Monday, December 22, 2008

Illusion of Wealth and a Fraud.

When Lehman Brothers evaporated and the official anouncement of recession started to do the headlines, I started to search for answers. I was lost. I had little or more correctly no understanding of the stock market then. And my understanding of economics did not go beyond the demand and suppy curve. So, for the next couple of weeks I read and reread a lot of material on the internet. Became, for a change, a listener in discussions that broke out at office over coffee and lunch. The frequency and duration of coffee breaks increased and I was educated.

Amidst the opinions and technical jargons like sub-prime loans, derivatives, levaraging and stuff like that, my common sense told me that what we are witnessing is the result of a fraud. In one of email conversations I had with a friend of mine I mentioned the following:

Human wants and needs are endless. But the resources
available are not. What the concept of the sub-prime
loans does is create an illusion of resource (wealth)
that is not present..... And in a market economy
that runs on demand and supply, this is evidently dangerous.
and

The whole concept of Sub-prime loans is in itself a fraud.
People applied it casually in US because they had other
markets to diversify the risk that they were taking in
their own country. High profit schemes are high
risk. This is the gamble that they didn't pull off.

I don't remember anybody use the word 'fraud' then to explain what happened. But even with minisculine understanding of the stock market and economics I understood one thing very clearly. When you are distributing loans to people who may really not be in a financial position to repay then in time you are in effect creating an illusion of wealth that really is not present. Wealth is created by adding value to the resources you have. Like, when sand (silicon) is converted to microprocessors. When iron ore is converted to multi-utility steel and stuff like that.

So why did they loan to people with bad credit history and to people who may not be exactly in a financial position to repay the loan. Well for that they had some of the brightest minds to create financial instruments to diversify and cut down the risks of lending out these loans. So the complete picture of sub-prime loans triggering the housing boom and the ways and methods used in the stock market to diversify and cut down the risks of loans given out, is a picture of fraud.

Well, so why am I writing about an issue that has been long debated and the reasons very clear now to the world. I do that becuase yesterday I read two articles that gave me bragging points. So, I am here to brag. One of the article was by this year's Nobel prize winner Paul Krugman wherein he explains why the economic fall is due to a fraud. And second, an article by Thomas L. Friedman wherein, to quote him in context of the sub-prime loans, "... we [Americans] enjoyed rising weath without rising income" which to me is same as saying 'the illusion of wealth was created".

If a person like me with modest intelligence could see the folly in the whole scheme of sub-prime loans, definitely, the smarter folks in the investment banks would have seen it. Yet, they overlooked it. That reinforces the idea that it was a fraud. So when Paul Krugman says, "...the money managers got rich; the investors saw their money disappear.", he is spot on.

I strongly recommend the two articles that I mention in this post. Below are the links to them.

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