Ponzi Schemes and How to Spot Them

As news spreads of Bernard Madoff's alleged $50 billion fraud, many are wondering what exactly a Ponzi scheme is and how to avoid becoming a victim.

Ponzi or "pyramid" schemes have been around for years, with slight variations. They "rob Peter to pay Paul": early investors - at the top of the pyramid - are paid off with money from newer victims - at the bottom. The modern name comes from Charles Ponzi, who stole millions of dollars from thousands of New Englanders in the 1920s. He promised that his postage stamp speculation would yield 40% returns in just 90 days, compared with the then prevailing 5% annual interest on savings accounts. Ponzi actually purchased only $30 worth of international mail coupons but, as with all such frauds, a few early investors were paid off to make everything look legitimate until the scheme collapsed under its own weight once new victims could no longer be found.

Reported victims of Madoff's alleged malfeasance include very sophisticated investors: the foundation of Nobel laureate Elie Wiesel; New Jersey Senator Frank Lautenberg, one of Washington's wealthiest legislators; and director Steven Spielberg's charity, the Wunderkinder Foundation. Worse still, some of the world's biggest financial institutions - Britain's HSBC and Royal Bank of Scotland, Spain's Santander, France's BNP Paribas, and Japan's Nomura Holdings - say they were taken in. Even the Securities and Exchange Commission (SEC), the government's own watchdog, has admitted that, although its staff had heard repeated allegations against Madoff and his firm beginning in 1999, none had been recommended for formal action.

Despite apparently fooling such august investors, the right checks into Madoff's fund might have revealed plenty of red flags consistent with Ponzi schemes.

Of course, simply reading a prospectus is not enough: successful fraudsters do not reveal their scams up front. It is no surprise that SEC Chairman Christopher Cox says that the commission's investigation "indicates that Mr. Madoff kept several sets of books and false documents, and provided false information...to investors and to regulators." Digging deeper into public documents filed on paper, rather than electronically, with the SEC, or others sent to Companies House - the British government's register of corporations - would have revealed that in 2001 and 2002 Madoff made personal loans of $62.5 million to an affiliated company of which he was the sole voting shareholder. These were ultimately converted to shareholder's equity in 2007 when Madoff's brokerage firm was experiencing a significant outflow of cash.

Interviews of investment professionals might also have yielded useful insight. Ponzi schemes typically promise sky-high returns over a short time or consistent ones even in economic downturns. Part of the attraction of Madoff's fund was the latter: since 2004, annual returns ranged from 7.3 percent to 9 percent, but over the last decade they were typically in the low-double digits according to one anonymous investor. This victim added that the fund claimed to follow a "split strike conversion" strategy. The latter entails owning stock and buying and selling related options, which limits upside potential as well as downside risk. Jon Najarian, an acquaintance of Madoff who has traded options for decades, said "many of us questioned how that strategy could generate those kinds of returns so consistently."

Also unusual was how Madoff kept his hedge fund's financial statements under "lock and key," according to prosecutors, and was "cryptic" about the firm. The hedge fund business was even located on a separate floor from the market-making one. Such a lack of transparency should have been a red flag for anyone willing to look.

Unfortunately, too many failed to do so. The moral of the story is: seek and ye shall find.

Comments

[RealityCheque]

I'm thinking of a little experiment. I'm thinking of running a Ponzi scheme. It won't be fraud - I'll be sure to tell all the investors and advertise it is in fact a Ponzi fund. Those who invest early will stand have the best profits. those later the worst, and the last will lose their investment.

Two questions. 1) Will I have any takers.

2) Is it illegal to run a Ponzi Scheme even if no fraud in involved.

[billw8017]

Charles Kindelberger covered all this in his classic Manias, Panics and Crashes. He looked for commonalities among recessions and depressions and found, among other things, that as a boom becomes unsustainable, hoaxes and frauds arise to absorb investment funds. Mary Shelley never wrote a more gripping and dramatic book. You can see ourselves in every page.

[Ponovision]

Feel sorry for people hoping to make a killing with too good to be true interest rates and payoffs? Here we go again, the aspiration to get wealth without work, to get way more than what you put into it. That is one of the core problems of our economic philosophy. Breaking even, which is what the laws of nature are, is "stagnation" in our convoluted system. In nature nothing consumes more than it produces or produces more than it consumes- it is perfectly balanced. We have to follow that rule. But no, we cheat on the rules and now our intentions are coming home to roost. Ponzi scheme victims deserve their fate.

[Tanyars5]

I agree totally with your comments!!!!

[research]

Lots of the people worked hard and then retired, hoping for a safe place for thier money.

They went to a world famous and trusted invention firm.

The Governments Investment firm "Police" we collectively hired to protect us, was fully subverted by the GOP conservatives.

Show your lack of sympathy all you want, that's a reflection on you.

And no doubt, some of these people were greedy and "deserved" this fall.

But I can't let this go: "to get way more than what you put into it." is an immoral Ponzi concept?

No animal makes a move it does not expect to profit from. To get more out of the venture that goes into it.

"In nature nothing consumes more than it produces or produces more than it consumes- it is perfectly balanced. ".

Locusts? Elephants create create desert? Natural Species extinctions? Nature is very messy and "wasteful" Only a subtle ways of evolution and perhaps Zen is Nature this perfectly balancing thing you image.

[oldmanwalking]

I was watching some guy on CSPAN from the Cato Institute who says Social Security is the biggest Ponzi scheme. Now, I'm not a big fan of the Cato Institute, but it got me thinking, he might be right.

[daulton]

Not quite. The Cato people have pounded this point for years, but both Al Franken and Thom Hartmann have done a good job of refuting it. Basically, Social Security is not like buying stock. It's like buying insurance--and your home or car insurance could hardly be seen as a Ponzi scheme.

BTW, I have a hard time taking advice on Social Security from an institute than names itself after Cato--the Roman citizen who disposed of his sick and elderly slaves by dumping them on an island in the Tiber, to starve to death.

[Rule Of Law]

Hey, this might be WHY it's called Social Security Insurance!

[billw8017]

For over 70 years Social Security has not merely paid pensions to large numbers of Americans, but it has consistently returned what might be called a profit to the government. It was organized separately from the rest of the federal budget until Lyndon Johnson decided to combine them so the SS surplus would conceal a small deficit due to attempting to wage the war in Vietnam without raising taxes. The Reagan administration went nuts with this idea, cutting benefits and increasing the surplus until (before the extent of the federal deficit became clear) they supposed SS would cover the entire national debt.

Over the years various complaints have been leveled at SS. Some said people got too much more than what they put in. That they exhausted their contribution within five years. Some said, the retirees got too little and compared it to a stock market investment that, in the years of a rising stock market, and considered as a straight investment amounted to less.

The current argument seems to be that SS is an unsecured investment. it is a self amortizing fund that works with the SS tax and supposing the money should be salted away before being dispensed is a little like when a person takes a job. Having so many years to work, etc. etc., his employer must put his life's earnings into a fund when he is hired, or be able to offer him only an unsecured investment for his time and labor.

[mamacat]

The key to this Ponzi scheme was its sheer size. No one expected such a large fraud to be possible. If it had been smaller, it would have been easier to spot.

The really large lies are the ones that we have to watch out for. Whether it is Madoff and his promises of unlimited returns, or Bush and Perino and their spin about everything, it's the really big whoppers that are hardest to spot.

[ciceroette]

Fortunately, the public escaped GW's biggest ponzi scheme...t­he one where he wanted to put social security monies into the stockmarket! Damn...if that had happened, we really would have had the Second American Revolution­.....I do have one cynical question though....­..what was the timing of the social security push? Just exactly WHEN did the Bush Admin. decide to go big time into pressuring for those monies? Did Bush and Co. know what was coming, and their access to social security was an attempt to head the mortgage/ stock market debacle off at the pass? I wonder...o­.k. 2nd generation Woodward and Bernsteins­... where are you? Inquiring minds want to know!

[daulton]

I wish ONE blow-dried media meat puppet had the brains and cojones to ask Bush that question: "What if you had succeeded in privatizing Social Security?"

[Tanyars5]

Ciceroette- you are dead on in your comments!!
The MSM is not doing enough to cover this story. They have more news on the corrupt gov of Illinois and Obama 's vacation than they do of analyzing exactly what happened with this scheme. Less reporting on things that don't matter. Where are the congressman who are outraged with the lack of over sight of the SEC? What reforms are being discussed to provide better oversight?

[Tanyars5]

I just want to know why this man is allowed to be out on bond? He is a crook and should be punished. I hope Obama cleans house at the SEC. Those guys were/are collecting a check for doing nothing. All those at the top should be thrown out.

[TommyObama]

Because he has some very good dirt on some very rich and powerful people? And they want him to disappear before he talks? Left in prison, he'd talk.

Ponzi schemes are like cocaine; a true indication that you have too much money for your own good.

[sollosi]

This is the reason why Republicans hate to raise taxes on the rich. The rich have all their money invested in Ponzi schemes.

[MissKaren]

When does "due dililgence" become acting like some kind of forensic accountant to save your neck? How much is reasonable? Madoff rooked sophisticated, knowing investors. What is the solution for those of us who are not wildly knowing?

[Egalitare]

Sooo...we shouldn't hear any more about sub-prime borrowers being careless for "not reading the fine print."

'Cause if the most sophisticated investors in the world got financially mugged, those "irresponsible borrowers" really were doomed from the moment the mass securitization of mortages was dreamed up.

[tomas0808]

"collapsed under its own weight once no more victims could be found."

Kinda sounds like the brand of capitalism we've been subjected to the last forty years, totally dependent on unrealistic growth.

[veracity]

Thanks for "How to spot an Ponzi scheme" fraud...

but couldn't we just say , "look for ENRON ACCOUNTING" ????

[kjo46]

The SEC is going to do an "internal investigation"? They are going to investigate themselves????
Hold your breath folks.

[stephanemot]

one should also mention the comedy played when you're being opted in (as if you were inducted to the Hall of Fame). a classic in Ponzzis.

[jackwaddington]

C'mon guys, The stock market and all in it are doing a 'ponzi' scheme. The whole economic shenanigans are the same thing. We'll not realize this until the weasel pops and no share is worth anything; which it isn't in reality.

[TwentyCharactersLong]

No, the stock market is a Keynesian beauty contest(the metaphor being a beauty contest where your goal is to select the most 'beautiful' woman out of a series of photographs, and the winner is whoever chooses the woman chosen by the most people--the optimum strategy is not to choose who you think is the most beautiful, but to choose what you think other people will choose. This isn't what you think other people will find the most beautiful, but what you think other people will think other people will choose, ad nauseam)

There are people who buy stock because they want to own part of the company, there are people who buy stock because they think the price will go up from people who want to do #1, there are people who buy stock because they think speculators will want it, and so on and so forth.

http://en.wikipedia.org/wiki/Keynesian_beauty_contest

[TommyObama]

So is Arizona real estate. Completely predicated on population growth.

[Artos]

I have a simple rule that I live by which helps me avoid scams of any sort. You don't get something for nothing and anybody that promises you pie in the sky is trying to sell you a bill of goods. When something looks to good to be true it usually is. I haven't had any problems avoiding being taken for a ride yet.