Total Pageviews

Saturday, May 22, 2010

Finance companies and Ponzie schemes

No Finance companies are not Ponzi schemes but they do have the seeds of Ponzi schemes embedded in them and are always in danger of becoming one. So what are Ponzi schemes.

In a pure Ponzi scheme, its manager asks for money from investors to put into some scheme that will give great returns. The manager doesn't put any money into investments but gives the great returns promised to the first investors. Seeing these great returns, more investors are attracted to invest. Of course this can't go on. Money plus interest is being given back to old investors using the money invested by new investors. At some point in the scheme, when the manager feels he is at the point of diminishing returns he scampers with the money leaving all but the very first investors out of pocket. Lets have a look at Finance companies.

Joe Blog decides to start a finance company. He has had a car dealership for some years and he is convinced that the finance companies are making all the money with very little effort. He decides that his finance company will finance cars since this is the market he knows. When someone wants to buy a car, he will give the dealership the money in return for an agreement from the buyer (much like a mortgage) to pay off the loan with interest over time. However, he doesn't have the money to set up the business. What does he do.

He advertises for people to invest in his finance company and here is where the trouble starts. In order to get people to invest, he has to promise them a return which is greater than they can get at a safe investment such as a bank (fairly safe anyway). Now he has a problem. Money is going out to pay for the cars but only coming back in dribbles as people start to pay their monthly payments. Moreover, he has expenses such as office rent, and the salaries of anyone working for him. He has to obtain a lot of investment money and get it out there loaned to people so that the money coming in from payments will be enough to cover his expenses and the dividends he has promised his investors. He will be in competition with other finance companies and will be tempted to offer better returns than them. Here is where it is very easy for his company to turn into a Ponzi scheme.

If he hasn't got enough money coming in, he will tend to give the promised returns partially from new investments always hoping that as he gives these good returns, he will attract enough new investors for him to get over the hump and have enough money coming in to cover his expenses. If he doesn't succeed he is on the road to financial ruin along with his investors.

If he is also somewhat dishonest or if he has a great feeling of entitlement (I deserve to get a big salary out of my business) the fall will be all the more rapid. In many jurisdictions, he can declare bankruptcy, having squirreled away some of the assets in, for instance, a large salary to his wife, and leave the mess behind but even the most honest, modest manager faces the basic problem of getting over the hump and staying there. This is, of course, a large problem in a small market with a lot of competitors, each of which needs considerable market share to be viable.

The situation will be even more serious when the economy takes a downturn and people can't pay. Yes he can reposess their cars but cars depreciate rather quickly and in a downturn, people are reluctant to buy. He can end up stuck with a great asset that he can't sell. In New Zealand it didn't even take an economic downturn for finance companies to fail. Some 20 finance companies fell over in the year before the recent crash and more subsequently. To add to the catastropy, some of the owners of the finance companies have been found to have been less than honest.

Of course there is a cure for the problem. Assuming for a moment, honesty in the personell of the finance company, the solution is to regulate them by insisting that they can't offer fixed returns. They must be audited and only be allowed to give returns from money coming in after all expenses have been deducted. The acilies heel of a finance company is in promising fixed returns which they than can not meet

No comments: