Friday, April 26, 2013

Beware of Ponzi schemes (or All "good" things always come to an end)

Source:http://www.soxfirst.com/50226711/ponzi_scheme_wrap_up.php

When  Sudipta Sen, CMD of Sharada  Investments was arrested on Tuesday, April 23rd along with two of his accomplices from a picturesque resort  in Sonemarg, near Srinagar in Kashmir; he appeared relaxed as if silently echoing his apprehension expressed a few weeks ago that like Jesus Christ , he’s a small guy with a humble background  fighting a system controlled by the rich & the elite and just like him he too will be crucified one day.  Sen is charged of running a Ponzi scheme whereby he uses multi-level-marketing model to rake in deposits from lakhs of small investors across Bengal, Jharkhand, Assam and Orissa. Sharada would promise exceptionally high returns to entice customers initially and then pay them  back using fresh deposits from new customers. The money was not invested in real businesses that earn returns . Instead close to 30-40% were disbursed to agents and the rest was deposited in the bank or siphoned off to support the luxurious lifestyle of Sen and his organization.

In short , Sharada was running a Ponzi scheme  which is characterized mainly by the following  principles.

 In a Ponzi scheme,

1.      Typically exceptionally high returns are promised to the poor  investors. For the latter, wealth by itself is a reward for survival  in an economy marked by high  unemployment and inflation.

2.       Initially high returns to old deposits are paid from the amount deposited by new entrants till the time new depositors stop entering when the scheme collapses as the payout becomes more than the deposits.

3.      Money is not invested in legitimate businesses that earn fair returns since such returns typically are less than that promised by the scheme and also because the promoters don’t have the expertise to run such businesses.

Charles Ponzi, who has given his surname to  such fraudulent schemes, said something similar to Sen . In 1920, when Charles Ponzi was charged with fraud and grand larceny in Boston he said that  all of his troubles came from the fact that the wealthy were trying to punish him for giving the "little guys" the opportunity to make a high rate of return. Chrales Ponzi had enticed investors in Boston in 1919 by promising 100% returns in 90 days through a grand scheme by which he would  use the opportunity of arbitrage in the prices of international postal coupons among several countries.  It was obvious that Charles Ponzi didn’t use the deposits from thousands of small investors ( it is reported he once collected  one million dollar in three hours flat, in 1919) to buy coupons at low value in Spain and sell them  at high rates in USof A;  not because of his ignorance that such actions at a large scale would reduce the price difference but because he’d put the money in the banks that earned only 5% interest to enable him siphon the profit  off for buying property and leading a luxurious life. 

Robert Schiller in his research paper , “From Efficient market theory to Behavioural finance,”( Journal of Economic Persepctives, volume 17, no 1, winter 2003, pp 84-105, published by Cowells foundation of Yale University) argues in favour of  “feedback theory” in  his seminal paper stating that when speculating prices go up creating success for initial investors, word-of-mouth enthusiasm picks up leading to spiraling upward of such prices until the feedback is disrupted. A Ponzi scheme, according to Schiller is one such real-time experiment where positive feedback from initial success is transmitted swiftly through social network of friends and relatives as well as through  communication media to hook new depositors. Schiller even goes further back to 1630s  to demonstrate his feedback theory . In 1630s, in  Netherlands there was a huge speculative bubble in Tulip Flower bulbs , known famously as “Tulipmania” , that  had occurred precisely due to the feedback mechanism in place till the rich started selling Tulip at 100% profit instead of  buying further Tulip bulbs and a negative feedback was created   taking the prices spirally downward and the event finally crashed.

The initial success and subsequent inevitable downfall of Ponzi schemes are  typically characterized by the highly amplified feedback, positive in the first case and negative in the latter.

Numerous Ponzi schemes have dotted the world  since  Charles Ponzi made them famous. Such schemes hide behind  not-for-profit organisations, portfolio managers, innovative farming techniques, stock-trading firms etc.  Among the most scandalous ones are the following .

Bernie Madoff , once the Chairman of NASDAQ, ran a Ponzi scheme that defrauded investors of 18 Billion US dollars (Rs. 99,000 crores) . Madoff ran his “wealth-management” business  for 17 years among the elite and the wealthy (minimum deposit in his scheme was $20 million (Rs. 110 crores) , paying old clients off from new deposits in the Chase Manhattan Bank. Madoff could do this by manipulating the stock-trading software whereby he backdated trades and created false trade receipts after  calculating returns of the clients. Madoff was arrested in December’2008 based on a complaint by his son and is now serving 150 years in prison.

In 1992, Damara Bertges and Hans Gunther Spachtholz founded the European Kings Club, a "non-profit" association that rallied against big European banks and promised to help the "little guys." They defrauded 94000 Swiss and German investors of $1billion (Rs.5500 crores) after running the scheme for two years. In that scheme, investors bought a club share for 1400 Swiss Francs (Rs. 80,000)  and were assured returns of 200 francs (Rs.11,400)  every month , effectively doubling the investment in 14 months. The positive feedback was so strong here that even during the trial there were loud cheers for the scamsters who finally served 7 years of prison terms.

 Wang Fengyou of Yelishen Tianxi Ltd introduced an ingenious scheme in China in the year 1999 to defraud 1 million investors of $2 billion (Rs.11000 crores) . In this scheme, investors were asked to engage in “ant-farming.” The investors were given a box of ants against $1500 (Rs.82,500) deposit .   To these ants,  every morning as well as in every evening , investors  had to feed sugar & honey and every 3-5 days , they had to feed  egg yolk & cake. But they were prohibited from opening the box. After 10 weeks the workers of Yelishen would take back the ant-boxes for grounding up the ants and converting them into aphrodisiacs to be  sold across 80000 pharmacies across China. For their farming effort, the investors were paid $2000 (Rs. 110,000) after 14 months, a 33% return. Wang’s scheme collapsed in Dec’2007 when he couldn’t pay his depositors and he  was arrested . And , yes the aphrodisiacs worked because they were found to be laced with Sildenafil (the chief ingredient of Viagra).

Sergei Mavrodi, a Russian scamster, in the early ‘90s found a company called MMM, which offered a platform to investors to buy or sell Mavros (unit of currency of MMM with Marvodi’s pictures). Mavrodi would call it a rebellion against the slavery of institutional banks & employers. MMM’s schemes were for helping small people with money. Investors have to join in with a minimum deposit to help others by buying Mavros and their money in real-time would be paid to old investors who needed help and were selling off Mavros. The price of Mavro would be decided twice in a week by Mavrodi himself. MMM defrauded 2 million investors of $1.5 billion ( Rs.8250 crores) before Mavrodi, a member of Duma, the Russian Parliament,   was arrested in 2003 . Mavrodi served prison for5 years and surprise of surprises, he has surfaced in India and running MMM India  as brazenly as Sen.

Closer home in Pakistan, the story of Double Shah had gained prominence. Shah, a science teacher, on his return from Dubai in 2005  promised to double his investors’ money in flat 7 days through some stock-program he said he’d learned in Dubai. Later he extended the period of doubling to 90 days. Double Shah was arrested in 2007 before he had raked in Rs. 4400 crores from 30000 investors. Shah died in prison in Nov’2012 .

In conclusion, Ponzi schemes have never disappeared in the world and they tend to appear   & resurface in areas marked either by unemployment,  lack of regulations or change in socialist regimes. Post the break-up of erstwhile USSR, hundreds of Ponzi scamsters, besides the  Mafia,  had sprung up in Russia to entice gullible  people with a “get-rich-quick” philosophy. Even  Albania, a European country to the north-west of Greece,  after the fall of East-European socialist regime, experienced similar Ponzi schemes. It went to such a disastrous extent that 2 out of 3 Albanians were investors in one of several such fraudulent schemes and the total amount involved was more that 50% of the country’s GDP. When the schemes collapsed in January’1997 there were such huge protests, violence as well as riots that the-then Albanian government  had collapsed. 

Sudipta Sen’s extent of fraud is still not clear. Initial estimates say that he’d have defrauded nearly 4-6  lakh of customers of Rs.1200 crores. Investigations would reveal the actual truth. But the concern is to the wide spread of number of such schemes floated by dubious promoters who public display their closeness to the authorities. Since the business model of all such schemes are the same, it is irrelevant if they have not yet defaulted. Because inevitably they will. If they are not investigated and stopped right now, the schemes will continue to carry forth large number of unsuspecting investors till the schemes collapse under its own weight of heavy redemption. If total number of such schemes are taken, the number may touch, by an estimate,  nearly a crore of investors defrauded by approximately  Rs.20000 crores .   

The uncanny similarity of Sen’s  modus operandi to that of other scamsters suggest the same process of  hobnobbing with government officials of  a state for publicity. Further, Bengal happens to be a state that had just seen an end to 3 decades of communist rule and is marked by large scale unemployment. Maybe the government  should be concerned about its medium-term survival since hundreds of Ponzi schemes are operating in the rural hinterland  with such brazenness and some with  official patronage that in the final analysis, the existing investors should stop further losses, lodge complaints and hope to get some money back from the authorities, if the latter  decide in their wisdom to immediately stop the functioning of similar schemes. New investors  have to necessarily be extra careful about parking their own money in schemes that have the 3 characteristics described earlier.  Am repeating that below.

Any scheme that offers very high Returns, which robs Peter to pay Paul and has no  legitimate business operation should ring alarm bells and should be avoided at all costs. Even a whiff of positive  feedback from friends/agents  bragging about initial successes  should only trigger an alarm but not a day-dream to get rich quick.

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