Notes and Ponzi Schemes

A few days ago I asked the head of a well-known note investment company if he sells notes to private investors. He said, “I don’t know anyone who does who is still in business.”

That's an overstatement -- there are a number of companies that do, especially non-performing notes.  But name one that has been in business more than a few years.

That trail is littered with the corpses of private investors who have lost their money and of the companies that took it. The companies either went under voluntarily or the government shut them down. 

I'm not talking about companies that sell one note to one investor and have nothing to do with the note from then on.  I'm referring to companies that pool investors' money and promise to pay them from the return they get on a pool of notes.  Call it a fund, a hedge fund, securitization, crowdfunding, it all amounts to the same thing.

One of two things usually happens: 1) they can’t raise money fast enough, so they use new investors’ money to market for more investors instead of paying existing investors what they owe them, or 2) investors throw so much money at them that they run out of good notes, so they use new investors’ money to buy junk. When the junk notes default, they use new investors’ money to pay earlier investors. That’s called a Ponzi scheme, and once the government gets wind of it, bye-bye company and bye-bye investors’ money.

If someone is running a Ponzi scheme the government can (and has) shut them down, fine them and send them to prison EVEN IF NO ONE HAS LOST A PENNY.

Why?  Because operating a Ponzi is illegal even if every investor is happy and being paid.

When the government swoops in, it confiscates all the assets.  Investors stop getting their checks.

There are some note funds that do everything by the book.  But they are few and far between.  

At the very least, avoid anybody who guarantees a certain return and/or guarantees the notes and/or services them.  Even if they aren't a Ponzi, they are dangerously close to violating federal and state securities laws unless the offerings have the proper registrations and the principals have the required securities licenses.  When the government closes them down and confiscates their assets, including your money, don't say I didn't warn you.