If it’s too good to be true, it’s too good to be true.

Yesterday i wrote about recognizing lies.  It is also fundamental to anyone who deals with contracts that they recognize that the higher a price one gets, the higher a risk one is taking.  So, if you buy “junk” bonds, you are getting a high interest rate, but along with the high interest rate comes a high risk you’ll get paid nothing at all.  That’s why they are called “junk” bonds — they’re the bonds of high-risk borrowers.  If you want to lend to those borrowers, you might get a lot back, but you might get nothing.  You can assume, therefore, that if you are told you can’t lose — that you’ll always make money, — that the risk you are taking is infinite.

These are the fundamental points Ben Stein made in this last Sunday’s New York Times when he connected the Bernie Madoff fraud, the sub-prime mortgage crisis, and the 80′s rise and fall of Drexel Burnham Lambert, the investment bank that specialized in the junk bond market:

ABOUT two years ago, a little delegation from a major investment bank arrived at my home in Beverly Hills. These nice young people were from the bank’s “wealth management division.” I told them straight away that I didn’t have anywhere near enough wealth to make their trip worth their time, but they smilingly insisted that we could help each other.

They told me that if I invested a certain sum with them, they would make sure that a large chunk of it was managed by a money manager of stupendous acumen. This genius, so they said, never lost money. He did better in up markets than in down markets, but even in down markets he did well. They said he used a strategy of buying stocks and hedging with options.

I protested that a perfect hedge would not allow making any money, because money made on the one side would be lost on the other. They assured me that this genius had found a way to spot market inefficiencies and, indeed, to make money off a perfect hedge.

I thanked them for their time and promptly looked up Bernard Madoff online. Nothing I saw was even a bit convincing that he had made a breakthrough in financial theory. . . .

My point is not that I was so smart. I am not and I was not. Mistakes are a big part of my life. My point is that, as humans, we seem unable to learn from our mistakes very well.

I have never heard of an entity that could make money in all kinds of markets consistently, year in and year out. Yet we continue to believe that there will be one.. . .

The same goes on a much larger scale for the debacle of subprime mortgages. In essence, it is a much larger version of the Drexel Burnham Lambert junk-bond debacle of the 1980s. Back then, investors were charmed by the idea that the lower-ranked the bond, the more money it would make. It seemed like a great idea: there’s this little corner of the market that the big boys turn up their noses at. But in this little corner, huge money is made. It’s almost like the myth that you get great bargains in poor parts of town.

In fact, the Drexel episode should have taught us to be wary, indeed, of poorly rated debt. But it didn’t. The new version of the myth was so alluring that it drew in not just billions of dollars from lenders and mortgage bond buyers, but much more in derivatives linked to the myth.