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Steve Chiotakis: Given the Bernard Madoff scandal this week, the word Ponzi's been used over and over.
Ponzi... sounds like a character from Happy Days, right?Or was that Potsie and Fonzi? Anyway, Ponzi was a real person. And his scheme is the theme of today's Marketplace Decoder. Here's Mitchell Hartman with the Ponzi primer.
Mitchell Hartman: We'll get to Mr. Ponzi in a minute, but first the Ponzi scheme. It's a bit like alchemy. The financial wizard offers to take your gold, your money, and turns it into more money. He claims to do this by secret and esoteric methods: "currency arbitrage" it might be called, or "high-yield hedges." And he promises to work his magic at a startling rate -- a guaranteed return of perhaps 20% each month, like clockwork.
Rich Dippel: If it's too good to be true, you're right, it is.
Rich Dippel teaches accounting at Webster University in St. Louis.
Rich Dippel: When you're investing, there are ups and down. But somebody who just seems like a genius, again and again and again? It's like, hey, is there a problem here?
There is a problem. In a Ponzi scheme, few if any assets are actually bought with your money. And there's no real return on investment, even though the operator may send you fictitious financial statements, on fancy stationary, showing your investment account growing quarter after quarter.
Rich Dippel: Instead of investing your money, he or she takes it, and then solicits more customers. And then basically takes the new money coming in, and pays the existing investors.
A Ponzi scheme needs ever-more investors to pay off the earlier participants and keep things afloat. Eventually, there's not enough new money coming in to pay back what was initially invested, or to keep delivering the huge returns that have been promised. What happens then?
Rich Dippel: Eventually it implodes or they take off to a South American country or something.
Or, like Bernie Maddoff, end up wearing an ankle bracelet and confined to his $7 million Manhattan apartment pending trial. And why did anyone fall for this latest Ponzi scheme? Well, greed, for one thing -- the returns were apparently steady and reliable, even if conjured up out of thin air.
And the original schemer? Charles Ponzi was an Italian immigrant who, in the early 1920s, offered astronomical returns through a strategy he dubbed "international postage arbitrage." His entire portfolio turned out to be $30 worth of postal coupons. Ponzi went to prison. The millions that had been invested disappeared into his magic cauldron of financial fraud.
I'm Mitchell Hartman for Marketplace.