A Source-Sink Perspective for Risk: From Subprime Loans to Pyramidal Schemes
Dr Abhijit Gosavi 25 January 2017
The worst kind of risk negatively affects society at large. One approach to understand risk is via the analogy of sources and sinks (from engineering) and that of rewards and penalties/risks (from artificial intelligence). In these analogies, the entity that generates risk is called the source and the one that absorbs it the sink. In most businesses, risk is accompanied by profits, often called reward in artificial intelligence. When the source and the sink are one and the same, and are in fact a private entity, such as a private bank or a business, the society at large remains unharmed. In this situation, the source receives a risk-adjusted reward, i.e., reward minus the risk (see Figure 1).  In the American financial system, this was the case for many years, from the Great Recession until 2000, during which banks made home loans very carefully because they owned the loans themselves – thereby serving as sources as well as sinks.
Figure 1: The best-case scenario, where the source and the sink are one and the same
However, when the source is a private entity and the sink is the government or taxpayer, the society at large suffers hugely, while the source gains the reward and stays away from the risk (see Figure 2). This is a dangerous situation that needs to be avoided at all costs, and safeguards should be in place to prevent it from occurring. When safeguards disappear, the least scrupulous humans are attracted to the system – leading to a major catastrophe in the end.  
Figure 2: The worst-case scenario occurs when government serves as the sink for the risk and a private entity (or entities) serves as the source
The Glass-Steagall Act (GSA) in the US was one such safeguard.  It did not allow banks to make risky bets; businesses or banks that lent money for loans had to remain separate from investment banks. In the last few years of the last century, however, banks wanted to become bigger. The GSA was repealed and derivatives were deregulated in 2000 – in response to lobbying from banks. This allowed investment banks to purchase high-risk subprime loans and combine hundreds of these loans with student, credit card and car loans to create derivatives called collateral debt obligations (CDOs). The CDOs were sold in the market, including to retirement funds, drawing enormous amounts of money. The subprime loans were offered to individuals who typically did not have the ability to repay them; but, since these loans had adjustable rates of interest, which were low for the first few years, borrowers could afford them initially. 
By 2006, many borrowers of subprime loans had started defaulting on their loans. But most banks owned billions of dollars in these loans and by 2007-2008 were swiftly moving towards bankruptcy. At that point, in order to prevent the collapse of the entire financial system, the US government had to step in to bail out many of these banks and also the American International Group (AIG), which insured many of these home loans. The result was a global recession in which thousands lost life savings and jobs. Since the original lenders of subprime loans did not own the loans at the end, they themselves were not sinks for the risk. The risk was shifted to others in stages (this is called risk shifting), and eventually to the government, which means to the taxpayer and the economy.  
Another significant example of risk where this source-sink theory can be used to explain harm caused by unethical behaviour is that of multi-level marketing (MLM) businesses, where selling occurs at multiple levels. Home-based franchises are examples of such businesses. MLMs often have pyramidal structures, where there are a large number of entities (humans) at the bottom, who make small profits, or in fact lose money, in each transaction, but a single entity (or a few entities), at the top, who makes money out of every transaction in the business (see Figure 3). 
In such businesses, people are invited to first buy products and then sell them to their friends, neighbours and colleagues. When the products remain unsold, the buyers are stuck with them. Whether they are sold or not, the person at the top makes profits, however. Rarely has anyone ever become rich at the lower or lowest levels in such pyramidal schemes.  At times, pyramidal schemes are also of a Ponzi nature in which their operators return as interest – to a fraction of the investors – money sitting in the principals of the investors, without investing the principals anywhere. Eventually, such schemes typically unravel when the entities at the bottom realize their mistake but only after losing most of their investments. 
Figure 3: A pyramidal scheme where the entity at the top of the pyramid gains all the reward while the risks are absorbed by the sinks at the bottom of the pyramid
The case of the Singapore-based firm QNet has been well-documented in Moneylife articles. QNet advertised that if one invested x rupees, the system would ensure that the investor would keep making x rupees every week thereafter. It was further claimed that an investor who would gain the so-called goldstar status (a rank achievable after significant investments) would earn the equivalent of a billionaire. This is clearly a very absurd claim, and, yet, unfortunately, the truth is that unemployed and underemployed people, desperate to make money, often fall for such claims. Most pyramidal or Ponzi schemes use false assertions to fool people. The QNet scam resulted in many losing huge amounts of money. Here, the source of risk, who also gained much of the transient reward from the buyers, was the operator(s) of QNet at the top of the pyramid, and the sinks were the persons at the bottom who invested their hard-earned savings. 
The Indian government has been very weak in formulating or enforcing consumer-protection laws, and the legal system is notoriously slow. A brave and persistent whistleblower exposed the QNet scam, which has now resulted in some arrests. I need to add that despite the existence of strong laws in the US and the issuance of numerous warnings from the Federal Trade Commission (FTC), Americans still fall prey to such predatory schemes in large numbers every year. As such, it is important for every person, anywhere in the world, to become financially literate – before starting businesses or investing in such schemes. 
There are numerous other instances where the source-sink theory can be used to better understand risk and potentially avoid danger. One of the most famous case studies on risk is that of the Challenger disaster. Challenger, a US space shuttle carrying several crewmembers, exploded soon after takeoff. Engineers had become aware before takeoff that the shuttle’s rubber seals (called o-rings) were not designed or tested for the range of temperatures it was going to encounter on that fateful morning; the temperature forecast for that morning was unusually low. Despite this knowledge and warnings from NASA engineers and the makers of the rubber seals, managers decided to go ahead with the takeoff. These managers were the source of risk here, and the crewmembers, who were not aware of it, the sinks. 
Finally, consider the case of Firestone tyres that were failing in a catastrophic manner on US highways leading to deaths in early 2000. At first, the blame was sought to be placed on the vehicle on which the crashes were happening – the Ford Explorer. Eventually, it came to light that in order to save money, tyres in one particular Firestone plant were being manufactured using a new process (a new raw material was being used in particular). That there were complaints about their tyres was known to Firestone for years, but until there was a huge outcry in the media, no action was taken. The particular manufacturing process and the material concerned were discontinued, and the plant in Illinois was shut down – but only after numerous, tragic deaths.
One lesson to be drawn from all of this is the following: sources of risk, in hopes of making profits, often turn the risk onto unsuspecting members of the public, who are forced to absorb the risk – either via loss of money or, in the worst case, death. Laws that penalise organisations for exposing the public to risk are needed. This is easier said than done, of course. Despite clear ethical violations, nobody in the US has been sent to jail for the financial crisis of 2007-2008. 
In the US, there is a non-governmental organisation (NGO) known as Consumers Union. It publishes a magazine called Consumer Reports, which actively surveys automobiles and numerous other products such as electrical appliances on a yearly basis. Consumers Union does not accept any funding from companies whose products it surveys and is hence widely respected. Not surprisingly, over the years, it has been sued by many organisations whose products it has surveyed but has never lost a case. To reduce risk to society, unbiased agencies and NGOs that act in the interest of consumers and have no conflicts of interest with the firms they survey are needed in every nation. 
NOTE: The author wishes to thank his former students, Aykut Kahraman, Mandar Purohit,  Shreerang Shewade, Anish Parulekar, Ozge Senoz, and Shuva Ghosh, for numerous discussions on risk and other related topics. Some of this work is based on an article by the author that appeared in the Proceedings of 2016 American Society of Engineering Management Conference in Charlotte, North Carolina.
(Dr Abhijit Gosavi is an Associate Professor in the Department of Engineering Management and Systems Engineering in Missouri University of Science and Technology at Rolla, Missouri, USA)
Ramesh Jaradhara
6 years ago
Financial literacy and consumer awareness is the key to protection from Ponzi schemes that were floated around the world. India seems to be the heaven of such schemes. Sahara India Pariwar, the now infamous Subrata Roy landed in a jail term for floating numerous Ponzi schemes to deceit lay Indians who were unaware of such facts. Govt. should enact strong laws to protect consumers and a strict vigil on companies can eradicate the problem.
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