A Bond Offering That Was Too Good To Be True

Asset Manager GWG Holdings is now in bankruptcy after buying life insurance policies on very old and sick people

Warren Buffett is famous for a lot of reasons. He's famous for a lot of the things he has said. And one of the things he said is that you know who's swimming naked when the tide runs out. There are a lot of people who seem to be offering good investment ideas, and what they really are is simply enjoying a high tide. You know, they say high tide lifts all boats. Well, when the tide goes out, you discover who's been swimming naked. And this is a wonderful illustration of that. 

A company called GWG Holdings, a big asset manager, has been selling bonds to investors, but they have been a very unusual kind of bond. Here's how it worked. They would sell you the bond. You would give them your money. They would offer you a very high interest rate - 8%, 10%, 12%. Often even higher (that's why you're willing to buy the bond). It's a really great interest rate but how are they generating the profit? To pay the interest on that bond. They would take your money and the money from all the other people who bought the bonds, and they would buy life insurance policies on old people and sick people.

People who had a relatively short life expectancy. They figure that enough of these people will die soon enough, that they'll take the death benefit and use that death benefit to pay you the interest and eventually give you your money back. Well, this idea was great in the beginning because they were collecting an awful lot of money from people who were buying the bonds. They were using the money to buy an awful lot of those life insurance policies. But now they've discovered not enough people have been dying and they haven't been able to generate enough cash flow to pay off the interest on the bonds. 

Why were retirees chasing the promise of great interest rates?

And now the government has stopped them from issuing more bonds. As a result, the company has filed for bankruptcy. So their whole strategy of buying life insurance policies from people, bundling them up, packaging them as bonds and selling the bonds to investors, that whole business model has collapsed. And that is the problem. With the company filing bankruptcy, the bonds are now worthless. The company sold $1.6 billion worth of these bonds, mostly to retirees who went after chasing the high interest rates that the bonds were offering. The people who bought those bonds. Not only are they not earning any interest, but they also can’t sell the bonds either because nobody's willing to buy them.

So as you are seeking investment opportunities, let's not get carried away. Let's not chase great stories and high promises of great interest rates in an effort to achieve our goals. Let's recognize that if somebody is coming up with a totally new and different story, you have to wonder, why is nobody else doing this? You don't want to be first when it comes to investment strategy. Often better to be second. Let's see how it's working. Let's see how it is done for others in different economic environments. And don't assume that over the last 10 years, which has been a great economic environment for everybody, everywhere, that it will do as well in a negative economic environment. 

It's sad to see that people get themselves into trouble, sometimes out of greed, sometimes out of ignorance, too often a lack of due diligence and a lack of financial advice to support their efforts. Make sure you're working with a financial adviser. I built the biggest and largest and most successful financial advisory company in America at Edelman Financial Engines. I encourage you to work with a financial advisor who can serve your best interest and help you avoid these kinds of pitfalls.