LeoGlossary: Ponzi Scheme
A form of investment fraud where existing investors are paid out of funds received from newer investors. The continued selling to new investors (or getting older ones to reinvest) is vital since the scheme generates little to no return on its own.
This is often accompanied by the promise of high returns with no risk.
They are successful, for a while, because they give the illusion of legitimate business practices that are generating cashflow. This makes things look sustainable and as long as all investors do not claim their money, it can go on for a while. The key is to keep luring in newer investors. Without them, the ability to keep making the payments dries up.
One of the goals is to have the older investors keep reinvesting their "profits". This helps to alleviate any cashflow issues while inflating everything to a great degree. The Bernie Madoff scandal is a prime example where some investors has balances that were into the hundreds of millions of dollars. Of course, these were all fictitious.
It was named after Charles Ponzi who ran one in the United States in the 1920s. He promised a 50% return within 45 days. This was not the first recorded event.
There were events in the 1800s which fit the general description of what a Ponzi Scheme is. One was by Sarah Howe. She ran a ladies deposit which was a female only clientele who was promised an 8% monthly interest rate. Howe ran off with all the money.
She was eventually captured and served 3 years in jail.
Ponzi took it to another level gaining international fame over it. His scheme was initially to arbitrage international reply coupons for postage stamps. What might have started out as legitimate quickly switched as he used newer money to pay off older investors.
He was able to keep it going for over a year until the house caved in on him. Ponzi eventually plead guilty to a count of Federal mail fraud and was sentenced to serve 5 years in prison. He was released after 3.5 years.
The State of Massachusetts immediately picked him up and charged him with 10 counts of larceny. Ponzi thought this was double jeopardy and sued. His case went all the way to the Supreme Court. It found that Ponzi was not facing double jeopardy because the federal government charge him with mail fraud and Massachusetts larceny.
Eventually, Ponzi was found guilty and sentenced to 9 years in jail.
Signs Of A Ponzi Scheme
- The claim of high returns with little to no risk
- Overly consistent returns
- Unregistered investments
- Unlicensed sellers
- Secretive and complex strategies
- Issues with paperwork
- Difficulty receiving payments
- pushy sales people
- addresses or names do not match up
- no way to verify if actual trades or business took place
- the contact came from a cold call or social media contact
- when maturity arrives, investors are pressured to roll profits over
How They Work
A Ponzi Scheme starts with a promoter. This could be an individual, such as the case with Charles Ponzi, or a group. Here is where the contacts are made. The idea is to start attracting capital to kick of the scheme.
There are many buzzwords used, most of which will be vague. A key component to the entire scheme is to offer enough to incentivize people to invest but give little that can be pinned down. This is why it is difficult to find if transactions took place or if there was any follow through. The answer is obvious.
The entire premise is the "rob Peter to pay Paul". As money starts to roll in, the list of investors grows. This is where the return is stressed. It also creates an opportunity to expand the entire affair.
With the additional capital, the ones behind the scheme can start to pay out some of the early investors. This obviously adds a degree of legitimacy. As the early ones get their return, they cannot help but to tell others. Word-of-mouth advertising starts to take hold. The friends and family of the early investors suddenly want in.
This helps to push the scheme to a higher level. As more money flows, the payouts become impossible. One tactic employed is to try to get the early investors to keep their money in the scheme. "Reinvesting" is sold as a sensible move because, after all, the first round went so well.
Greed can be a powerful motivator and many do fall victim to this. Their returns, if taken out, would be real. However, be reinvesting, the "paper returns" only start mounting. This was the situation where investors thought they had hundreds of millions of dollars after a decade or more of Bernie Madoffs con. The reality is the numbers were fictitious.
Eventually, the word-of-mouth advertising comes to hinder the scheme. As people start to question things, the pieces do not align. Perhaps payments are missed or delayed. We also see situations where the main participants become hard to track down. Phone calls go unanswered and people do not get any feedback. This starts the snowballing in the opposite direction as earlier.
The funding starts drying up making it impossible to keep paying out. As the pyramid starts to implode, things keep accelerating. This is how Ponzi Schemes can operate for an extended period of time but collapse almost overnight.
Many of these schemes use legitimate vehicles. Bernie Madoff was using the financial markets. Mark Sanford was drawn to certificates of deposits (CDs). Structure can also be applied as in the case where a hedge fund evolves into a Ponzi Scheme.
There other schemes that can resemble this.
Pyramid Schemes, like those often employed in multi-level marketing, often has similar characteristics. For the venture to be successful, it continually requires the bringing in of new member (and capital). There is little actually buying of products.
Pump and dumps are also in the same vein. Here we see a promoter amass a position in an asset, such as a stock or derivative, and them pump the price higher. As things go up, those who started the scheme start selling off their portfolios. This eventually leaves the later people as the bagholders.
Bubbles in markets often has the feel of a Ponzi Scheme. While this is not done by an individual or group, the entire market allows the early entrants to cash out early. Those who get in late end up taking the major losses.
Government deficit spending is often associated with this characteristics. Irving Fisher called it "Ponzi Debt". Here the government keeps selling bonds to pay off the earlier debt obligations it has.
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