Chit funds - basics

I did a post once -of-p2p.html and keep getting queries about chit funds... so here goes a post which captures the basics of chit funds. (Disclaimer : I claim to be no expert in this and is purely based on my participation in them a few years ago)

A chit fund is a purely Indian invention of accessing money. To that extent I have in the past compared it to peer-to-peer lending. A few people come together, pool a fixed sum of money for a fixed period regularly and every month based on the need, the money is taken by a member. Lets work with an example : Chit A is for 12 months of 1000 each, so the pool available is 12000 (a small technicality, if there are 24 people in the group then 2 chits will be available that month and so on). So all people pay the money to either a designated person or to the chit fund or operator, and then people who require that money bid for it. So if I were to say bid for Rs 1000, then I will get 12000-1000. I now keep paying my 1000 monthly. What happens to the 1000 I paid? - usually a small portion of it goes to the chit fund/operator as charges. The rest are divided amongst the group in either of 2 forms - as a cash payout or as a deduction from the next payment due. Also there is a variation where there is something called a double chit, which is essentially all the bid amount is collected and is available to the group to bid, so that the time period for which you pay the chit is reduced.

What determines the bid amount - multiple factors but most basic is the cost of carry and the demand for money from amongst the group of members. So the bid amounts are usually higher in the initial stages and keep falling, in large chits mostly towards the end bidding does not happen and base bids are fixed. Also most chit have a reserve price and a minimum tick. The demand and supply works differently - if a group consists of mostly businessmen who are looking at short term funding the rates tend to be higher compared to group of housewives - basic concept of benchmark rates and the return that people can get on the money that they took out of the chit. People ask me why shouldnt they just go start a recurring deposit in a bank - both inculcate the same regular saving habit. Simple answer - power of compounding and higher return. Typically if the group you belong to is of people who bid higher then the return on your investment is high and a RD pays you interest in the end, a chit fund is immediate.

But the fundamental laws of finance - risk and return correlation run true here - higher bids mean people are desperate for that cash, which in turn means strained finances (not an issue if it is a temporary cash flow problem) but if it is long term - one runs the risk of default. Also the other problem is of chit fund operators absconding with the money. so the due diligence that you should carry out is check on the operator first and then your group members before you start. Dont bid unless you need the money and have a good use in mind which will pay you more than what you paid them.

The industry is now regulated, so check if the chit is registered and then step into it. Stick to the biggies, there might be safety in numbers. Avoid mom-pop setup unless you trust those guys with your kids.

so it serves them right?

A lot of my friends speak to me about the current market mayhem and the feeling they seem to have is it is wrong for tax payers money to be used to bail out the excesses of a few 'rich spoilt bankers - let them fry in hell'. yes I am one of that creed of bankers, those arrogant self professed 'masters of universe' as Thomas Wolfe put it.... but hear me out...

what did these bankers do which has brought the great market to its knees? a simple concept called leveraging....using 26 bn dollars as in the case of Lehman to create a balance sheet of ~400 Bn...thats the beauty of the system and this is not the forum to explain what was happening...

Just that, remember when these same bankers were driving up prices of that corner plot (directly by investing or indirectly by giving money to that builder to build his land bank) we didnt hear too many cribs from people who flipped that apartment they bought during construction for a 50% return in 12 months....or when these banks needed backend support on research and spawned a few 100 of KPO's in India creating jobs or giving those great IT companies large amount of business....remember financial services probably has the largest trickle down effect after pure manufacturing in terms of ancillary jobs created.... so lots of wealth was created...

and where did this wealth come from : the main investors in all this were supposed to be hedge funds and sophisticated investors who knew what they were getting into (different point that I dont think anyone knew what the heck was happening) and ofcourse those pension funds - again with well paid fund managers...so hopefully some wealth got shifted in this process..... a lot of it got destroyed but was it all created by this swell of financial engineering....

so dust to dust is what has happened....and as it is said great fortunes are made in the ruins of financial markets and realized in bull runs....so keep investing.... dont listen to the experts on TV, do your research or else just buy an index fund...and while you are it, spare a thought to all those people who lost jobs, lost pots of money....a fool and his money part ways, but it still hurts to be a fool...

and yes, when we were back in school, Lehman, Bear, Merrill were the ones we dreamt about....great institutions having been through 100+ years seen the great depression, the meltdown, the dot com crash....gone...RIP

What governments jobs do.... a positive side effect...

Most kids in India today would'nt want to be caught in a government job (when I say a government job here, please read it as quasi government, public sector undertakings, nationalized banks and such) but a small thought crossed my mind the other day. Our generation, the post liberalization, middle class generation is aiming higher, dreaming big and trying to reach out we should realize that a major part of this is due to our education ( oh yes, there are cribs there too, but still the base is education). Our education irrespective of public/ private schools etc was mainly possible due to the stability of earnings offered by these government created jobs in our parents generation... combined with the middle class interest in education and the quest for a stable 'service sector job' parents skipped meals, gave up promotions, stuck to lower paying jobs just to keep their kids education intact. Basic necessities like books, food, private tutions, cycles/ bikes to school were all financed by the salary of these government sector anchored jobs. The government created a large working middle class which created our generation of 'aspiring to beat the world to reclaim our spot under the sun' generation.

So it is quite understandable that even today a government job is something to clamour for. The fight for reservations, the huge army of clerks, peons, sweepers, gardeners that have been created will hopefully push more and more people out of the 'safe zone' of a government job. Ofcourse there is the whole side income which a government job creates, the sense of power, the 'mai baap, ji hukum' sense…. The perks of being government, but yes the government has served some purpose.

It takes a generation of stable job to take a family out of poverty to middle class ( not withstanding 'acts of god' like medical emergencies, loss of wealth due to bad habits, low financial education that leads to low capital creation, etc) and probably takes a generation of entrepreneurship to lift a family to the 'rich category' - the disconnect I see in my own case and many of my friends is we have gone through the former phase, but have very little clue of how to do the latter - we lack role models in close circles, capital large enough to allow the freedom of a large gestation period and maybe the ability to take a risk and bite the bullet….


But yes, the above view probably helps me think, the taxes I pay is doing something to the country since a large part of it is being used to pay this army of government employees…. Since I don’t see the roads, don’t have enough power, lack basic infrastructure or a social security system being created…… yes it’s a sorry view to take, but atleast I get less frustrated !!!

Follow up on "The Pygmy Effect"

(Reader Warning : Long post ahead - this is in reply to Aditis comment on my last post - Pygmy effect)

Hey Aditi, welcome back was afraid I had lost a reader, and thanks for taking time out to comment, and apologies for not having replied back on the previous ones….

Here goes : Why pick on the family owned entities : I don’t think I have too much of a hope for the government entities… they served a purpose in the planned economy stage and are probably tied down due to vicious cycle of their own (some of them are fantastic organisations mind you - there is a nice theory on their second level contribution to the economy - subject of my next post), you have highlighted a few reasons and there are many more… I am a born capitalist when it comes to matters related to capital finding its own way and demand being addressed (my socialistic tendencies are there but as one of my well known Profs told me "if u think you are best suited to earn money then do that damn thing, leave social upliftment to the ones more qualified to do it, if money is all u can contribute so be it!!!". There is a role for a regulator but mostly the I love the concept of a market, make it competitive, let labour and capital flow freely and then magic happens

But the decision to analyse the family owned firms is (my guess here on the number) probably 80% of the enterprises in India are family owned or controlled and unless they are able to come out of the cocoon of treating the business as an extension of family and self, ( don’t know your background, but in corporate law, what I am saying is similar to the divorce of management and ownership or what we call the lifting of corporate veil but more on a financial and operational control part is what I want) the companies will not grow…. Why do I want them to grow : multiple reasons - industrial cycle follows a predictable pattern : unorganized sector - few organized - many organized - large companies/ small unorganized - niche warriors with large companies - multiple smaller but larger than stage 3 companies. In the past when you had tariff barriers, information asymmetry, no 'global supply chain', the market and the competition was largely local and we could get away. But since we are opening up and largely the world trade is becoming freer, this phenomena is both an opportunity and a risk…. If you are not large, you might be the largest organised player in India but in the global industry cycle you are already in 4th stage and risk getting wiped out and even if I assume we will be able to graduate to the next stage and occupy niches, there is lot to be done……..

Size gives a different swagger to your moves, opens up your mind (makes you reckless also!!), allows you to see at an opportunity differently, allows you to setup systems, attract professionals, attract capital, beat down the bank which will offer you PLR when you are a 30 cr company and will offer you PLR -300 bips when you 300 and then allows you name your terms when you are 1000 and will restructure loans to suit you when you are 3000 ( don’t believe me, check the CDR packages doled out in this country in the last downshift we saw - case study a few steel companies, oil companies). Economics 101 teaches us about Scale and Scope economies - a critical mass sets off a chain reaction - talent attracts talent, money attracts money, opportunities attract opportunities

And on the other note, why are professionals important : a entrepreneur serves a purpose in the birth and evolution of an organization, his/her intolerance to status quo and creativity gives birth to a business, his hunger for more gives fillip to grow and his/her 'animal instincts' (its an economic term :) ) keep the economy growing when both fiscal and monetary policy are screwed up…. So by definition, they come with vision…. Some prodding is required to enhance its coverage and scope, this is the void advisors (pseudo, proxy, quacks, intelligent, experienced, effective, gyan giving - various forms of consultants!!) come in…. A professional on the other hand is by definition mostly attuned to a systems mindset - setup/ follow/ break systems mode….not a radical free thinker…. The fear of failure for most professionals is what he feared when he gave his last entrance exam but for an entrepreneur it is that order which if it did not materialize would have meant 30 employees going without salary and his precious wealth vanishing…. The reactions are different in the face of adversity and the capability to visualize is different. I once was presenting to a very successful entrepreneur and told him they will need 800 cr to meet his vision, he said 'Why not' but it had taken me 15 days to convince his whole management team to even persuade them to let me present this to him :)

And on the visionary note : they are far and few I agree…… but there are levels in visionary behaviour I think - like sports which starts are second division to olympics/world cup level - you need to define the level you want to operate…. My advise is "everyone jump 3 steps on the vision, atleast then we will have a few more nationally important entities (and Olympic gold!!) . 'Cutting corners' is by definition an dangerous area, but one of the IAS officers I worked with used to say, "only thing which is atleast light shade of grey is the word illegal, both immoral and unethical are new shades which can be called 'invisible grey' " - So in this I will go by what my B-school taught me - don’t do that thing which you don’t want your mother to read in the next days newspaper - my sole test :) else we are all prisoners of choice - the master piece 'Bhagvad gita' was born out of doubt and the problem of choices to be made.

And lastly, is profit a byproduct of vision or can that be the vision? Yes it can be your vision, but I would say it’s a gulli cricket level vision, if you defined your vision as "I will make 100 cr profit in year 2010" (unless you are making 1 today). A business in my mind, a tool/ a purpose/ a calling of a higher order that cannot be just confined to profits, but profit is an essential ingredient and probably not the end result, its just one of the many measures…..

And on a lighter note, yes maybe a tinge of disappointment, I keep telling my friends if my grandfather had been a land grabber or even a normal bribe seeking government employee rather than the well respected but not well paid writer he was, I would also have been employing people like myself rather than peddling my wares to the corporate world :) so yes, ovarian lottery worked in a different form in my case…..now its left to the rich/influential father in law to do the trick - hope I atleast get a consolation prize there :) !!