What Is A Ponzi Scheme?

by Darren

The question “what is a Ponzi scheme?” is being asked a lot these days now that Bernard J. Madoff has perpetrated the biggest Ponzi scheme in world history, with an estimated $50 billion of investor money lost to fraud.

A Ponzi scheme is named after Boston-area Italian immigrant swindler Charles Ponzi. Ponzi instituted a simple scheme, involving postage stamp speculation.

“Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period—and this was 1921″

Ponzi schemes rely on trust and a constant stream of new investors

The key was that Ponzi paid return to earlier investors with the proceeds of the newest people to the scheme. A Ponzi scheme can only keep functioning if new investors are constantly brought in. The irony of Ponzi’s scheme and the fraud by Bernard Madoff is that much of the marketing is done by “satisfied” clients, who don’t know what’s really going on but are impressed by the massive returns.

Ponzi was eventually brought down because many people felt the returns were too good to be true. Once they realized that there was no “postage stamp arbitrage” occurring, they moved in to arrest him.

Bernard Madoff is the latest scam operator to engage in a pyramid scheme

Bernard Madoff’s Ponzi scheme was more sophisticated. Madoff was receiving billions of dollars that were being solicited by hedge funds, often funds that were run by highly respected individuals. As long as the investors “trusted” the hedge fund advisor and were certain of high returns, they didn’t ask too many questions.

Of course numerous red flags exist for investors who are considering putting money into a Ponzi scheme. The phrase “too good to be true” comes to mind. Even investors who were bilked by Madoff realized that his annuals returns in the 10-11% range seemed a bit pat, especially considering the performance of the market as a whole.

In the U.S., these types of schemes are called “Ponzi schemes” because of the singular success of Charles Ponzi. But in many other parts of the world, they’re referred to merely as “pyramid schemes.” They all end the same way. When the musical chairs stop and the stream of new investors dries up, the company can’t make payments and investors “wise up.”

The single biggest reason pyramid schemes fail is because of their size. At some point, they have trouble attracting new investors. When they can’t find fresh meat, the money dries up and any redemptions from older investors can’t be paid. At that point, things tend to decelerate quickly. In the case of Madoff, his scheme grew so large and went on for so long because had so many accomplices, both witting and unwitting. Hedge funds became very attractive to people in the last few years because of the huge returns they promised.

When people lose all sense of rationality and invest with the idea of “highest return” only, they are making themselves perfect targets for fraudulent operators. A Ponzi scheme can never exist without at least some greed on behalf of the investors and a lot of greed from the operator.

As Bernard Madoff proved, Ponzi schemes can take in victims including some of the wealthiest and most savvy investors around. The only question now, is, will Charles Ponzi fade in the minds of consumers to be replaced by Bernard Madoff, the true and undisputed kind of pyramid schemes?