only for compensation but for tripled damages. It's also worth noting that, even if the law to which you're subject does have such a provision, if what you said was ignorant enough, a jury may not believe you.

[2]GE, somewhat famously, spent many years leading up to The Crisis borrowing a lot of short-term debt, rolling it over when it came due, while building large capital equipment that took a long time to build and sell.  As the markets began to unravel GE Capital was actually providing about 40% of the company's profits, but even the industrial portion of GE was operating a lot like a bank in some ways, and was subject to the same difficulties when it became hard to borrow money.

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