Making Money Without Providing Value

What if you could make money by selling people securities, or equivalent, that have no inherent value, but people think will eventually be worth substantially more than they paid you for them?  You can potentially make money from an endeavor that provides no value to the economy or society.  You can make money off of money despite the complete lack of intrinsic value.

Isn’t this how shares of stock work?  No, it is not.  Shares of stock provide partial ownership of a company that sells products and services to the marketplace, gains revenues from these sales, and makes profits from these sales and shares these profits with you, as an owner, via dividends.  If they are good at this, the values of their shares increase and your (very) partial ownership is more valuable.

A Ponzi scheme, according to Wikipedia, is “a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. The scheme leads victims to believe that profits are coming from legitimate business activity, and they remain unaware that other investors are the source of funds.”  This is a great example of a “something for nothing” investment that deludes investors.

According to Investopedia, “A cryptocurrency is a digital or virtual currency that is secured by cryptography, making it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. They are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.”

Analytics Insight argues that, “Just like any other investment, crypto assets come with lots of risks, but also plenty of potential rewards. However, without a doubt, cryptocurrency is a great investment, especially if you want to acquire direct exposure to the demand for digital currency.”  In other words, such investments are worth it if you believe other people believe in them.

This brings us to market bubbles.  Bubbles eventually burst, whether joyful children playing with soapy water create them, or greedy people playing with other people’s money fashion them.  One of the earliest economic bubbles concerned tulip bulbs in Holland as chronicled by Mark Dash in Tulipomania: The Story of the World’s Most Coveted Flower & the Extraordinary Passions It Aroused (Broadway, 2001).

Tulipomania involved speculative buying and selling of rare tulip bulbs in the 1630s by Dutch citizens.  Coveted bulbs changed hands for amazingly increasing sums, until single bulbs were valued at more than the cost of a house.  When the bubble burst, the value of bulbs quickly plummeted and fortunes were lost.

We recently experienced a real estate bubble as chronicled by Michael in Lewis in The Big Short: Inside the Doomsday Machine (Norton, 2011) as well as Alan Blinder in After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (Penguin. 2013).

In real estate mortgage markets, impenetrable derivative securities were bought and sold.  The valuations and ratings of these securities were premised on any single mortgage default being a random event.  In other words, the default of any particular mortgage was assumed to have no impact on the possible default of any other mortgage.

The growing demand for these securities pressured mortgage companies to lower the standards for these loans.  Easily available mortgages drove the sales of homes, steadily increasing home prices.   Loans with initial periods of low, or even zero, interest, attracted home buyers to adjustable-rate mortgages.  Many of these people could not possibly make the mortgage payments when the rates were adjusted after the initial period.

This real estate bubble led to people buying and flipping houses they often could not afford, but prices were rising so quickly they could move on before the adjustable-rate mortgage caught them.  One friend was building a house in Florida and someone offered him an audacious price. He accepted and starting building again. Another audacious price arrived. He accepted again and then again.

This was of less concern than one might think because people expected to flip these houses by selling them quickly at significantly increased prices.  This worked as long as prices continued increasing, but as more and more lower quality mortgages were sold, the numbers of defaults increased and dampened the increasing prices, which led to further increases of defaults.  The bubble quickly burst.

The overall phenomenon outlined in the post is about making money without providing value.  It about betting on other people’s greediness and gullibility when looking for quick, easy wins.  In contrast, there is the satisfaction of gaining a fair return for providing a highly valued product or service.  Either way, it is money in the bank, but these two approaches seem, to me, far from equivalent.

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