Sunday 5 December 2010

Beware of well-disguised Pyramid Schemes

Beware of well-disguised Pyramid Schemes

We've all heard of a wide range of scam stories, pyramid schemes, etc.

I'm forwarding an excerpt from a mail that I received some time back that talks about one such obvious pyramid scheme:

 

----- Original Message -----
From: BS

As we found out, some 90% of PQR's borrowings are secured against the very loan it gives out, in a remarkable case of pyramiding. Banks are funding its receivables arising out of gold loans even though the underlying gold does not belong to it. In effect, thanks to an interesting piece of financial engineering and support from banks, the gold people loan out to PQR becomes an asset for the company! This looks like a pyramid scheme but everyone believes that the pyramid will not topple as long as the going is good. While we have no forecast on the price of gold, we certainly believe that a business model, built by pyramiding money, entirely based on the speculative price of a single product, has huge potential risks. What are these risks?

 

In the original mail, the name of the company was clearly mentioned. I'm referring to the company as "PQR" for the following reasons:

  • Since I'm not 100% sure of the absolute facts of the case, I feel that it is inappropriate to mention the name on a blog post with negative implications
  • I'm personally aware of at least half-a-dozen companies to whom this anecdote would apply. Hence, there's no point naming a single entity.
  • This blog post is intended solely as an "educational post" - The idea is to make you conscious of the kind of environment that we are finding ourselves in, and, to that extent, be better prepared.

I would like to elaborate on the mail with a clarificatory note:

  • Let's say, PQR is a small-time lender with a capital of Rs. 1,00,000/= to lend towards gold loans. Let's further assume that 10 persons borrow a sum of Rs. 10,000/= each by pledging their gold jewels. Thus far, there is no undue risk to any person.
  • Now, if PQR takes a loan of Rs. 90,000/= against the amount receivable from these 10 borrowers from a bank, they can make a further disbursal of 9 such loans of Rs. 10,000/= each. However, their capital remains Rs. 1,00,000/=.
  • If the above process is repeated a dozen times, we have a situation where the capital of PQR remains 1,00,000/=. However, thanks to what the financial experts would call "leverage", the quantum of loans disbursed would run upwards of Rs. 10,00,000/=.

This is not in any way unduly risky for the borrower who is pledging his gold. However, for people who have invested their hard-earned money in PQR (either by buying equity stakes in PQR or by making a fixed deposit with PQR), this can become quite risky.

Let's see how:

  • Supposing a bank hears rumours about
    • A few defaults by customers of PQR or
    • The trustworthyness or otherwise of PQR
  • Immediately, the bank will ask PQR to repay those loans. Soon the matter will be out in the market, and other banks will also ask for their money.
  • Unfortunately, PQR can't ask all their borrowers to repay right away. Nor can they sell the gold. They are obviously stuck between a rock and a hard place.
  • Result: Either significant losses for PQR or for bankruptcy of PQR. Both of these consequences are bad for people who have invested in PQR.

Moral of the story:

  • If you are borrowing (by pledging jewels) from a company like PQR, you should be aware of the risks involved. But, as your requirement is apparently urgent and critical, it is perhaps OK. Even then, your first preference should be to borrow from a recognised bank (preferably a public sector bank). Only if all such alternatives are exhausted should you approach people like PQR.
  • If you are an investor in PQR (either buying shares of PQR or by making fixed deposits in PQR) - BEWARE OF THE RISKS INVOLVED
  • Once you understand the risk involved thoroughly, if you still desire, you may choose to invest a very small portion of your overall portfolio of investible surplus funds in companies like PQR. And watch your investments like a hawk.

For the benefits of readers who wonder who is this notorious PQR, here's my response:

  • It doesn't matter. All companies which give loans to individuals like you and me have to manage this inherent risk of leverage.
  • If you still want clues, look at the "Loan available" ads among the Sunday Classfied columns, Gold Loan advertisements on TV, etc. 
  • Some of them, like banks, are well-regulated entities, operating under strict rules and regulations, including prudential capitalisation norms.
  • Others, like PQR, are either unregulated or are coming under much less rigourous regulations.

Hence, you just need to understand your risk profile and invest accordingly. On both a long-term and short-term basis, you'll find that well-regulated, adequately capitalised banks have less volatile share price movements, but companies like PQR will have share price movements which are much more volatile. You'll find companies like PQR quoting at ridiculously low levels at the depth of a bear market.

  • If you have a sufficiently high risk appetite, and are reasonably confident that PQR will not go bankrupt before the next bull run, you can go ahead and invest your money in buying shares of PQR. You may very well have a multi-bagger in your hands.
  • However, if you're the kind of person who will lose sleep over erosion of the value of your portfolio, better stay away from companies like PQR.

Regards,

N


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