The Ultimate Ponzi Scheme … Beware of these Investments (and Short them to Profit)

I get forwarded a lot of fun e-mails—jokes, stories and the like. Usually I just skim them, get a chuckle or two, and I’m on to the next thing.

But there’s one I got last week that really stuck with me, and it will probably stick with you, too.

The e-mail went like this:

“A rich tourist is driving through a town where everyone lives on debt. He stops at the motel and lays a $100 bill on the desk, saying he wants to inspect the rooms upstairs in order to pick one to spend the night.

“As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher. The butcher takes the $100 and runs down the street to retire his debt to the pig farmer. The pig farmer takes the $100 and heads off to pay his bill at the supplier of feed and fuel. The guy at the Farmer’s Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her ’services’ on credit. The hooker rushes to the hotel and pays off her room bill with the motel owner.

“The hotel proprietor then places the $100 back on the counter so the rich traveler will not suspect anything. At that moment the traveler comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money, and leaves town.

“No one produced anything. No one earned anything. However, the whole town is now out of debt and now looks to the future with a lot more optimism.

“And that, ladies and gentlemen, is how the United States government is conducting business today.”

I couldn’t have said it better myself!

One of the biggest problems with today’s debt is that it’s nearly self-sustaining. In other words, in order to pay off the debts coming due, we create more debts that we’ll someday have to pay for down the road.

Sound like a Ponzi scheme? That’s because, in a lot of ways, it is!

Debt distorts the decisions people make. If rates are low enough, marginal buyers swoop in. They buy houses, cars, and anything they can charge on a credit card.

And if debt gets cheaper (through lower interest rates), why not pile on more, so you can enjoy things now that you’d have to wait to earn otherwise?

The Bottom Line for Corporate America

I’d like to think A-Letter readers are more responsible. But for many companies out there, who do business on the above model, a day of reckoning is rapidly approaching. One where companies that acquired massive debts need to repay them— to the tune of over $800 billion in corporate bonds by the end of 2012!

Unlike the citizens in town, who can flip one asset around to cancel a series of debts, the companies will endure major repercussions. The biggest will be the bankruptcy of dozens of companies.

Consider General Motors. For years, even decades, this company managed to hide its ballooning debt by issuing more shares. And because of these new shares, and borrowed money, GM paid shareholders a generous dividend – despite the company’s inability to make money. What a Ponzi scheme!

General Motors Hid Debt Per Share by Increasing Shares Outstanding!

And of course, thanks to too much debt outstanding and the inability to increase revenues, it’s no surprise that GM is now “Government Motors.”

But it doesn’t end with the big mega-bailouts of 2008 and 2009.

Dozens of companies are hitting the chopping blocks as debts that can’t be repaid come due. Some companies will “extend and pretend” by using new debt to pay off the old, but it can’t last forever.

For the ones that can’t manage this financial miracle, I recommend you short these companies as they see years of gains evaporate in days and weeks. (Last week, you learned about my favorite way to short, using options.)

And, of course, governments are in on their own similar Ponzi schemes.

The lesson in this for you? Well, for starters, beware going long Treasuries!

Reporting from the short side,

Andrew Packer
Editor, Credit Crunch Short Report

Editor’s Note: I’ve just opened my Credit Crunch Short Report up for new subscribers today. If you would like to know more about the Report, click here for details, plus a limited-time 50% discount.

More From the Author:

• Another Day, Another Business Fails… - September 1st, 2010
• M&A on the Rise as Stocks Get Cheaper - August 24th, 2010
• 'I Will Gladly Pay You Tuesday For a Hamburger Today' - August 17th, 2010