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So what's a Ponzi scheme anyway?

Charles Ponzi

TEXT OF STORY

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.

About the author

Mitchell Hartman is the senior reporter for Marketplace’s Entrepreneurship Desk and also covers employment.
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He is a crook and deserves to go to prison, but my question is where was the sec thru all of this? They were tipped off years ago, why didn't they catch him, was Madoff paying them off?

Stop vilifying Bernie Madoff. In capitalism it is OK to cheat people. If a charity took donations and gambled with them on wall street instead of keeping them safe in treasuries, that charity betrayed the donors. Bernie cheated people, yes. But he did not force anyone to play with him. It is the investors whose greed led them to BM, and he tricked them. If a man goes to a prostitute or drug-dealer to get a fix, and then gets tricked, can you really blame the drug-dealer or prostitute? Greedy investors never cared how Bernie made his money, they just wanted their 'fix'. Like drug-dealers and prostitues, stock brokers and investment bankers know that only needy people come to them, and it is easy to fool these people. So they do. But before passing judgment, ask yourselves, could Bernie Madoff cheat anyone that was not greedy? Nope. The real culprits are the greedy charities and rich people who wanted to gamble in wall street. Don't blame the prostitute for prostitution or the drug-dealer for drug-addiction. For as long as there are greedy charities and rich people, there will be and should be a Bernie Madoff to take advantage of their greed. ST

A large part of the Stock Market is actually a Ponzi scheme! The 'fair-value' of a stock is based on the dividend it pays an then adjusted by changes in future dividend payments. But what if a stock doesn't pay a dividend. Like Google (GOOG)! How do you decide its fair value? Well, GoldmanSachs, the underwriter is sitting on a load of Google stock, they got them cheap, say $10/stock. They now loan money to Google to create fake profits. They 'influence' all sorts of media to constantly drum up Google's growth. Marketplace is one such media, that starts reporting on Google-this an Google-that, -all positive. Then as demand grows for Google stock, the price goes up. Goldman's brokers start selling from their position, making a killing. The stock price is effectively being held up by this new money. As people watch Google go up, they invest more money an the price goes up even more. Google hasn't paid a 'dime' to any shareholders yet, and may never do. When GoldmanSachs and Google bosses have dumped enough of their stock, they stop pumping it up with loans, google profit falls and the stock tanks. It happened to Enron, and is happening again with Google. And if you think you can sue a Bank for helping in this Ponzi scheme, -you are wrong! The supreme court has repeatedly ruled that it IS LEGAL for a bank to be an accomplice in a pump-and-dump case, as Enron law-suites have proven. But this Ponzi scheme has legs. As people keep making payments through 401k's, the money keeps flowing, the price keeps rising, and the self-sustaining Ponzi scheme goes on. Now, as companies start cutting 401k contributions, things might change :)

I just could not believe this "Ponzi Scheme" lasts for so long. Is there any "check and balance" system in in the business of investment? Probably there is not! Most probably Bernie Madoff will still be in his $7 million Manhattan appartment enjoying his life style if there were not financial crisis in the history of financial businesses in the USA. Because of his greeds, many people suffer from his "smart Ponzi scheme" business. Most people also know that all the people who invest their money at Bernie Madoff beusiness also want to be richer because they believe their investment will yied high ROI (Return On Ivestment). Now some of the investors lost their money, so they must also accept the reality of investing. To begin with, investors should understand that the possibility of losing their money is there. Now that some of the investors at Madoff lost their money, they should blame two sides, Madoff and themselves.

For sure Bernie Madoff will be the smartest Ponzi Schamer of the century. I believe he is just one of the greediest persons on earth. There are many other people who have the greed as Bernie Madoff in this world. This kind of person, Madoff, should get the heaviest punishment for what he has done to the investors,and to the $50 billion that he is responsible for. What a "crook"!

Robert,

Technically you are partially correct, but only partially. Some of the money was paid out to earlier (lucky) investors, but a lot of the money has really disappeared. You can create your own "Ponzi" scheme on an Excel spreadsheet and see how this works. Imagine you take in $1 billion a year from investors and promise them a 15% return. In truth, you try to make 15% a year but find instead it is so much easier to lose 15% a year. So, grab an excel spread sheet and add one more factor: after two years of investing, each "class" of investors cash out.

And remember, you will now have 2 sets of books: the stated books with balances and imaginary gains, and the real books. After 2 years your stated books will say: invested capital, $2 billion, gains, $0.45 billion. Total, $2.45 billion. You send your Year One investors their initial investment of $1 billion plus their "gains" of 15% a year (for simplicity sake I am not compounding)or a total check of $1.3 billion.

So, at this moment, right before a new "class" of investors put up their new $1 billion in new money, the stated accounts show $1.15 billion (that is, the Year Two investors, happy with their %15 returns, willing to sit through another year).

The reality? The 2-year performance of the fund has been minus $0.45 billion, so the $2 billion is really only $1.55 billion. But, the fund has to pay out the Year One Class a total of $1.30 billion, so the real cash in the till is only $0.25 billion. Year Two Investors think they have a 15% gain, but it is ALREADY a 75% loss. If no new investors are found and the Fund loses another $0.15 billion, then they will receive only 10% of their original investment. Fortunately for Year Two investors, new investors (patsies, marks) are coming over the horizon, lured by steady, attractive returns.

When Year Three pays in $1.0 billion, then the real account only goes up to $1.25 billion, while the stated (fraudulent) accounts read: $2.15 billion. Now we are short in the accounts $900 million, and the race is on.

Of course, it's much worse than this, because of compounding and some of the marks leaving their money in to compound at these great rates over longer periods. Add in the salaries, bonuses, payouts and donations that Madoff is making all the while he is keeping up billionaire appearances and you can see that the real accounts can teeter at about zero until the new money comes in. Now add to this that clients were not only living in anticipation of their $50 million stated accounts at Madoff, but borrowing against them, and we have a multiplier effect outside the Madoff scheme.

So, in summary, losing 15% a year (or take any number you like) will result in real losses, and investments that truly disappeared. The $50 billion is, remember, what the stated accounts read at the time of the collapse.

Madoff did this for more than a decade? Amazing.

wearing an ankle bracelet and confined to his $7 million Manhattan apartment ?

if one had stollen a $25 item from kmart, they'd likely be in jail...

Do you know anyone who doesn't think this "crook" should experience the same treatment ?

The $50 Billion in Bernie Madoff's ponzi scheme did not disappear. Money doesn't disappear. Some of it exists in his personal possessions, and a goodly portion of it is in the bank accounts of the earlier investors who were paid the high returns in order to create the myth. Could money be recovered from them?

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