Over the last few years the name “Bernie Madoff” and the term “Ponzi Scheme” have been used almost interchangeably. Obviously we all know that this man was a crook and that he committed a very serious act of fraud by stealing millions of dollars from trusted investors. But have you ever stopped to ask yourself just what one is or what a Ponzi Scheme example would even look like?
Don’t be embarrassed if you don’t know exactly what one is. When Madoff was arrested and his wife was told about his crime, she replied “What’s a Ponzi Scheme”?
As students of investing and diligent savers for retirement, it is very important that we protect our financial well-being by staying away from scrupulous investment opportunities After all, as the old saying goes:
- “If an investment sounds too good to be true, it’s probably isn’t real”
Greed is a very powerful motivator, and crooks know this. When you save up a sizable chuck of money for retirement, there will be people that will try to cheat you out of it by promising you unrealistic returns. The best thing you can do for yourself is learn how to recognize these types of scams and avoid a Ponzi Scheme right from the beginning.
Why Is It Called a Ponzi Scheme?
The term “Ponzi Scheme” is named after the con-artist Charles Ponzi. In the 1920’s, Ponzi defrauded investors using the price differences on international reply coupons (IRC’s).
The purpose of the IRC was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. The price of an IRC was at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed. If these two values were different, there was a potential profit.
Unfortunately, what Ponzi didn’t realize was that this system only worked as long as new investors kept coming. As the scheme continued, he started using money from new investors to pay back the old ones and get rich himself. As you can guess, this turned into a vicious cycle with no where to go but failure. Eventually the system became completely unstable and his investors lost everything.
To demonstrate exactly how that works, we’ll go through a Ponzi Scheme example that would be more along the lines of a more modern day Bernie Madoff crime.
A Ponzi Scheme Example – Step by Step:
So to summarize the history lesson above:
- A Ponzi Scheme is a fraudulent investment crime where the new money in is used to pay off the former investors.
- The investment returns and portfolio values reported to the stakeholders are basically fake and only sustained with the new incoming money.
- Eventually, as more of the former investors begin to request their money, the bubble pops and crime is exposed.
The easiest way to explain this scenario is to show you with an illustrated example. Let’s start with two groups of people:
1) The “Suckers” who are investors that will be robbed of their money.
2) The “Ponzi-Fund” which will steal the money from the Suckers.
For simplicity, this example will ignore how much money is stole by the con-artist, investment losses due to poor choices or crime-ridden investments, and tax fraud.
Cycle 1 – The Beginning:
The Ponzi Scheme begins with the con-artist convincing Sucker 1 to invest in his fund. In return for his investment, the con-artist promises a whopping (fake) 30% return! Naturally, this sounds incredible to Sucker 1 and he agrees to invest.
Cycle 2 – One Year Later:
After some time, Sucker 1 receives a statement with the 30% return and he has $2.6M!! Awesome! But what is really in the Ponzi-Fund? Probably not anywhere close to that.
For each year of the Ponzi-Fund, we’ll use the historical 10% average return (since this is what financial experts believe you can never beat over any great length of time anyways!).
Also after the first year, Sucker 2 hears about these great returns and wants in. Now the Ponzi con-artist is now promising a (fake) 40% return! Sucker 2 joins in with $1M.
Accounting for the new money and theoretical returns, as you can see by the red arrow, the two amounts are not in balance.
Cycle 3 – Trouble Builds:
After this is where the trouble begins! Sucker 1 decides to cash out with $3.64M. Oh, no! This nearly drains the entire Ponzi-Fund. The Ponzi con-artist recruits two more Suckers, 3 and 4, and again promises a (fake) 50% return. Suckers 3 and 4 contribute a total of $1M. Even with this new influx of cash, the true value of the Ponzi fund is now not nearly enough to cover all the assets.
Cycle 4 – The Bubble Bursts:
Finally, the gig is up! Sucker 2 decides to cash out but is only able to receive less than half of his statement value. Why? Because the fund is now completely exhausted! What about the rest of Sucker 2’s money? What about Sucker 3 and 4’s money? Gone! Unfortunately, it went to money Heaven
Now take this simple Ponzi Scheme example and compound it by hundreds or even thousands of investors! Also remember that the con-artist was also probably working with millions of dollars!
Not only was the crook likely stealing money for himself (he is a criminal after-all), there is also the possibility that he was investing very poorly and losing money at a very fast rate. All around, this would be a horrible way to lose your life savings.
Who Was Bernie Madoff?
In March 2009, Bernard Lawrence “Bernie” Madoff pleaded guilty to 11 federal felonies relating to using his business to create a massive Ponzi scheme. He was a Wall Street investor and the founder of the firm Bernard L. Madoff Investment Securities LLC. Sometime between the 1970’s and 1990’s, he began to report illegitimate returns to his investors while diverting some of the money to himself and others. The amount missing from client accounts was reported at $65 billion; however, the actual losses were estimated to be approximately $18 billion. For these crimes, he was sentenced to the maximum punishment allowed: 150 years in prison.
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Image Credit: Microsoft Clip Art