A Ponzi scheme is a fraudulent form of investment in which funds are gathered from investors to pay disbursements to previous investors of a non-existing fund. These schemes are prevalent throughout sections of economy and gained notoriety following the subprime mortgage crisis.
What is a Ponzi scheme? Any investment operation that provides returns to investors that are paid from their own money or the money of subsequent investors is called a Ponzi scheme. These schemes work on the basis of claims that fraudulent investments will produce strong gains. In reality, no investments are made and no or very little profit is actually earned. A Ponzi scheme can be identified by the fact that they offer larger returns than other investment options and usually operate in dispersing dividends consistently and in a short time frame. In order for the scheme to fully function, it needs an ever-increasing flow of money so it can continue administering payouts to those people who “invested" first. It operates very similarly to a standard pyramid scheme.
The Charles Ponzi Scheme
The idea of this fraudulent operation is named after Charles Ponzi, although he did not invent the concept himself. After emigrating to the U.S. from Italy, Ponzi took advantage of the discrepancies of the international postal reply coupon business. These coupons are purchased at the cost of stamp in a specific country, but can be sold at face value in the United States. He promised his clients a 50 percent profit in just 45 days. In late 1919, he began collecting money and in less than a year he acquired millions of dollars and attained controlling shares in five banks. Eventually, Ponzi was exposed when the funds were found to be millions of dollars in debt and caused the collapse of all the banks. Ponzi was sentenced to 14 years in prison.
Right: Charles Ponzi. (Provided by the U.S. Federal Government; Wikimedia Commons; Public Domain; http://en.wikipedia.org/wiki/File:Ponzi.jpg)
Success of a Ponzi Scheme
A successful Ponzi scheme relies principally on the continued investments of new individuals or organizations. The scheme generally will work very well in its initial stages. The early investors get the biggest payoffs as new investors join on. The Ponzi schemer will introduce new “options" for these principle investors and produce a number of monthly statements in order to get re-investments. This keeps the deception going for an indeterminable amount of time and minimizes the amount of withdrawals. As new cash flows continue to transfer money in to the scheme, any requests for payouts are processed, providing the illusion that the funds are legitimate.
There are three ways for a Ponzi scheme to end. Often, the promoter of the scheme will vanish or otherwise get away with the money that has been put into the scheme. Sometimes, the scheme will completely collapse as problems arise. When liquidity falters, investors may panic and request their money creating what is essentially a bank run. Otherwise, the promoter is exposed by an outside source such as regulatory authorities.
Following the subprime mortgage crisis of 2007 and 2008, a number of Ponzi schemes were exposed due to the downturn of the global economy. Hundreds of fraud charges were brought against a number of false investments. These ranged in size and scope, but billions of dollars in the worldwide economy were found to either not exist or were roped into one of these schemes.
One of the most famous Ponzi schemes in history arose during this period of time. Bernie Madoff, former chairman of the NASDAQ stock exchange, was exposed in late 2008 as having committed eleven counts of securities fraud. He bilked investors of $65 billion, the largest known investment fraud committed by a single person in history.
The Bernie Madoff Ponzi scheme was successful for at least 20 years, establishing a structure that worked in both up and down markets. The difference with his stock market Ponzi scheme is that he worked with a number of large-scale investors and charities that continued to reinvest the payouts. He also showed only reasonable “gains" in the investments as to not draw attention from authorities.
Above: Bernard Madoff. (Provided by the U.S. Justice Department; Wikimedia Commons; Public Domain; http://en.wikipedia.org/wiki/File:BernardMadoff.jpg)
"Ponzi Schemes" Investor.gov (http://investor.gov/ponzi-schemes/)
"Charles Ponzi" U-S-History.com (http://www.u-s-history.com/pages/h1800.html)
"The Talented Mr. Madoff" New York Times (http://www.nytimes.com/2009/01/25/business/25bernie.html)