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An Introduction To Pyramids
A tried and trusted method of duping nave people We Told You So In July 1996, Intelligent Investor published an article that I had written on junk bonds. In that article, I talked about a very important principle of intelligent investing - The deficient safety of a fixed income contract cannot be compensated by an abnormally high interest rate. I gave instances where people and institutions, who forget this sound principle eventually suffer inevitable losses. One such example mentioned how gullible investors in Tamil Nadu were being cheated by unscrupulous organisations who were then inviting deposits that offered very high rates of interest but negligible margin of safety. Here is what I wrote at that time: "During the last few years, several hundred outfits have cropped up in India to part many fools from their money. These organisations - many of which are run out of one-room-one-man offices are more common in Tamil Nadu then anywhere else. To escape RBI regulations, most are un-incorporated bodies. Many do not even conform to the regulations that do apply to them. These organisations have been offering very high rates of interest on unsecured fixed deposits to lure investors who want current income. These deposits are not rated by credit rating agencies. If they were, they would be given below-investment grades. To lure depositors, many such entities have offered interest rates going up to as high as 30% and on top of that, most such entities are offering huge incentives such as gold coins when substantial deposits are made. Huge incentives are also being offered to brokers who naturally leave no stone unturned in convincing the public to put its money in these deposits. These ill-informed investors are foolishly handing over their hard-earned money to such entities in the belief that the high risk of default will be compensated by high interest rated being offered." The end of this story came earlier that I had expected. In the last few weeks, tens of thousands of members of the public in Tamil Nadu have lost crores of rupees by becoming victims to unscrupulous unincorporated firms such as Devi Gold House, Sneham Finance, Ramesh Cars Finance, Eswari Finance and Investments, Dakshina Finance, Badma Investments and many others. All these firms invited deposits offering very high rates of interest together with huge incentives. Most have defaulted on their commitments. Many have been shut down by their promoters some of whom have absconded. Some promoters have been arrested, but there is little hope that depositors will recover their entire investment. The hard fact is that thousands of educated members of the public have been taken for a ride and have suffered a permanent loss of their capital. What went wrong? Why did so many people take unnecessary risks with their hard earned money? Why were such schemes doomed to fail eventually? To answer these questions, let me explain the concept of "pyramids" in finance by giving two other recent examples of pyramid schemes - one from Ghana and the other from Russia. A Pyramid in Ghana In May 1995, the entire population of Ghana was talking about the "money people." Since 1993 these "money people" were offering a monthly rate of interest of 30 percent on cash deposited with them. By 1995, so popular had these schemes become that several unlicenced firms started doing fantastic business
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in Accra and Kumasi. Tens of thousands of people, rich and poor, put in their money in them. Stories were abound of people closing their accounts elsewhere, selling their homes, and depositing their life savings at these places. The central bank of the country - The Bank of Ghana - warned the public that it is impossible to sustain a 30 percent monthly return, and the deposit-taking firms refused to explain how they did it. An accountant for one of them said, "We can't tell you how we make our money, but we will never, never default." Another would get no more specific than to say their investment strategies were a "special African secret." The central bank's warnings went unheeded and people came forward and formed giant queues to hand over their money to these firms. Each day, by 7 am, a thousand people or so would gather outside the humble offices of Pyram Business Consultancy Services, which claimed to have 50,000 clients. Housewives, office workers, soldiers, custom officers, students and unemployed sat all day on hard benches for their names to be called so they could make deposits. One of them explained, "People don't want to know how Pyram gets its money. All they care about is that it keeps its promise. Every month we get our money. There is no single customer who has not been paid." All that changed in a matter of months when Pyram defaulted. By late 1995, most Ghanian pyramids collapsed due to simple arithmetical logic which I shall give later in this article. The fate of thousands of members of the public was the same as that of the gullible public in Tamil Nadu - a permanent loss of capital. And Another One in Russia This huge pyramid was operated during 1991-94 by one Sergei Mavrodi whose company MMM offered "guaranteed" returns of 3,000 percent a year to its investors. Mavrodi first became famous in 1991 when, on two occasions, he paid for a day's free travel for all Muscovites on the metro in order to publicise MMM. Using a slick advertising campaign, Mavrodi convinced millions of Russians to deposit their cash with MMM. By July 1994, MMM had 60 offices in Moscow, another 76 in 49 cities spread across Russia and claimed to have 10 million shareholders. The price of MMM shares, which were for a time the most actively traded in Russia, rose from 1,600 roubles in February 1994 to 119,000 roubles in July 1994. A manager of one of MMM's Moscow branches revealed how he was splitting MMM shares into "tickets" so that everyone could afford to buy a part of a share "in order to build the pyramid from the bottom." As in any classic pyramid financing scheme, this pyramid was doomed to collapse under its own weight and that is exactly what happened. The rout began on July 26 1994, when all but one MMM office in Moscow stopped buying back shares. By 3 August 1994, MMM's share price had fallen to 1,275 roubles - a fall of 99 percent from its peak. The collapse of MMM devastated millions of people and Mavrodi eventually landed in jail. However, the end result for most participants in the MMM pyramid scheme was a familiar one - a permanent loss of capital. How To Build A Pyramid As the above examples explain, to build a financial pyramid all that is required is the ability to sound convincing and the availability of gullible people with spare cash to invest. To attract the initial investors in the scheme, outrageous rates of return, together with free gifts and other incentives are offered by the promoters of the pyramid. The initial contributors do get high returns on their investment. They all go and tell their happy experiences to their friends and relatives. Many happily agree to tell their stories in advertisements prepared by the promoters to attract more people in the scheme. A part of the initial money received is invested. The rest is spent on advertisements to attract more
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members in the scheme. The money brought in by the new investors together with returns from invested funds are used to pay off those who want their money back. That is the reason why these schemes are called "pyramids". Their shape can be visualised as that of a pyramid. The new members in the scheme are at the bottom of the pyramid. Their money is blocked for a little while. The oldest members are at the top of the pyramid. The money collected from those at the bottom is used to pay of those at the top of the pyramid. The Short Life of Financial Pyramids There is only one problem with the pyramid structure. For it to succeed, the members at the bottom of the pyramid have to grow in a geometric progression. Only if that happens will the money received from the new members be sufficient to pay off the old ones. But geometric progressions cannot go one forever. And as Herb Stein once said: "If something can't go on forever, it will end." A time comes when the money coming in the scheme is no longer sufficient to pay the promised sums to those at the top of the pyramid. Usually, under these circumstances, the promoters try to convince those at the top of the pyramid to renew their deposits. Usually, such attempts fail. The end result is always the same: financial pyramids, unlike architectural ones are bound to collapse sooner or later. That is exactly what has happened in Tamil Nadu. At one time, Devi Gold House claimed to have 200 firms in the group and had accepted deposits from 25,000 depositors totalling more then 20 crores. A significant portion of the money raised was spent on advertising in order to attract more deposits. Maruti Esteems were offered as prizes in contests. One firm, Call Centre, offered depositors from outside of Madras reimbursement of rail fare in cash. Its inaugural function was telecast on local TV channels. Another firm, Dakshina Finance floated an ingenious scheme for women called "Women's Instant Interest Bond." Designed for "the woman of today, who don't wait for tomorrow" the scheme offered the entire interest on the 1 year deposit in advance in cash. What the advertisements did not mention was that the principal was unlikely to be redeemed in full. Another firm, New India Finance and Investments advertised the names of its group firms in which the deposits were to be invested. Some of these were New India Astrological Services, New India Paradise, New India Cultural Academy & New India Matrimonial Services - hardly the type of businesses that could generate post-tax returns on capital well in excess of 30% a year. One noteworthy point is that the Reserve Bank of India tried to warn the members of the public by issuing an advertisement in which it actually named 30 firms and cautioned the public that these deposits have no government or RBI safety net and that any deposits with such firms would be at the sole risk of the depositors. No matter. The public was taken in by the high rates of interest being offered together with tempting incentives. And after all, hadn't these firms always fulfilled their promises? Why should they fail to do so in the future? Many educated investors knew the risks of giving money to these firms and yet did not hesitate in depositing their cash with them. Some figured that at the first sign of trouble they will be the first to get out. As it turned out, they were wrong. Others thought they could spread their risk by investing in many such firms instead of one. They forget an elementary lesson - a diversified portfolio of lousy investments will produce a lousy result. Spotting Pyramids Just like one can learn a lot about intelligent investing by studying successful investors, one can learn a lot about intelligent investing by learning from others' mistakes. Investing money in a pyramid scheme is a big mistake, regardless of the attractive returns or incentives being offered (these "incentives" are not
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big mistake, regardless of the attractive returns or incentives being offered (these "incentives" are not really incentives; they are traps) and regardless of the fact that there are others who have made money perhaps a lot - by participating in a pyramid scheme. The problem is that one cannot always spot a pyramid scheme. Some pyramid schemes are perfectly legal and some are, in fact, run by governments. But there is one common characteristic in all financial pyramids - in order to succeed for a while, there must be more members coming in the scheme than leaving so that money from the new members can be used to pay (1) the old members wishing to leave the scheme; and (2) the advertisement and publicity expenses required to attract even more members to sustain the scheme. If you are offered a TV or a Sofa at an incredibly low price with a condition that you have to give your money in advance and that you will get your goods after a few weeks or months, and if you are being hard-sold the scheme by being offered great incentives, chances are you are being asked to participate in a pyramid scheme. Watch out. If you are asked by some stranger to send money by post to an unknown person, with the promise of being sent a lot more money by other strangers, you are being conned into a chain-letter that is nothing but a pyramid. Watch out. If you are frequently asked by a company having a low-return business to subscribe to its shares or bonds, the proceeds of which, in effect, will be used to pay for (1) interest or redemption of bonds issued by it earlier and/or (2) dividends on its equity shares, you are being asked to participate in a perfectly legal, but not often noticed pyramid scheme. Watch out. Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1996.

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