Sunday Musings: Pyramid Schemes

One sunny afternoon, thirty years ago, when I was working as a young real estate broker in Southern California, I received “the phone call.”

It came from a friend of mine, and the instructions were clear: Go to the bank, get a $1,000 in cash, and meet him at a residence in an upscale neighborhood. And yes, bring a friend. While I didn’t get the money, I brought a friend, and we met at a very nice home, which was already buzzing with activity.

We could barely get through the front door, it was so crowded. The “proceedings” started within a few minutes and, over the next few weeks, I witnessed one of the most amazing pyramid schemes I have ever seen in real life.

The basic idea was that you bought into the pyramid at the bottom with $1,000. As demand for that bottom position increased, your name moved up the food chain until you reached the top about 7 days later, when you received the pay-off consisting of 10 envelopes for a grand total of $10,000 in cash.

I am not making this up. It really happened. For fun and entertainment, I spent many evenings following some friends around who were involved in multiple pyramids and subsequent multiple payoffs. Soon thereafter, $5,000 pyramids were starting, where the payoff was $50,000.

This went on for a few weeks when—all of a sudden—it was over. People still went to meetings, but the volume had dried up. Everybody’s friends were already involved at some place and, as in any pyramid scheme, the late comers were left holding the now empty envelope. The scheme had simply run out of people.

As quickly as it started, it had ended. Revival attempts quickly failed. In many discussions with friends, we came to the conclusion that any pyramid scheme that had pulled in this many people was not to be repeated in their lifetime. And so far this conclusion has been correct.

Why bring it up now?

Because that’s exactly what happened as the biggest real estate bubble in world history burst.

Artificially low interest rates in conjunction with fraud and deception (no documentation loans and no lending standards) enabled those who where not qualified to buy a home to get into the market thereby providing the volume/demand necessary to push prices higher benefiting those who got into the game early.

Eventually, just as in the above pyramid scheme I witnessed in 1978, the real estate orgy simply ran out of people to fuel the fire. Demand dropped, prices followed, buyers defaulted and the game was over.

The big question is will there be a recovery and when? There are some who possess better forecasting skills than I have, and their prevailing opinion seems to be that a bottom may occur in 2011 after all Alt-A and Pay-Option-Arm loans have reset.

I can agree with that. Where my view differs from many is that the expectation of a “V” type recovery in 2011 still exists. I think that is way off base.

As we’ve seen in my above pyramid example, once a large number of people have been financially hurt by any scheme, they will be hesitant to make the same mistake again in the future. Hence I believe that any real estate recovery will be in form of an “L” shape, which means that prices will move sideways, down and up in a similar fashion as we’ve seen mostly in the 80s and 90s.

Those, who are counting on an imminent recovery along with price increases as seen over the past few years, will be sadly mistaken. While real estate may again be a good long-term investment in the future, the times of quick and easy money generated from flipping houses were a one-time phenomenon, which may not repeat itself for this current generation.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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