The “Greater Fool Theory” declares that it’s possible to make money by foolishly buying over-priced securities and later selling them at a profit because there will always be an even greater fool who will pay an even higher price. The greater fool theory relies on market “optimism” (a.k.a. the “something for nothing” mentality) concerning a particular stock, an industry, or the market as a whole.
Acting under the Greater Fool Theory, a foolish investor buys questionable securities without any regard for their real, intrinsic value, but with the expectation of nevertheless selling them off to another, even greater fool. That next “greater” fool likewise expects to take the overpriced security and sell to a third, “even greater” fool, and so on.
When a market becomes saturated by greater and greater fools, an investment “bubble” develops. In that speculative bubble, investors (actually, gamblers) keep buying a particular security at higher and higher prices, simply because everyone else is buying that same security at higher and higher prices and everyone, presumably, will keep making more and more profits off a security that is, in fact, hugely and irrationally overpriced.
In fact, every speculative “bubble” is animated by the Greater Fool Theory. Everyone knows it. It’s not news. It’s not a surprise. But we play the game anyway, just like we play roulette in Las Vegas, knowing that most will lose big but betting that we will be among the lucky few who get in and get out with a profit.
Unfortunately, the Greater Fool Theory’s fundamental premise—that there will always be a “greater fool”—is false. Sooner or later, like any other Ponzi Scheme or run of gambler’s luck, speculative bubbles burst, causing a sudden depreciation in price of the formerly overpriced security—and leaving some poor saps (the greatest fools) left holding the suddenly worthless security and thereby losing their shirts.
BANKS BUY BACK THEIR OWN SECURITIES
With the Greater Fool Theory in mind, consider the report from the August 7th, A.D. 2008 New York Times entitled “2 Banks Buying Back $17 Billion in Securities”:
“Citigroup will buy back $7.3 billion and Merrill Lynch offered to buy back $10 billion of ‘auction-rate securities’ that they had sold to thousands of individual investors. . . . Auction-rate securities were invented in the late 1980s and worked fairly well until this year, when the auctions began to fail amid the credit crisis, and investors could no longer sell their securities.”
“Securities,” my ass. These “auction-rate securities” were flat-out, get-rich-quick schemes with no real “security” in them beyond the opportunistic belief that there’s a sucker (greater fool) born every minute. The last “investors” could no longer sell their “securities” because they’d run out of fools. At that point, prices fell like stones.
The “auction-rate securities” concept sounds so incomprehensible that it was probably fraudulent from the beginning. But the scheme worked just fine so long as the economy continued to grow, the value of homes continued to rise, and there was an endless supply of credit and “greater fools” to buy these “auction-rate securities” at a higher and higher prices. In other words, so long as it was “summertime and the credit was easy,” there was no shortage of fools and greater fools.
But once the economy went South, the value of homes fell, consumers ran out of credit, the market ran out of ever-greater fools and these “auction-rate securities” were revealed as just another scam. In fact, according to the NYTimes,
“The New York attorney general’s office and other state regulators said that Citigroup would buy back . . . auction-rate securities from individual investors, charities and small and midsize businesses. These customers, about 40,000 in total, have been unable to sell their securities since mid-February. . . . If Citigroup buys back all $7.3 billion of the securities, as it has agreed to do, it would represent one of the largest amounts ever recovered by investors from a single company as a result of state and federal regulator action. . . . Citigroup’s purchases of the securities will cause the bank to take a pretax charge of about $500 million to reflect the current value of the securities.”
The NYTimes article is unclear but apparently indicates that Citigroup will pay $7.3 billion for stocks currently valued at just $500 million. Citigroup thereby emulates our federal government by “bailing out” the “greater fools” left holding the nearly worthless “securities”. If so, Citigroup’s “bailout” will result in a 93% loss. On the other hand, if the article means that the stockholders will only be paid $500 million for stocks previously valued at $7.3 billion, then the stockholders will take the 93% loss. But either way, a “security” formerly valued at $7.3 billion is now valued at $500 million. (This 93% loss in value is right in line with my predictions that we are going to see the value of most debt instruments (promises to pay) depreciated by 80 to 90% before this economic crisis ends.)
And what do you think “persuaded” Citigroup to take a 93% loss on $7.3 billion in order to “bail out” their customers (fools)? Compassion? A sense of charity? A strong commitment to public service?
The involvement of the New York attorney general’s office suggests that the motivating factor behind “eating” a 93% loss was the threat of sending a bunch of Citigroup officers to jail. The NYTimes reports that government “regulators have been examining how brokers sold the ‘auction-rate securities’ and whether they fully disclosed the potential risks to buyers.” That means Citigroup’s marketing was probably fraudulent and the sellers faced criminal liability unless they “agreed” to buy back all of their snake oil.
Apparently, the government “made them an offer they couldn’t refuse.” The great irony in this story is that the Wall Street companies that originally “invented” and marketed the “auction-rate securities” based on the “greater fool theory” are being forced to play the “greatest fool” and ultimately buy back their own snake oil in order to avoid civil or criminal lawsuits. What goes around, . . . hmm?
Arthur Tildesley, administrative chief of Citigroup’s global wealth management division, said that the settlement reflects a “truly favorable solution for our investors and our clients.” Uh-huh. I’ll bet these settlements are also “truly favorable” to the Citigroup executives who might otherwise have been indicted for fraud and jailed for 3 to 5.
SYSTEMIC CORRUPTION
Citigroup is not alone. Firms including Goldman Sachs, Lehman Brothers, JPMorgan Chase, Morgan Stanley, UBS and Wachovia are also reportedly among those under scrutiny by regulators.
For example, Morgan Stanley reached an agreement with the Massachusetts attorney general’s office to reimburse the cities of New Bedford and Hopkinton $1.5 million for the investments in the securities. Christine Pollak, a spokeswoman for Morgan Stanley said, “We are pleased to settle this matter without penalty.” Indeed. I’ll bet they’re even more pleased to settle the matter without going to the slammer.
The NYTimes reports that Merrill Lynch has been under investigation by the New York State attorney general’s office and several state agencies. But, “Unlike Citigroup, Merrill Lynch has no plans to mark down the value of the securities it buys. A Merrill spokesman, said the company views the securities as high-quality assets whose credit has not been hurt; investors’ inability to sell them is the investments’ only problem.”
So, if I understand correctly—being unable to sell a security is only a minor problem? . . . These Wall Street spokesmen should be writing for Saturday Night Live.
The humor gets deeper and darker: “Merrill said its focus on the frozen markets convinced it that it will not need to raise more capital to back up the securities once it purchases them from clients in January.”
Ohh, really? Citigroup wrote off 93%, but Merrill is apparently “convinced” they won’t have to write off anything. Gee, in these turbulent times, it’s so refreshing to see such “confidence, isn’t it?
Nevertheless, if I had “invested” in some of Merrill’s allegedly “high-quality assets” that Merrill won’t buy back until January, I’d watch very closely to see if Merrill Lynch was going to file for bankruptcy by January and thereby leave all of its “investors” with nothing.
Despite Merrill’s expressions of confidence, I’d bet my $1,000 to your $10,000 that Merrill-Lynch will be financially bye-bye by January. Merrill might not be executed in bankruptcy by then, but I’ll bet they’ll be so strapped for cash and litigation fees, that they might not be able to pay for their internet connection. Hopefully, Merrill’s “auction-rate securities” have a pleasing and colorful pattern, because, come January 31st, those paper debt instruments’ principle value may be as wall paper.
The problems at Merrill and Citigroup are systemic. According to the NYTimes:
“Bank of America, the nation’s largest retail bank, said that Countrywide Financial, the mortgage lending giant it bought last month [what timing, hmm?], had responded to subpoenas from the Securities and Exchange Commission and that the unit faced a formal investigation by that agency. . . . Countrywide is also under investigation by the F.B.I., . . . . The F.B.I. last month said it had 21 corporate targets in its investigation of potential corporate fraud in the mortgage industry. California, Connecticut, Florida and Illinois have sued Countrywide over its lending practices.”
If the FBI and at least four states are investigating 21 corporate targets, you can bet that those 21 are facing criminal penalties. If the FBI’s “21 corporate targets” are all on or near Wall Street, this indicates that criminal activity (primarily, fraud) has been common on Wall Street for years.
Remember—the “auction-rate securities” were “invented” in the 1980s. If those “securities” are fraudulent today, they were probably fraudulent from the beginning. If so, for over 20 years, no one minded the fraud so long as there were plenty of greater fools and everyone was making money. But once they ran out of fools and people started losing their shirts, criminal investigations and indictments started to fly. This suggests that the system no longer regards fraud, per se, as criminal—only fraud that fails to generate an endless stream of profits for an endless stream of fools. Apparently, if it makes money, it can’t be a crime, hmm? But if it loses money, somebody’s got to be jailed.
Given that at least some of the biggest names on Wall Street are implicated in this fraud, we can reasonably expect that some of these firms will soon perish in litigation, criminal charges, mergers or bankruptcy.
TOO FEW FOOLS?
The Greater Fool Theory can work pretty well for quite a while, unless it succeeds too much and finally exhausts the supply of fools. Once you hit the “critical mass” of greater fools—and that critical mass loses their butts buying snake oil “securities,” the masses will complain to the S.E.C., state attorneys general, and the F.B.I.. At that point, it’s either “bail” or jail. That is, somebody’s got to “bail out” the greater fools by paying them enough to make them shut up and dismiss their criminal complaints, or somebody’s going to jail—or worse (Gasp!) some political party (and sometimes an entire political system) will be overthrown.
How many government “bail outs” (like Bear Stearns) have we seen in the last few months? How many do you expect to see in the near future? How are those “bail outs” of banks and investment firms any different from the Citigroup and Merrill “bail outs” for those holding “auction-rate securities”? Isn’t it apparent that whoever provides the “bail outs” is, ultimately, a greater fool? Isn’t that what the Greater Fool Theory is all about? A greater fool “bailing out” a lesser fool by agreeing to pay “something” for “nothing”?
For example, when the Federal Reserve agrees to accept nearly worthless mortgages at face value for collateral for loans to the banks holding those mortgages, isn’t the Federal Reserve giving those banks a “bail out” and thereby playing the “greater fool”?
And why does anyone ever play the greater fool game? A: Because they think there’s an even greater fool who will pay an even more absurd price for the worthless security and ultimately be left holding the bag as the “greatest fool of all”.
If so, Federal Reserve and the federal government must be willing to play the “greater fool” game (engage in bail-outs) because they are both betting that there’s an even greater fool who will ultimately “bail” them out by “buying” the worthless securities the Fed and the feds are currently purchasing. And who, pray tell, might these ultimate, great, greater, greatest fools finally be?
Can you say “tax-payers,” boys and girls?
And the Fed/feds are probably right. They probably will sell the irrationally over-priced “securities” to the greatest fools of all: those who vote Republican and those who vote Democrat. But what’s going to happen when the country finally runs out of fools and the value of our nationalized “securities” (paper promises to pay) are overtly repudiated by 80 to 90%? Some people will be jailed. Some political parties will be radicalized. The political system itself may be overthrown. And after some very painful social upheavals wherein all the “greatest fools” are finally forced to pay the fool’s price, we will agree to stop playing the “greater fool” game. We will agree to work rather than hustle and invest rather than gamble. At least for a while.
In the end, the greatest fools will be made to pay—and pay big time. That’s probably only right. It’s certainly inevitable.
How do you become the greatest fool? By investing in paper promises to pay. The paper promises to pay (stocks, bonds, retirement funds, So-So Security, etc.) are intrinsically identical to Citigroup’s “auction-rated securities”. When the markets for either run out of fools, “the prices will fall . . . and down will come the economy . . . taxpayers and alllll!”
Prudent people take tangible payments rather than subjective paper promises to pay. Fools gamble on paper. Prudent people invest in gold and silver.
