By Monish Chhabra ǀ 5th March 2014

Australian unemployment hit 6.0% last month; a 10-year high. Adding further gloom was the Toyota announcement that it will close its factories in the country by the end of 2017 that would result in a loss of about 2,500 jobs. There would be no major automaker left in Australia after Toyota’s exit.

Brevan Howard, world’s 3rd largest hedge fund shop, shut down its emerging market hedge fund. The fund with AUM of $2 billion had lost 15% in 2013 and another 2% in January this year. Typically known for its low-risk macro strategies, Brevan seems to have had enough of the volatile EM fun(d).

Big shops need new strategies to keep growing. And grow is what Apollo did. This mega private-equity manager reported that its credit unit has swelled to $103 billion in assets from about $4 billion in seven years. Credit now accounts for about 2/3rd of Apollo’s assets; it may as well be called a credit shop now.

Two of its big rivals - Blackstone and KKR - have also grown their credit books to about a quarter of their total assets. The pull-back by the western banks since 2008 amid a sea of distressed borrowers, has led to the rapid rise of these non-bank intermediaries, who are transforming credit creation.

However, it is one thing to take long-term risk capital from qualified investors, and a very different one to take retail deposits with promises of high interest & principal guarantee.

On 7th Feb, Alibaba launched its first wealth management product – through its online payment platform Alipay - offering 7% yield with principal guarantee. This is its second foray as a shadow bank.

Last year, the company launched its online money market fund – Yuebao – on June 13th promising 6.3% yield. Then on October 28th, Baidu entered the money fund business by launching – Baifa - offering 8% yield. On January 22nd this year, Tencent launched its own online money market fund - Licai Tong – through its mobile messaging application WeChat, offering 7.4% yield.

High rates promised to small unsuspecting savers, by unregulated deposit-taking entities, operating under no capital or reserve requirements and investing without constraints or guidelines; if that combination doesn’t strike fear, please look across to India.

On 26th Feb, the Supreme Court of India issued a non-bailable warrant against the chief of Sahara Group, Subrata Roy.

This conglomerate - that has run everything from hotels, property, airlines, newspaper, TV, media, retail and manufacturing, to official sponsorship of the Indian cricket team & a stake in a F1 team – has been in this tussle with SEBI for the last 3 years. Roy’s arrest might bring about the finale.

The core issue is how this company collected $4.5 billion from small investors by promising about 15% return pa on the debentures of two unlisted thinly-capitalized companies (SHIC & SIREC). This is the decades-old business model of Sahara.

It has been collecting deposits (as little as $1 per month) from the lower-income group directly at their doorstep. The high rates and the convenience offered underlie Sahara’s appeal, while it claims to be filling up the gaps left by the banks.

Since its formation in 1978, the company has been banned 6 times by regulators. Each time it evolved and changed its model of raising funds from public and in total collected – by some estimates – $38 billion since inception.

Sahara was last banned from raising fresh deposits in 2008 by RBI. That’s when it decided to use the debenture route, calling it a ‘private placement’. Such a placement is legally restricted to 50 investors while the company obtained funds from 30 million people with an average investment of $130.

This was eventually discovered (2010) and investigated (2011) by SEBI, went all the way to the Supreme Court, which ordered the group in August 2012 to pay the full amount with interest to the regulator, who would then refund the investors.

Sahara deposited less than $1 billion. It kept delaying the proceedings with various excuses, including claims that it had already returned the money to the investors. A frustrated court summoned Roy and other directors to appear in person. When he didn’t, the warrant was issued.

While the suspicions lingered for a long time, the SEBI officer himself alluded to a possible Ponzi scheme in his 2011 report. The company has relied on an army of agents to collect funds from small towns and villages. The offerings were designed to be outside the regulatory surveillance. The proceeds were invested in businesses with suspect prospects and undisclosed balance sheets.

Ponzi concern aside, SEBI actually has a bigger problem on its hands; it cannot find the depositors. Of the 20,000 investors that SEBI tried to contact, only 68 responded. Many didn’t even have contact details, and many more had phantom addresses or untraceable identities.

What else is going on? The possible answer; money laundering. This company could be a front for black money, making this scandal first of its kind; a Black Ponzi.

The end-game is not likely to be pretty. While the rich tax-evader deserves no sympathy, the poor rickshaw-puller - who was saving for his children’s future - would be devastated.

As this $5 billion scandal casts its shadow on India, the online money funds in China could cause an eclipse.

These schemes promise yields 2-3 times the bank deposit rates. The proceeds are invested in inter-bank loans, corporate bonds, equities and funds. Small investors are piling in, once again enticed by the convenience and high rates.

The Yuebao fund grew to $1 billion within 18 days of launch. By November last year, it had become the largest fund in China with assets exceeding $16 billion. By the mid of February recently i.e. within 8 month of its launch, it had reportedly surpassed $65 billion in size.

To put that in perspective, money market funds around the world add up to about $5 trillion, of which 60% are in the US. The following are the 5 largest money funds there.

• • Vanguard Prime MMF ($131 billion)

  • JP Morgan Prime MMF ($117 billion)

  • Fidelity Cash Reserves ($117 billion)

  • Fidelity Institutional MMF ($69 billion)

  • BlackRock Liquidity TempFund ($51 billion)

If Yuebao keeps growing at the current rate, it would take the pole position, before the end of this year. This is just one fund from one company.

These unregulated online banks are drawing in the smallest guy on the street, unlike the usually-feared trust products that involve mainly the high-net-worth. The burgeoning load of promises is supported by a web of inter-dependent guarantees.

The party is jam-packed and ‘error’ has been asked to sit out. Too tempted by the fun & music, he might just pop in.