The more famous scams impacting the share market in India have been the following: (no I am not going to the Mundhra scam, too old)

1. The Harshad Mehta scam of 1992 – a banking scam
2. The Ketan Parekh scam                   – a banking scam
3. Hometrade                                             a banking scam
4. Nsel                                            commodity based scam.

If you go into the detail of all the scams, they arise from a flaw in the banking system. Our banks are not allowed to lend money for many NORMAL day to day activities. For example a restaurant cannot get much money for working capital. Nor can a retail operation. This is the old Nehruvian mindset thinking that banking has a social duty and ‘low priority’ things like retail should not be funded.

Similarly, bank finance is not easily available for big share brokers – too many conditions on the banks to lend to capital market players. Here are an amazingly smart set of people who have an unending appetite for money (- it is their raw material, right?) being denied access to money.

So they come up with a scheme. They tell many of the big players that they could organise some money against the assets that they have. This is fair – I can borrow against my house, right? Loan Against Property it is called. So a bank should be able to borrow against its assets? Simple I give Rs. 4 crores to a broker to buy government bonds – and once I have the bonds I should be able to borrow against that – AND lend that money? Simple?

So a legitimate business is born. The trade uses something called ‘bills’ – these are payable after say 90 days, and since I need the money now, I discount it. It is a fair claim – I have supplied goods, and want a quicker payment.

Only problem is after sometime the players realize that all one needs is documentation. The underlying assets NEED NOT BE THERE because the banker does not have the capability to check whether the goods – engineering goods, government securities, commodities,..etc. exist or do  not exist.

In all such cases, the borrower, lender, banker,…all believe that the documentation is perfect, the assets move to the right place at the right time, and that the money will be paid on time. The underlying assumption is that the guy who is borrowing is able to earn MORE than the cost of funds, so he has no reason to upset the apple cart.

However, there is soon a pressure to earn more, grow more, and greed steps in. So what was considered ‘safe and manageable’ for Rs. 50 crores – goes out of hand at Rs. 5000 crores. Suddenly when the music stops, you realize that the documentation was wrong, stamp duty was not being paid properly, the underlying commodities were non existent – which means these intermeidaries were almost PRINTING their own notes!! They were creating credit out of paper.

Now come to the ‘sophisticated investor’. Ok finish laughing.

The sophisticated investor is told ‘here is an asset backed funding mechanism, guaranteed by the bank (ok in NSEL case commodity exchange), AND your money is safe. By the way sir you will get 12% p.a. with clockwork precision.

Now come to the Madoff case. Exactly same promise – 12% return, year on year with clockwork precision. INVESTED SUPPOSEDLY in equities. Again our old joke ‘sophisticated investor’.

Do these people not know that :

a) equity markets CANNOT give smooth return?

b) when somebody gives a ‘risk free’ return, he should NOT BE PAYING YOU A RISK premium of 50%? I mean if SBI fixed deposit is 8%, and I tell you ‘sovereign risk’ I SHOULD BE PAYING YOU LESS THAN 8% simple, is it not? So why did it not make the sophisticated investor suspicious? beats me.

Viswapriya Financial services was a company which would give ‘documents backed’ 12% interest when bank rates were 8% – the promoter obviously is in jail now – for a lot of related crimes. Ditto Jignesh Shah. Ditto Madoff.

MOST OF THESE INVESTORS WOULD HAVE been better off in an index fund.

Why did they choose Madoff? (ditto Jignesh) BRILLIANT BFSI marketing:

1. it is sold like a very secret product
2. high sounding titled people are appointed – Wealth Manager is one of the favorite titles.
3. hedge fund, value discounting, forward selling, options, futures, calls, strategic funding, – all meant to scare you.
4. it is not sold directly – you are invited to an exclusive club where your friend has just managed to get an entry.
5. the entrance fee to this club is SPECIALLY slashed from Rs. 250,000 to Rs. 54,000 as a SPECIAL case.
6. you should not discuss this with too many people – jokers like Subra cannot understand it.
7. time is of essence…’Sir scheme closes on 22nd Dec. and today is already 19th’.

Wow! works like magic. Every time.

Who loses? ‘sophisticated investor’ who missed out reading Subra’s blog asking people to invest in Franklin India bluechip, Most 35, or I pru discovery.

Dammit, an index fund would have given you better returns 🙂