Indian Millennial: April 2013

When Bernie Maddoff made billions of dollars in a Ponzi Scheme by cheating Wall Street Junkies and Hollywood celebrities,I learnt wat a Ponzi Scheme means.
Since then I believed that a Chit fund and a Ponzi Scheme are one and the same eventhough i know one of them is legal.
Now I,ve got my answer.
Vivek Kaul from FirstPost explained the same in this article
Saradha chit fund has been in the news lately for all the wrong reasons. But the question that no one seems to be answering is whether Saradha chit fund was really a chit fund? A little bit of digging tells us that Saradha was nowhere near a chit fund. It was nothing but a Ponzi scheme, where money brought in by new investors was used to pay off the old investors. Before we get into the details, lets first try and understand what exactly is a chit fund.
A chit fund is basically a kitty party with a twist. Yes, you read it right. The essential part of any kitty party organised by ‘bored’ housewives across India, other than the eating, drinking and gossiping, is the money that is pooled together. So lets say a kitty has twelve women participating in it, with each one of them putting Rs 5,000 per month. The women meet once a month.
When they pool their money together it works out to a total of Rs 60,000 every month. Twelve names are written on chits of paper. From these twelve chits, one chit is drawn. And the woman whose name is on the chit gets the Rs 60,000 that has been pooled together.
When they meet next month eleven names are written on chits of paper and one chit is drawn. The woman who got the money the first time around is left out because she has already got the money once. The woman whose name is on the chit gets the Rs 60,000 that has been pooled together this time around. And so the system works. Every month a chit is drawn and the pooled money is handed over to the woman whose name is on the chit that has been picked. Of course, the women need to keep paying Rs 5,000 per month, even after they have got Rs 60,000 once. By the time the women meet for the twelfth time everyone who is in on the kitty gets Rs 60,000 once. And that is how a kitty more or less works. So what is a chit fund? A chit fund works more or less along similar lines but with a slight twist. Lets assume that the 12 women that we considered earlier come together and decide to contribute Rs 5,000 every month, as they had in the previous case. This means a total of Rs 60,000 will be collected every month. This amount is then auctioned among the 12 members after a minimum discount has been set. Lets say the minimum discount is set at Rs 5,000. This means the maximum amount any women can get from the total Rs 60,000 collected is Rs 55,000 (Rs 60,000 – Rs 5,000). After this discount bids are invited. All the women bid. One woman bids a discount of Rs 12,000. This is the highest discount that has been bid. And hence, she gets the money. Since she has agreed on a discount of Rs 12,000, that would mean she would get Rs 48,000 (Rs 60,000 – Rs 12,000). She will also have to bear the organiser charges of around 5 percent or Rs 3,000 (5 percent of Rs 60,000). This means she would get Rs 45,000 (Rs 48,000 – Rs 3,000) after deducting the organiser charges. The discount of Rs 12,000 is basically a profit that the group has made. This is distributed equally among the members, with each one of them getting Rs 1,000. This money that is distributed is referred to as a dividend. Of course the woman who got the money, will have to keep contributing Rs 5,000 every month for the remaining eleven months, like was the case with the kitty. This is how chit funds works and they are perfectly legal if they are registered under the Chit Funds Act 1982, a central statute or various state-specific acts. What if two or more women bid the maximum discount? It is possible that two or more women in the group are equally desperate for the money and bid the highest discount of Rs 12,000. Who gets the money in this case? In this case there names can be written on chits of paper and one chit can be drawn from those chits. The woman whose name is on the chit drawn, gets the money. Who do chit funds help? A chit fund helps those people who are facing a liquidity crunch and by bidding a higher discount amount they can hope to get the money being accumulated. So in the example taken above the woman gets Rs 45,000 by bidding the highest discount amount of Rs 12,000 and paying charges of Rs 3,000. But her contribution to the chit fund has been only Rs 5,000. So by effectively paying Rs 5,000, she has managed to raise Rs 45,000, which she can spend. Of course she will have to keep paying Rs 5,000 for the remaining eleven months. But by doing that the woman gives herself an opportunity to get a bulk amount once. The chit fund company typically does not ask what the winner of the amount wants to do with the money. As Margadarsi Chit Fund, one of the largest chit funds in the country points out on its website “The purpose of drawing the prized amount need not be disclosed. It can be used for any need by the member for Example: House construction, Marriage, Education, Expansion of business, buy a Computer or any other purpose at his discretion.” What kind of returns do chit funds give? As is clear from the above example, chit funds the way they are structured cannot give fixed returns. The kind of return an individual participating in a chit fund gets depends on the maximum discount that is bid in each of the months. The higher the discount, greater is the dividend that is distributed among the members of the chit fund. In the example taken above the maximum discount bid was Rs 12,000. This meant Rs 1,000 dividend could be distributed among the women who were participating in the chit fund. If the maximum discount bid was Rs 6,000, then a dividend of only Rs 500 would have been distributed. The returns also depend on the organiser charges. At 5 percent, the organiser of the chit fund in the example taken would get Rs 3,000 every month. At 3 percent he would have got Rs 1800 every month. Higher organiser charges mean that there is lesser money to distribute and hence lower returns. While organiser charges are fixed in advance, the maximum winning discounts are likely to vary from month to month, depending the desperation of the individuals bidding. Given this, there is no way a participant in a chit fund can know in advance the kind of returns he can expect. The same stands true for the organiser of the chit fund as well, who cannot know in advance the kind of returns that a participant is likely to get. Also even at the end of a chit fund, calculating returns is not easy. There are multiple cashflows. In the example taken above, every month there is an outflow of Rs 5,000 for every women who is a part of the chit fund. There is an inflow of dividend every month, which varies from month to month. One month in the year there is an inflow of the bulk amount that the woman wins because she bids the maximum discount in that month. To calculate the exact return, the internal rate of return formula needs to be used. It is difficult to execute this formula manually and needs access to a software like Excel. Was Saradha a chit fund? As we just saw a chit fund cannot declare in advance the return an individual is likely to make, given the way its structured. With Saradha chit fund and its promoter Sudipta Sen, that doesn’t seem to have been the case. Returns were promised to prospective investors in advance. As an article in the Business Standard points out “Sen offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.” If the principal multiplies four times in seven years it means a return of 22% per year. The question is how can such a high rate of return be promised, when bank fixed deposits are giving a return of 8-10% per year? Also, the fact that a rate of return was promised in advance clearly means that what Sen was running was not a chit fund. This is proven again by a recent order brought out by the Securities and Exchange Board of India (Sebi) which is against the realty division of Saradha. As the order points out“The average return offered by the noticee (i.e. Saradha)…when the investor opts for returns were between 12 percent to 24 percent.” At the cost of repeating, a chit fund the way its structured cannot declare returns in advance. So what was Saradha then? The various investment schemes run by the various divisions of the so called Saradha chit fund, which were raising money from investors in West Bengal and other Eastern states, can be categorised under what Sebi calls a collective investment scheme. A collective investment scheme(CIS) is defined as “Any scheme or arrangement made or offered by any company under which the contributions, or payments made by the investors, are pooled and utilised with a view to receive profits, income, produce or property, and is managed on behalf of the investors is a CIS. Investors do not have day to day control over the management and operation of such scheme or arrangement.” Lets take the case of the realty division of the Saradha chit fund which the Business Standard article referred to earlier says was “the company most active in collecting money from depositors.” Against the money collected Saradha promised allotment of land or a flat. The investors also had the option of getting their principal and the promised interest back at maturity. The land or the flat was not allotted to investors and the investors did not have day to day control either over the scheme or over the flat or land for that matter. The money/land/flat came to them only at maturity. Given these reasons Saradha was actually a collective investment scheme as defined by Sebi and not a chit fund. Where did all the money collected go? This is a tricky question to answer. But some educated guesses can be made. If the Saradha group was collecting money and promising land or flats against that investment, it should still have those assets? Can’t these assets can be sold and some part of the money due to the people of West Bengal be returned? Media reports seem to suggest that all this was simply a sham and there are no real assets. Saradha was trying to create an illusion and was trying to tell its investors and its agents that this is what we are trying to do with the money we are collecting from you. But there was nothing really that it was doing. The Business Standard quotes a Saradha group agents as follows : “We were bemused to see that only three or four people were working at the site which was being developed as a township. Sen said it would take 20 years to develop the projects as the company had so many businesses and it was not possible for him to oversee all of them,” says Abradeep, a Saradha agent.” Agents were also frequently taken to Sen’s Global Motors factory which had stopped production in 2011. But when agents came visiting, around 150 people posed as workers in an operational motorcycle factory. If the money being raised from depositors was put to actual use, then flats would have been built and motorcycles made and sold. All this leads this writer to believe that Saradha and Sen were simply rotating money. They were using money brought in by the newer investors to pay off the older investors whose investments had to be redeemed. At the same time they were creating an illusion of a business as well, which really did not exist. In the end Sen had to ask his agents to rotate money as well. As the Business Standard points out “Depositors say Sen’s companies were prompt with payments in the first year. Trouble started in January when his employees didn’t get their salaries on time. Then agents were told to make payments for maturities with fresh collections or make adjustment against renewals.” This is what happens in any Ponzi scheme. So where do chit funds fit into all of this? Saradha chit fund is not a chit fund. And that seems to be the case with many other so called chit funds in West Bengal. A report in The Asian Age says that there are 73 chit funds running in West Bengal. The question is how many of these funds are genuine chit funds. What seems to have happened is that a private deposit raising effort from the general public has been labelled as a chit fund. As Vinod Kothari writes in The Hindu “The West Bengal ‘chit funds’ are not chit funds at all, since these have a different structure. Chit funds are mutual credit groups where money circulates among the group members, and the monthly contributions of the chit members are received in rotation by one of the members who bids for it — much like a ‘kitty’…The several names that keep popping up in West Bengal are Collective Investment Schemes or Public Deposit Schemes.” Most of these collective investment schemes or public deposit schemes do not have any business model in place. They simply rotate money using money brought in by later investors to pay off earlier investors. They also pay high commission to agents to keep bringing new investors. That keeps the Ponzi scheme going. And as long as money brought in by later investors is greater than the money that has to be paid to earlier investors, these schemes keep running. The day this equation changes, these so called chit funds go bust. The same happened in case of Saradha chit fund as well.
Thanks to Vivek Kaul for the above detailed explanation on Chit funds