Robert Shiller

Why believing that real estate prices will never fall is a stupid idea

India-Real-Estate-MarketVivek Kaul

In a piece I wrote yesterday I said that banks in India play an important role in ensuring that real estate prices do not fall. The main point was that loans given by banks to commercial real estate, between November 2012 and November 2013, has grown at a much faster rate than their overall lending.
This has happened in an environment where real estate companies have a lot of unsold homes(or what is referred to as inventory in technical terms). The number of new projects being launched by real estate companies has also fallen significantly.
Hence, fresh loans given by banks has helped real estate companies pay off their old loans. And this has ensured that they haven’t had to cut prices in order to sell their unsold inventory. If bank loans to commercial real estate hadn’t grown as fast as it has, then the real estate companies would have had to sell off their existing inventory to repay their bank loans. And in order to do that they would have to cut prices.
In response to this piece several readers said that real estate prices never fall. Still others agreed that there is a real estate bubble in India but that bubble would never burst (whatever that meant). And this is not the first time I have received such responses.
So what is it that leads people to believe that real estate prices never fall? People have seen real estate prices only go up over the last 10 years. A home that was bought for Rs 25 lakh is now worth Rs 2 crore. Hence, there is a firm belief that real estate prices can only keep going up.
In fact such confidence was observed even during the American real estate bubble that ran from the late 1990s to late 2006.
As Alan S. Blinder writes in After the Music Stopped “A survey of San Francisco homebuyers… found that the average price increase expected over the next decade was 14 percent per annum…The Economist reported a survey of Los Angeles homebuyers who expected gains of 22 percent per annum over the same time span.”
At an average price increase of 14% per year, a home that cost $500,000 in 2005 would have cost $1.85 million by 2015. At 22% it would have cost $3.65 million.
If we apply this in an Indian context we get some fairly interesting numbers. A three bedroom apartment near the Sector 12 metro station in Dwarka, a sub-city of Delhi, went for around Rs 25 lakh nearly 10 years back.
Now it costs around Rs 2 crore. If prices rise at 14% per year it will cost Rs 7.4 crore in 10 year’s time. At 22% it will cost Rs 14.6 crore. If prices rise at the same rate as they have in the last ten years, then the home would cost around Rs 16 crore. And these are huge numbers that we are talking about here. This small calculation tells us how ridiculous it is to assume that real estate prices will continue to go up at the same rate as they have in the past.
We all know what happened in the United States. The real estate bubble peaked in 2006. Prices started to fall after the last. For the last 16 months real estate prices as measured by the 20 City S&P/ Case- Shiller Home Price Index, have been rising. But they are still 20.7% below their 2006 peak.
A similar thing is playing out in the Indian context as well, wherein people are extrapolating the price rise of the last 10 years over the future. They are “anchored” into the price rise that real estate has seen over the last 10 years and this has led them to believe that prices will continue to rise forever.
What they forget is that real estate prices fell dramatically between 1997 and 2003. As Manish Bhandari of Vallum Capital writes in a report titled The End game of speculation in Indian Real Estate has begun “The previous deleveraging cycle in year 1997-2003 witnessed price correction by more than 50% in Mumbai Metro Region (MMR) property.” Yes, you read it write, prices fell by 50% in Mumbai, the last place you expect prices to fall, given that the city is surrounded by the sea on three sides and can grow only in one direction.
Other than the price rise, another reason behind the belief that real estate prices will continue to go up is the fact that there is only so much land going around. In fact, this reason has been offered for more than 100 years.
As George A. Akerlof and Robert J. Shiller point out in Animal Spirits “In a computer search of old newspapers, we found a newspaper articles from 1887—published during the real estate boom in some U.S. cities including New York—which used the idea to justify the boom amid a rising chorus of skeptics: “With the increase in population, the demand for land increases. As land cannot be stretched within a given area, only two ways remain to meet demands. One way is to build high in the air; the other is to raise price of land…Because it it perfectly plain to everyone that land must always be valuable, this form of investment has become permanently strong and popular.”
The point I am trying to make here is that the ‘limited land’ argument to justify high real estate prices is as old as land being bought and sold. Nevertheless, in most cases there is enough land going around. This is reflected in the American context in the fact that real estate prices have barely risen over the last 100 years, once they are adjusted for inflation.
As Akerlof and Shiller write “Moreover, real home prices in the United States rose only by 24% from 1900 to 2000, or 0.2% per year. Apparently land hasn’t been the constraint on home construction. So home prices have had negligible real appreciation from the source.”
What about India? While land maybe an issue in a city like Mumbai, it clearly is not much of an issue anywhere else. There is enough land going around.
Economist Ajay Shah did some number crunching in a May 2013 column in The Economic Times. He showed that there is enough land to house India’s huge population. As he wrote “A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
Also, it is worth pointing out here that real estate prices have fallen dramatically even in countries like Japan where land unlike the United States is scarce. “Urban land prices have recently fallen in Japan (where land is every bit as scarce as it is in other countries). In fact they fell 68% in real terms in major Japanese cities from 1991 to 2006,” write Akerlof and Shiller. And the property prices in Japan are still lower than they were in the 1980s.
The moral of the story is that just because something has continued to happen till now, does not mean that it will continue to happen in the future as well. There are many fundamental reasons behind why the Indian real estate bubble is unsustainable (I made some of them in yesterday’s piece).
Let me make a few more here. Indian real estate has now become totally unaffordable. As Bhandari writes “The current real estate price represents affordability of very few, while average users have to sell their twenty years of future earnings to afford a house.”
The employment situation remains extremely grim. In a report titled Hire and Lower – Slowdown compounds India’s job-creation challenge,Crisil estimates that “employment outside agriculture will increase by only 38 million between 2011-12 and 2018-19 compared with 52 million between 2004-05 and 2011-12.” This in an environment where “India’s working age population would have swelled by over 85 million. Of these, 51 million would be seeking employment.”
With fewer non agriculture jobs being created a direct implication would be that incomes will not continue to grow at the same pace as they have in the past. And that in turn will mean a lower amount of money waiting to get into real estate. There are other economic indicators also which clearly show that the Indian economy has slowed down considerably than in comparison to the past. And the real estate sector will have to adjust to this reality.
Bhandari believes that the scenario that played out during the period 1997 ad 2003 will play out again, very soon. As he points out “One of the most important proponents of fall in the property prices is likely to start from the deleveraging cycle, by the Indian banking sector, which is running a multi decade investment to deposit ratio (108%). The reversal of easy business cycle, scarcity of capital, tight monetary cycle in domestic and international market will force scheduled commercial banks to deleverage their balance sheet over the next three to four years. One can observe the same scenario, witnessed in 1997-2003, when deleveraging by the Indian Banking Sector was accompanied by deleveraging corporates that had accumulated huge debts on their books during good times. This augurs a difficult time for the Real Estate Industry.”
Even with all these reasons it is difficult to predict when the Indian real estate bubble will start running out of steam. But that does not mean that real estate prices will never fall in India. It may happen this year. Or in 2015. Or the year after that.
But in the end, all bubbles burst. It is just a matter of time. As Blinder aptly puts it “Anyway, one thing we do know about speculative bubbles—whether in houses, stocks, or anything else—is that they eventually burst.” And what that tells us is that days of earning huge returns from Indian real estate are more or less over.
The article originally appeared on www.firstpost.com on January 8, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

The theory that caused the financial crisis gets a Nobel prize

alfred nobelVivek Kaul
Do financial markets have bubbles? Like most things in economics, the answer to what seems like a rather straightforward question, is yes and no. It depends on which economist you are talking to.
Eugene Fama and Robert Shiller are two of the three economists(the third being Peter Hansen) who have won the Nobel Prize in Economics this year.
When it comes to the bubble question Fama feels there are no bubbles. Shiller, on the other hand, has done some of his best work in economics around financial market bubbles. In fact, he was one of the few economists, who predicted both the dotcom bubble as well as the real estate bubble. Ironically enough, both of them have won the Nobel Prize in the same year.
Eugene Fama, who teaches at the University of Chicago, came up with the efficient market hypothesis(EMH), sometime in the 1960s. A lot of financial theory that followed was built around EMH.
Benoit Mandelbrot, a mathematician who did some pioneering work in economics, was Fama’s thesis advisor. As Mandelbrot (along with Richard Hudson) writes in The (Mis) Behavior of Markets – A Fractal View of Risk, Ruin and Reward “It (i.e. EMH) became the intellectual bedrock on which orthodox financial theory sits.”
So what is the EMH? As Mandelbrot and Hudson write “At its heart: In an ideal market, security prices fully reflect all relevant information…Given that, the price at any particular moment must be the “right” one.”
And how is that possible? How can the price of a financial security( lets say a stock or a bond) at any point of time incorporate all the information?
Mark Buchanan explains this through a small thought experiment in his book Forecast – What Physics, Meteorology and Natural Sciences Can Teach Us About Economics “Let’s do a thought experiment, which I’ll call the 5 percent problem. Suppose that on Tuesday morning everyone knew for sure that the markets would recover, stocks gaining 5 percent(on average) in a big rally in the final half hour at the end of the day. Everyone in the market would expect this rise, and lots of people on that morning would be eager to pay up to 5 percent more than current values to buy stock, as they would profit by selling at the day’s very end. Knowledge of the coming afternoon rise would make the market rise immediately in the morning, violating the assumption we made to start this thought experiment; the prediction of a late rally would be totally wrong.” Hence, information about the market rising by 5% towards its close, would be incorporated into the price of the stocks immediately.
Mandelbrot and Hudson give another similar example to explain EMH. “Suppose a clever chart-reader thinks he has spotted a pattern in old price records – say, every January, stocks prices tend to rise. Can he get rich on that information by buying in December and selling in January? Answer: No. If the market is big and efficient then others will spot the trend, too, or at least spot his trading on it. Soon, as more traders anticipate the January rally, more people are buying in December – and then, to beat the trend for a December rally, in November. Eventually, the whole phenomenon is spread out over so many months that it ceases to be noticeable. The trend has vanished, killed by its very discovery,” write Mandelbrot and Hudson.
And this happens primarily because the market is made up of many investors, who are all working towards spotting a trend and trading on it. As Buchanan explains in Forecast “In this view, a market is a vast crowd of investors with diverse interests and skills all working hard to gather information on every kind of manufacturing company, bank, nation, technology, raw material, and so on. They use that information to make best investments they can, jumping on any new information that might affect prices as it comes along, and using that information to profit. They sell currently valued stocks, bonds, or other instruments, and buy undervalued ones. These very actions act to drive the prices back toward their proper, realistic, or “intrinsic” values.”
Given this financial markets are correctly priced all the time. Robert Shiller summarises this argument best in Irrational Exuberance. As he writes “The efficient markets theory asserts that all financial prices accurately reflect all public information at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times.”
And if financial assets are correctly priced, there is no question of any speculative bubbles occurring. As John Cassidy writes in How Markets Fail – The Logic of Economic Calamities “During the 1960s and ’70s, a group of economists, many of them associated with the University of Chicago, promoted the counter-intuitive idea…that speculative bubbles don’t exist. The efficient market hypothesis…states that financial markets always generate the correct prices, taking into account all of the available information…In short financial prices are tied to economic fundamentals: they don’t reflect any undue pessimism..If markets rise above the levels justified by fundamentals, well informed speculators step in and sell until prices return to their correct levels. If prices fall below their true values, speculators step in buy.”
This ensures that all the available information is priced in. Hence, at any point of time, the market price is the correct price. And given that where is the question of any bubbles popping up? As Fama put it in a 2010 interview, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
Robert Lucas, another University of Chicago economist who won the Nobel prize in 1995, reflected Fama’s sentiment when he said “The main lesson we should take away from the EMH for policy-making purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.”
And this is the view that came to dominate much of the prevailing economic establishment since the 1960s. It is surprising that economists have had so much confidence in a theory for which the evidence is at best sketchy. Raj Patel makes this point in The Value of Nothing “The problem with efficient market hypothesis is that it doesn’t work. If it were true, there’d be no incentive to invest in research because the market would, by magic, have beaten you to it. Economists Sanford Grossman and Joseph Stiglitz demonstrated this in 1980, and hundreds of subsequent studies have pointed out quite how unrealistic the hypothesis is, some of the most influential were written by Eugene Fama himself.”
Also, if EMH were true, prices of financial assets would be right all the time, which is clearly not the case. As Buchanan writes “In November 2010, the New York Times reported on a dozen “mini flash crashes” in which individual stocks plunged in value over a few seconds recovering shortly thereafter. In one episode, for example, stock of Progress Energy – a company with eleven thousand employees – dropped 90 percent in few seconds. There was no news released about the business prospects of Progress Energy either before or after the event…On May 13(2011), Enstar, an insurer, fell from roughly $100 a share to $0 a share, then zoomed back to $100 in just a few seconds.”
Shiller gives the example of eToys and Toys “R” Us, two companies which were into selling toys. As he writes “Consider, for example, eToys a firm established in 1997 to sell toys over the Internet. Shortly after its initial public offering in 1999, eToys’ stock value was $8 billion, exceeding the $6 billion value of the long established “brick and mortar” retailer Toys “R” Us. And yet in fiscal 1999 eToys’ sales were $30 million, while the sales of Toys “R” Us were $11.2 billion, almost 400 times larger. And eToys’ profits were a negative $28.6 million, while the profits of Toys “R” Us were a positive $376 million.”
So a company with no profits had a greater market capitalization in comparison to a company making substantial profits. Now as per the EMH this should have never happened. Investors would have sold the eToys’ stock and driven down its price. But that did not happen, at least for a few years. And the stock price of eToys went from strength to strength.
But despite the weak evidence in support of EMH, the prevailing economic thinking since the 1960s has been that market prices of financial assets reflect the fundamentals, and hence, there was no chance of bubbles popping up. And even if bubbles did pop up, now and then, there was no chance of identifying them in advance. Alan Greenspan, the Chairman of the Federal Reserve of United States between 1987 and 2006, believed that a central bank could not spot a bubble, but could hope to mitigate its fallout, once it burst.
This led to him letting the dotcom bubble run. A few years later he let the real estate bubble run as well. He was just following the economic theory that has dominated over the last few decades. As Patel writes “ Despite ample economic evidence to suggest it was false, the idea of efficient markets ran riot through governments. Alan Greenspan was not the only person to find the hypothesis a convenient untruth. By pushing regulators to behave as if the hypothesis were true, traders could make their titanic bets…Governments enabled the finance sector’s binge by promising to be there to pick up the pieces, and they were as good as their word.”
In the end, Greenspan did find out that the model did not work and that bubbles did occur, now and then. As he admitted to before a committee of the House of Representatives in October 2008, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak…I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
So Eugene Fama’s EMH doesn’t really work and has caused the world a lot of harm.
Now compare this to Robert Shiller who in the first edition of Irrational Exuberance, which released some time before the dotcom bubble burst, compared the stock market to a Ponzi scheme. As he wrote “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasise the positive news and give less emphasis to the negative.”
Hence, financial markets at times degenerate into Ponzi schemes, where prices are going up simply because prices are going up. These bubbles can keep running for a while, just as the dotcom bubble in the US and the real estate bubble all over the developed world, did. When these bubbles burst, they caused huge economic problems, as we have seen over the last few years.
The trouble is that the dazzle of efficient market hypothesis has blinded economists so much that they cannot spot bubbles anymore. Hence, it is important that economists junk the efficient market hypothesis, and start looking at a world where bubbles are possible and keep popping up all the time. Else, we will have more trouble ahead.

The article originally appeared on www.firstpost.com on October 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Japan to India: Busting the biggest myth of investing in real estate

India-Real-Estate-MarketVivek Kaul 
Japan saw the mother of all real estate bubbles in the 1980s. Banks were falling over one another to give out loans and home and land prices reached astonishingly high levels. As Paul Krugman points out in The Return of Depression Economics “Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
As prices kept going up, the Japanese started to believe that the real estate boom will carry on endlessly. In fact such was the confidence in the boom that Japanese banks and financial institutions started to offer 100 year home loans and people lapped it up.
As Stephen D. King, the chief economist at HSBC, writes in his new book When the Money Runs Out “ By the end of the 1980s, it was not unusual to find Japanese home buyers taking out 100 year mortgages (or home loans), happy, it seems, to pass the burden on to their children and even their grand children. Creditors, meanwhile, naturally assumed the next generation would repay even if, in some cases, the offspring were no more a twinkle in their parents’ eyes. Why worry? After all, land prices, it seemed, only went up.”
Things started to change in late 1989, once the Bank of Japan, the Japanese central bank, started to raise interest rates to deflate the bubble. Land prices started to come down and there has been very little recovery till date, more than two decades later. “Since the 1989 peak…land prices have fallen by 60 per cent,” writes King.
Every bull market has a theory behind it. Real estate bull markets whenever and wherever they happen, are typically built around one theory or myth. Economist Robert Shiller explains this myth in The Subprime Solution – How Today’s Financial Crisis Happened and What to Do about It. Huge increases in real estate prices are built around “the myth that, because of population growth and economic growth, and with limited land resources available, the price of real estate must inevitably trend strongly upward through time,” writes Shiller
And the belief in this myth gives people the confidence that real estate prices will continue to go up forever. In Japan this led to people taking on 100 year home loans, confident that there children and grandchildren will continue to repay the EMI because they would benefit in the form of significantly higher home prices.
A similar sort of confidence was seen during the American real estate bubble of the 2000s. In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. Such was the belief in the bubble.
India is no different on this count. A recent survey carried out by industry lobby Assocham found that “over 85 per cent of urban working class prefer to invest in real estate saying it is likely to fetch them guaranteed and higher returns.” 
This is clearly an impact of real estate prices having gone up over the last decade at a very fast rate. The confidence that real estate will continue to give high guaranteed returns comes with the belief in the myth that because population is going up, and there is only so much of land going around, real estate prices will continue to go up.
But this logic doesn’t really hold. When it comes to density of population, India is ranked 33rd among all the countries in the world with an average of 382 people per square kilometre. Japan is ranked 38th with 337 people living per square kilometre. So as far as scarcity of land is concerned, India and Japan are more or less similarly placed. And if real estate prices could fall in Japan, even with the so called scarcity of land, they can in India as well.
Economist Ajay Shah in a recent piece in The Economic Times did some good number crunching to bust what he called the large population-shortage of land argument. As he wrote “A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
The interesting thing is that large population-shortage of land is a story that real estate investors need to tell themselves. Even speculators need a story to justify why they are buying what they are buying.
Real estate prices have now reached astonishingly high levels. As a recent report brought out real estate consultancy firm Knight Frank points out, 29% of the homes under construction in Mumbai are priced over Rs 1 crore. In Delhi the number is at 11%. Such higher prices has led to a drop in home purchases and increasing inventory. “The inventory level has almost doubled in the last three years. In the National Capital Region, the inventory level reached 31 months at the end of March 2013 against 15 months at the end of March 2010, while in the Mumbai Metropolitan Region the inventory level has jumped from 17 months to 40 months. In Hyderabad, it reached 49 months in March 2013 as compared to 23 months in March 2010, according to data by real estate research firm Liases Foras. Inventory denotes the number of months required to clear the stock at the existing absorption rate. An efficient market maintains an inventory of eight to ten months,” a news report in the Business Standard points out.
The point is all bubble market stories work till a certain point of time. But when prices get too high common sense starts to gradually come back. In a stock market bubble when the common sense comes back the correction is instant and fast, because the market is very liquid. The same is not true about real estate, because one cannot sell a home as fast as one can sell stocks.
Real estate companies in India haven’t started cutting prices in a direct manner as yet. But there are loads of schemes and discounts on offer for anyone who is still willing to buy. As the Business Standard news report quoted earlier points out “As many as 500 projects across India are offering some scheme or the other, in a bid to push sales in an otherwise slow market. According to Magicbricks.com, an online property portal, Mumbai has the maximum number of projects with schemes/discounts at around 88, followed by Delhi with 56 and Chennai and Pune with 33 each. Kolkata has 30 such offers, while Hyderabad has 18 and Bangalore has 16. On a pan India level, Magicbricks has about 274 projects with discounts offer.”
Of course the big question is when will the real price cuts start? They will have to happen, sooner rather than later.
The article originally appeared on www.firstpost.com on July 2, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
 
 
 
 

Saradha and Ponzi schemes: Why there will be more suckers

Saradha-Group-headquarters-650x430

Vivek Kaul

In Ek Thi Daiyan, the latest horror flick to come out of Bollywood, the dying daiyan (witch) says something to the effect of “main wapas aaongi (I’ll be back).” Ponzi schemes are a tad like that. They keep coming back one after the other. 
Only sometime back we were talking about the Stockguru Ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space.
MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won’t be able to withdraw it. The Saradha Chit fund has collapsed. 
The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank.
As The Economic Times points out in an editorial “the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system.” This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them. 
Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well. 
So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in. 
Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled From Efficient Market Theory to Behavioural Finance as follows: A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme. 
The phrase to mark in this definition is “high returns generate excitement”. Very recently, MMM India promised returns of 100% per month to prospective investors. The prospect of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme. 
As Robert Shiller writes in Finance and the Good Society“The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets…This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.” 
This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become the advertisers for the scheme. If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the ‘circular mills’ of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you.
Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi Scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance.
This happens because the attraction of easy money is something that investors cannot resist. Ponzi Schemes offer the prospect of huge returns in a short period of time vis a vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi Scheme. As Charles Kindleberger wrote in Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. 
Overconfidence also has a part to play. Most people are confident that they won’t become victims of financial frauds. This also leads them to invest in Ponzi schemes. Ove
rconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments.
The contract effect is also at play. It becomes relevant in the context of a Ponzi Scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market for investment at that point of time. The high returns of offered by a Ponzi scheme stand out clearly and attracts investors.
So a Ponzi scheme just doesn’t spread only because of a weak banking structure though that might be true in case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller’s definition of a Ponzi scheme, which is: “A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors.”
So people running Ponzi schemes spend a lot of time in building a ‘supposed’ business model and building a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors. 
Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, Speak Asia was in the magazine and survey business. It also advertised majorly in the publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks. 
MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 football worldcup. When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy. 
Over the years, investors have been fooled into investing their money into Ponzi Schemes which keep appearing in various forms. They ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are naïve enough to believe in what is communicated to them by the people carrying out the fraud. 
Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones, which are reported and investigated, get stuck in the quagmire of our legal system. This encourages more people to run Ponzi Schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down.
The most commonly suggested solution for prevention of Ponzi Schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgement. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited.
Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the Ponzi Schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.

The article originally appeared on www.firstpost.com on April 23, 2013

 (Vivek Kaul is a writer. He tweets @kaul_vivek)

 

 

Wiser after Stockguru: 5 ways to spot a Ponzi scheme


 
Vivek Kaul
So a Ponzi scheme is in the news again. Last time it was the emu Ponzi scheme. Before that there was Speak Asia. Now it’s the turn of Stock Guru to take investors across the county for a ride. The modus operandi as is the case with all Ponzi schemes is the same: the lure of high returns. In the end more than the frauds who ran Stock Guru it’s the investors who invested in the scheme have only themselves to blame.  There greed did them in.
While one Ponzi scheme differs from another, but despite the details changing, the structure abides. Let’s first try and understand what exactly is a Ponzi scheme and why is it so called.
Charles Ponzi
Chalres Ponzi was an Italian immigrant who landed in America in 1903. Sometime in August 1919, in the process of starting an export magazine, he realised that there was money to be made through an arbitrage opportunity that existed. Ponzi sent an offer to a person in Spain requesting him to subscribe to the magazine. The subscriber agreed and sent Ponzi an international postal reply coupon. This coupon could be exchanged at the post office for American stamps which would be needed to send the magazine to the Spanish subscriber. The coupon in Spain cost the equivalent of one cent in American currency. In America when Ponzi exchanged the coupon, he got six cents worth of stamps. And this set Ponzi thinking.
What was the plan?
The plan was very simple. Ponzi could buy international postal reply coupons convert them into American stamps and sell those stamps and make money. So he would need one cent to buy an international postal reply coupon in Spain. That coupon could be exchanged for stamps worth six cents in America and those stamps could then be sold for six cents. Hence there was a clear profit of five cents, assuming there were no other charges, to be made on every one cent that was invested. The trouble of course was that Ponzi needed money to get started.
Double your money in 90 days
So Ponzi launched an investment scheme asking people to invest. He promised them that he would double their money in 90 days. Ponzi would make a profit of five cents for every one cent that he invested. That meant a profit of 500%. As far as investors were concerned he was only promising to double their money and that meant a return of 100%. Hence, on the face of it looked like a reasonably safe proposition. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme.
What went wrong?
As if often the case what sounds great in theory cannot be put into practise. The idea was brilliant. But Ponzi had not taken into account the difficulties involved in dealing with various postal organizations around the world, along with other problems involved in transferring and converting currency. Also with all the money coming in Ponzi couldn’t stop himself from living an extravagant life and blowing up the money investors brought in.
But soon doubts started arising on the legitimacy of the scheme. The Boston Post newspaper ran a story on July 26, 1929, and within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi settled the obligations of the people who had gathered. The anger subsided, but not for long.  On Aug 10th, 1920, the scheme collapsed. It was revealed that Ponzi had purchased only two international postal reply coupons and was using money brought in by the new investors to pay off old investors.
So what is a Ponzi scheme?
Robert Shiller, an economist at Yale University in the United States defines Ponzi schemes as “A Ponzi Scheme involves a superficially plausible but unverifiable story about how money is made for the investors and the fraudulent creation of high returns for initial investors by giving them money invested by subsequent investors. Initial investor response to the scheme tends to be weak, but as the rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. ( Adapted from Shiller 2003).” Hence, a Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses.
This kind of financial fraud happened even before Ponzi’s name came to be attached to it. And it continues to happen more than ninety years after Charles Ponzi ran his scam.
Any Ponzi Scheme will differ from another Ponzi Scheme. But if one may borrow a French phrase, Plus Ca Change, Plus C’est La Meme Chose, the more things change, the more they remain the same. The details might change from scheme to scheme, but the structure abides. Here are some characteristics of Ponzi schemes.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors.
In case of the emu Ponzi scheme an investor was supposed to rear emus and then sell their meat, oil etc. In order to become a member of Speak Asia one had to invest Rs 11,000. This investment was for subscribing to the electronic magazine issued by the company called “Surveys Today”.
This also allowed the member to participate in two online surveys every week and make Rs 500 per survey or Rs 1000 per week. This when converted into a yearly number came to Rs 52,000 (Rs 1000 x 52). So an investment of Rs 11,000 ensured that Rs 52,000 was made through surveys, which meant a return of 373% in one year.
And this was basically the main selling point of the scheme.  So the business model of the company was pretty vague. The legal advisor of the company Ashok Saraogi said at a press conference “The company is not selling any surveys to panellists but e-zines (electronic magazines) to its subscribers. Surveys are offered as additional benefit and can be withdrawn anytime if the company’s contract with clients comes to an end.”
Stock Guru also worked along these lines. The company claimed to be making money by investing in stocks and had this to advise to its customers: “We advise our clients to buy shares at a low price and sell them at a higher price. Selecting the right share at the right price and entering the capital market at the right time is an art. We help all our clients to make huge profits by investing in good shares for very short/short/medium/long term depending upon the client’s requirements.” Very sane advise when it comes to investing in the stock market but nothing specific about how the company plans to help its clients make a huge profit.
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose.
Let’s take a look at some of the Ponzi schemes of yore. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stock Guru helped investors make money by investing in stocks.
The most important part of a Ponzi scheme is assuring the investor that their investment is safe.
This is where the meeting of initial obligations becomes very important. Early investors become the most important part of the scheme and spread it through word of mouth, so that more investors invest in the scheme and help keep it going. Ironically enough, in many cases it is their own money that is being returned to them. Let us say an investor invests Rs.100 in a scheme that promises 20% return in 60 days. So Rs.20/- can be paid out of investor’s own money once every two months up to ten months. The Ponzi scheme can keep going by essentially returning the investor his own money. Speak Asia did this by returning around Rs 250 crore to the investors from the Rs 2000 crore it had managed to collect. This gave the scheme a greater legitimacy.
Stock Guru also worked along similar lines. As an article in the Money Life magazine pointed out “You pay Rs10,000 as investment and Rs1,000 as registration fees. There is no limit on the maximum amount one can invest. Stockguruindia.com offered a return of 20% per month for up to six months and the principal amount invested is returned in the next six months. It also gave post-dated cheques of the principal and a promissory note as security.”
As a story in The Times of India points out “People invested between Rs 10,000 and Rs 60 lakh at one go in Stock Guru India as Ulhas promised to double their capital…He (i.e.Ulhas Khaire who ran the scam) also returned money to some investors to win their trust so that they would recommend Stock Guru to others,” said an officer. In fact this initial lot of investors become brand ambassadors and passionate advocates of the scheme. When this writer wrote about Speak Asia being a Ponzi scheme he got stinkers from a lot of people who had invested their money in Speak Asia at the very beginning and made good returns.
The rate of return promised is high and is fixed at the time the investor enters the scheme. So the investor knows in advance what return he can expect from the scheme. The promised returns were substantially higher compared to other investment avenues available in the market at that point of time. The rate of return was also fixed in advance. So there was no volatility in returns as is in other forms of investment. This twin combination of high and fixed returns helps in attracting more and more investors into the scheme.
In Speak Asia the investor knew that he would get paid Rs 1000 per week for conducting surveys. And by the end of the year he would earn Rs 52,000 on an initial investment of Rs 11,000.
In case of Stock Guru a minimum of Rs 10,000 was to made as an investment. And Rs 1,000 was the registration charge. The company promised a return of 20% per month against the investment for the first six months. For a person investing Rs 10,000 that would mean a return of Rs 2,000 per month or Rs 12,000 after the first six months. The principal amount of Rs 10,000 would be returned over the next six months. Hence on an investment of Rs 11,000, a profit of Rs 12,000 was being made in a very short period of time. These were fantastic returns.
Brand building is an inherent part of a Ponzi Scheme.
MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and  became very famous in Russia.  Hometrade also used the mass media to build a brand image for itself. It launched a  high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was. Anubhav Plantations also ran a huge advertising campaign. Film stars also advocated investing in the emu Ponzi schemes.
Speak Asia ran a huge ad campaign. The irony was it advertised extensively in newspapers which dealt with personal finance. Stock Guru did its level of brand building as well. As a report in the Times of India points out “ Ulhas Prabhakar Khaire andRaksha Urs, masterminds of the multi-crore Stock Guru fraud, would organize their promotional events in Macau, Malaysia, Mauritius and several other countries, taking only a few premium investors on expenses-paid trips, say Delhi Police sources. The events were reportedly organised regularly in five-star hotels, and Ulhas made all the arrangements, including booking flights for investors and celebrities. Ulhas is learnt to have named two Bollywood celebrities he invited to his promotional events.”
All these things lead to people investing in these schemes. The attraction of easy wealth is something that investors cannot resist. Ponzi schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense. Greed also results when investors see people they know make money through the Ponzi scheme. As economic historian Charles Kindleberger  once wrote  “ There is nothing so disturbing to one’s well being and judgment as to see a friend get rich.”
Given this, even though a lot of questions can be asked they are not asked. Ponzi schemes have not been eliminated. This is sad because for the economy as whole, they are undesirable. The world has not learned from its experience. “Mundus vult decipi-ergo decipitaur-The world wants to be deceived , let it therefore be deceived ”. (Winkler 1933 as quoted in Kindlberger 2000).
All Ponzi schemes collapse in the end once the money leaving the scheme becomes greater than the money entering it. Stock Guru was no different.
To conclude, any investment scheme promising more than 15% return a year has to be a very risky proposition. It may not always be a Ponzi scheme, but the chances are that it is more often than not.
The article originally appeared on www.firstpost.com on November 15, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])