The classic elements of a Ponzi scheme are paying the initial investors with money from later investors. That's great for the first guy who gets his money, but at some point you run out of new victims to come along and pay all the earlier investors. Then the whole thing collapses, there's no new money coming in, all the old money is gone, end of game. That's almost exactly what happened in the real estate mortgage market in the last decade.

A customer would hear over and over again about how real estate prices are always going to go up over time and how owning a home provides not only a place to live, but also a great investment for the future. They saw people making their living by buying and selling homes over and over again. They got greedy and wanted a piece of that action. When they went in to a bank to ask for a mortgage, they were offered all kinds of loans. "You don't have a down payment? Don't worry, we can provide a zero down mortgage. You can't afford closing costs? Don't worry we can roll them into the mortgage. You can't afford the monthly payments? Don't worry, we can offer an Adjustable Rate Mortgage with interest for the first three years that is way below market prices. You can't afford monthly payments even with lowered interest? Don't worry we can offer interest only loans, where you need not pay back a dime of the principle for a few years." It was almost impossible to get turned down for a mortgage. If you did, you could go to a subprime mortgage broker who would get you a mortgage with the terms you wanted, but with a much higher interest rate that only kicks in later on.

Sometimes a customer would ask, "What if I still can't afford those higher payments when the interest rate increases?" Often the answer would be something like, "By then your home will probably have increased in value and the additional equity will give you enough for a conventional down payment to refinance under better terms." Few customers asked the next logical question, "What if it doesn't?" If they did ask the question, they most likely would have been diverted again by the likelihood that housing values will continue to rise forever. Typical Ponzi scheme tactics. The price will always go up because you'll always be able to find someone willing to buy it from you for more than you paid.

How could banks afford to give out these mortgages? Surely they must have known that these people could not afford them? There are two possible answers to that question. The first is that the banks believed what they said; they thought real estate prices would rise forever. The second is the more likely scenario however. The banks had a double Ponzi scheme going. They didn't care if the people paid or not because they sold the mortgage notes to other investors almost before the ink dried. That gave them the money to loan out to a new crop of mortgage seekers, and they just kept piling it higher and higher.

When the banks sold the mortgages, they offered a new kind of insurance policy along with them against the mortgage notes defaulting. Of course, they couldn't call it insurance because there are rules governing insurance. Basic common sense rules like, if you give someone a million dollar insurance policy, you have to be able to pay out the million dollars if they need to collect. This simple rule would have prevented the vast majority of banking industry liquidity problems that we see today. Instead the banks were allowed to sell the low quality mortgages with a guarantee called a credit default swap which amounted to a nebulous promise that if the mortgages went bad, somebody somewhere would find a way to reimburse the purchaser of the loan. In a sense, this also relied on the promise that real estate prices would rise forever. Worst case, they thought, we'll foreclose on the property and resell it. It'll probably be worth even more than is owed on it, so there'll be no trouble getting the money back. And everybody bought it.

This easy credit for anybody, led to a boom in the housing market. That led to a boom in construction, appliances, building materials such as lumber, and all the skilled trades involved in building and selling a house. And of course it also led to a boom in the banking and financial industry. The banks were flush with profits from all these new mortgages and offered car loans and every other kind of loan to make even more money. Credit cards with limits in the tens of thousands of dollars were offered. Consumers snapped up the credit cards and went out to buy big screen televisions, fancy new laptops, power tools, or anything else that struck their fancy. After all, if the credit card debt became too onerous, guess what, they could always take out a home equity loan because the value of their home would increase to cover it.

(To be continued in The Great American Ponzi Scheme Part II)