ponzi and pyramid schemes
I wrote an article for the newspaper Fréttablaðið that appeared over the weekend. Here is the English version of the article.
Ponzi and pyramid schemes
A Ponzi scheme refers to any fraud or scam that must continually bring in new investors in order to pay returns to existing investors: the arrival of new money is the only way to keep the scheme “afloat”. Such schemes often masquerade as legitimate businesses, but the business is loss-making and relies on continual supplies of new funds to survive.
In securities fraud, a Ponzi scheme is classified as a type of “offering fraud”, that is an offering of a fraudulent investment opportunity to investors. Ponzi schemes are also called pyramid schemes because the structure of the scheme can be thought of as a pyramidal shape, with an ever-broader base necessary to support the layers above.
The original Ponzi scheme
Carlo (“Charles”) Ponzi emigrated to Boston from Italy in 1903 with two dollars and fifty cents to his name. By 1920 he had become known as a successful businessman and investor. In reality his business was simply a giant pyramid scheme. Since those days, such schemes have often been named after Ponzi, who is now considered one of the great swindlers or con men in American history. Ponzi collected millions of dollars from unsuspecting investors, and continually used his newest investors to pay back those who asked to redeem their money.
Ponzi’s scheme itself was quite simple. In those days one could buy something called international reply coupons in one country that could be exchanged for postal stamps in another country. If it was cheaper to mail a letter in one place than another, it was theoretically possible to make an arbitrage profit by buying cheap postal reply coupons in, for example Italy, and exchanging them for more valuable stamps in the U.S. Ponzi told his investors that this simple trade was how he was making money for them. In actuality, these coupons were difficult to exchange and there were not enough of these coupons in existence in the world to support the eventual size of Ponzi’s investment program. He was simply taking money from more and more investors and paying anyone who asked for their funds back with the money he had just taken, promising an amazing rate of return of 50% in only 45 days. Money poured into the scheme from all over New England, as people emptied their savings accounts and mortgaged their homes, handing the cash over to Ponzi. He kept plenty of that cash for himself along the way: he moved into a mansion, bought part of a Boston bank, and arranged to have his mother visit from Italy via a luxury stateroom on an ocean liner.
In the summer of 1920, as the press and law enforcement became more and more curious about how Ponzi made his money, the scheme began to collapse. It turned out that Ponzi, instead of being fabulously rich, was $7 million in debt. The scheme had never made money and in fact was run at a large loss. Many of Ponzi’s bank accounts were actually supported by huge loans. When the Boston bank Ponzi controlled was seized by Massachusetts authorities, that action kept Ponzi from activating his final plan: to “borrow” funds from the bank’s vault in order to pay off unhappy investors. In the end, Ponzi went to jail and his investors lost most of their money, receiving less than 30 cents on the dollar.
Some common features
Ponzi schemes often make use of affinity fraud, or fraud that targets a group of individuals who have a pre-existing connection or relationship with the fraudster. The scheme thereby abuses a relationship of trust within a community. These individuals often come from the same religious group, ethnic group, or country as the fraudster. The fraudster can say, “I am not some stranger, we come from the same community.” For this reason, Ponzi schemes can pose a real regulatory challenge, as the defrauded investors remain loyal to their “group” rather than the regulator. Even after their money is gone, many still don’t want to believe it was actually stolen. In many cases the victims “fall in love” with the fraudster, and will stick up for him no matter what evidence is presented to the contrary.
Often during or after the collapse of a Ponzi scheme, the fraudster will exclaim publicly that he never profited personally. In reality, the schemer profited all along by spending the money on luxury items, often as soon as that money came in the door. “It is easy to spend money you didn’t earn,” says a senior fraud investigator at the U.S. Securities and Exchange Commission, “you wouldn’t believe how fast these people can spend money.” In more recent schemes, Ponzi fraudsters have spend other people’s money on wine, cars, private jets, vacations, jewelry, and luxury homes and offices for themselves.
Who carries out Ponzi schemes? Schemers are often people who dream of big wealth, and have started one or a series of failed businesses. They can also be small-timers who set out each day to swindle their fellow man: con men, liars, confidence men, flim-flam men, grafters, and poker-table card-markers. In general, Ponzi schemers are people who know how to exploit the confidence of others, often by exploiting greed, dishonesty, credulity, or naïveté in their marks.
Ponzi schemes do not always start out as schemes, however. Any unsustainable business model can degrade into a Ponzi scheme, as the business owners run away from disclosing their early losses by raising ever more new investor money in an attempt to outrun their past.
In truth it is impossible to sustain a Ponzi scheme. These are business models that always collapse in the end: basic math says a scheme cannot keep collecting new money forever. By design, then, they are doomed to failure, as the number of new investors needed to keep them going quickly exceeds the population. Often, a collapse in stock markets will trigger a collapse of Ponzi schemes as investors suddenly face a need for cash and demand their money all at once.
Stages of a Ponzi scheme
A Ponzi scheme has three stages. First is the formation stage, where early investors are drawn to a promise of low risk and high return. In this stage the fraudster himself markets directly to investors. To increase his stature and believability, the fraudster will often engage in high-profile activities, such as sponsoring sports teams or giving large sums to charity. The fraudster seeks frequent mention in the press and in society pages to expand his visibility and aid in his future fund-raising efforts.
Next comes the fund-raising stage, where new investors join as the scheme generates successful payoff cycles: the first few rounds of investors will have made incredible profits and word-of-mouth is encouraging new investment. To extend the life of the scheme, the fraudster will often impose a “lock out” where investors’ money cannot be touched for a certain period. He will also encourage investors to “roll” their profits back into the scheme, to compound their gains. At this point the fraudster no longer needs to market as the scheme is well-known. He may even close the scheme to new investors to create an air of exclusivity. At this point people may beg him to take their money, and feel fortunate to have had the opportunity to invest.
Finally comes the collapse of the scheme. This happens when principal and interest owed to old investors exceeds the funds coming in from new investors. External events, such as depressed stock markets, may trigger a “run on the scheme”. Wealthy investors with Bernie Madoff who had lost money on their other equity investments in the down markets of 2008 might have thought, “I had a good run with Bernie, so maybe I should get out while I am ahead and put my gains in a bank account.” Negative publicity of other schemes may also trigger a scheme to collapse. News of the Madoff scheme triggered employees of at least one other scheme to wonder if they themselves were working for a fraudster.
Warning signs
There are many warning signs for a Ponzi scheme. The most basic of these is consistent, high investment returns that do not vary greatly from period to period. Often the investment strategy of a scheme is difficult to understand or in some cases a “black box”. Even if the investment strategy is stated, others may have difficulty duplicating it. There are often serious conflicts of interest within the organization conducting the scheme, or the same organization performing multiple conflicting roles, such as investment selection and valuation. There is often sloppy record keeping done by a small staff dedicated to bookkeeping, with auditing conducted by small or unknown auditing firms. Finally, employees of the scheme may be compartmentalized, separated from knowledge of what each other is doing by physical or informational barriers.
Ponzi schemes go by many other names, among them "Forex" frauds, "prime bank" frauds, and Madoff schemes, a new name bestowed in 2008 in honor of the most recent famous scheme. Coming up in Part II: an example of a real and recent Ponzi scheme that ran for more than a decade.
Ponzi and pyramid schemes
A Ponzi scheme refers to any fraud or scam that must continually bring in new investors in order to pay returns to existing investors: the arrival of new money is the only way to keep the scheme “afloat”. Such schemes often masquerade as legitimate businesses, but the business is loss-making and relies on continual supplies of new funds to survive.
In securities fraud, a Ponzi scheme is classified as a type of “offering fraud”, that is an offering of a fraudulent investment opportunity to investors. Ponzi schemes are also called pyramid schemes because the structure of the scheme can be thought of as a pyramidal shape, with an ever-broader base necessary to support the layers above.
The original Ponzi scheme
Carlo (“Charles”) Ponzi emigrated to Boston from Italy in 1903 with two dollars and fifty cents to his name. By 1920 he had become known as a successful businessman and investor. In reality his business was simply a giant pyramid scheme. Since those days, such schemes have often been named after Ponzi, who is now considered one of the great swindlers or con men in American history. Ponzi collected millions of dollars from unsuspecting investors, and continually used his newest investors to pay back those who asked to redeem their money.
Ponzi’s scheme itself was quite simple. In those days one could buy something called international reply coupons in one country that could be exchanged for postal stamps in another country. If it was cheaper to mail a letter in one place than another, it was theoretically possible to make an arbitrage profit by buying cheap postal reply coupons in, for example Italy, and exchanging them for more valuable stamps in the U.S. Ponzi told his investors that this simple trade was how he was making money for them. In actuality, these coupons were difficult to exchange and there were not enough of these coupons in existence in the world to support the eventual size of Ponzi’s investment program. He was simply taking money from more and more investors and paying anyone who asked for their funds back with the money he had just taken, promising an amazing rate of return of 50% in only 45 days. Money poured into the scheme from all over New England, as people emptied their savings accounts and mortgaged their homes, handing the cash over to Ponzi. He kept plenty of that cash for himself along the way: he moved into a mansion, bought part of a Boston bank, and arranged to have his mother visit from Italy via a luxury stateroom on an ocean liner.
In the summer of 1920, as the press and law enforcement became more and more curious about how Ponzi made his money, the scheme began to collapse. It turned out that Ponzi, instead of being fabulously rich, was $7 million in debt. The scheme had never made money and in fact was run at a large loss. Many of Ponzi’s bank accounts were actually supported by huge loans. When the Boston bank Ponzi controlled was seized by Massachusetts authorities, that action kept Ponzi from activating his final plan: to “borrow” funds from the bank’s vault in order to pay off unhappy investors. In the end, Ponzi went to jail and his investors lost most of their money, receiving less than 30 cents on the dollar.
Some common features
Ponzi schemes often make use of affinity fraud, or fraud that targets a group of individuals who have a pre-existing connection or relationship with the fraudster. The scheme thereby abuses a relationship of trust within a community. These individuals often come from the same religious group, ethnic group, or country as the fraudster. The fraudster can say, “I am not some stranger, we come from the same community.” For this reason, Ponzi schemes can pose a real regulatory challenge, as the defrauded investors remain loyal to their “group” rather than the regulator. Even after their money is gone, many still don’t want to believe it was actually stolen. In many cases the victims “fall in love” with the fraudster, and will stick up for him no matter what evidence is presented to the contrary.
Often during or after the collapse of a Ponzi scheme, the fraudster will exclaim publicly that he never profited personally. In reality, the schemer profited all along by spending the money on luxury items, often as soon as that money came in the door. “It is easy to spend money you didn’t earn,” says a senior fraud investigator at the U.S. Securities and Exchange Commission, “you wouldn’t believe how fast these people can spend money.” In more recent schemes, Ponzi fraudsters have spend other people’s money on wine, cars, private jets, vacations, jewelry, and luxury homes and offices for themselves.
Who carries out Ponzi schemes? Schemers are often people who dream of big wealth, and have started one or a series of failed businesses. They can also be small-timers who set out each day to swindle their fellow man: con men, liars, confidence men, flim-flam men, grafters, and poker-table card-markers. In general, Ponzi schemers are people who know how to exploit the confidence of others, often by exploiting greed, dishonesty, credulity, or naïveté in their marks.
Ponzi schemes do not always start out as schemes, however. Any unsustainable business model can degrade into a Ponzi scheme, as the business owners run away from disclosing their early losses by raising ever more new investor money in an attempt to outrun their past.
In truth it is impossible to sustain a Ponzi scheme. These are business models that always collapse in the end: basic math says a scheme cannot keep collecting new money forever. By design, then, they are doomed to failure, as the number of new investors needed to keep them going quickly exceeds the population. Often, a collapse in stock markets will trigger a collapse of Ponzi schemes as investors suddenly face a need for cash and demand their money all at once.
Stages of a Ponzi scheme
A Ponzi scheme has three stages. First is the formation stage, where early investors are drawn to a promise of low risk and high return. In this stage the fraudster himself markets directly to investors. To increase his stature and believability, the fraudster will often engage in high-profile activities, such as sponsoring sports teams or giving large sums to charity. The fraudster seeks frequent mention in the press and in society pages to expand his visibility and aid in his future fund-raising efforts.
Next comes the fund-raising stage, where new investors join as the scheme generates successful payoff cycles: the first few rounds of investors will have made incredible profits and word-of-mouth is encouraging new investment. To extend the life of the scheme, the fraudster will often impose a “lock out” where investors’ money cannot be touched for a certain period. He will also encourage investors to “roll” their profits back into the scheme, to compound their gains. At this point the fraudster no longer needs to market as the scheme is well-known. He may even close the scheme to new investors to create an air of exclusivity. At this point people may beg him to take their money, and feel fortunate to have had the opportunity to invest.
Finally comes the collapse of the scheme. This happens when principal and interest owed to old investors exceeds the funds coming in from new investors. External events, such as depressed stock markets, may trigger a “run on the scheme”. Wealthy investors with Bernie Madoff who had lost money on their other equity investments in the down markets of 2008 might have thought, “I had a good run with Bernie, so maybe I should get out while I am ahead and put my gains in a bank account.” Negative publicity of other schemes may also trigger a scheme to collapse. News of the Madoff scheme triggered employees of at least one other scheme to wonder if they themselves were working for a fraudster.
Warning signs
There are many warning signs for a Ponzi scheme. The most basic of these is consistent, high investment returns that do not vary greatly from period to period. Often the investment strategy of a scheme is difficult to understand or in some cases a “black box”. Even if the investment strategy is stated, others may have difficulty duplicating it. There are often serious conflicts of interest within the organization conducting the scheme, or the same organization performing multiple conflicting roles, such as investment selection and valuation. There is often sloppy record keeping done by a small staff dedicated to bookkeeping, with auditing conducted by small or unknown auditing firms. Finally, employees of the scheme may be compartmentalized, separated from knowledge of what each other is doing by physical or informational barriers.
Ponzi schemes go by many other names, among them "Forex" frauds, "prime bank" frauds, and Madoff schemes, a new name bestowed in 2008 in honor of the most recent famous scheme. Coming up in Part II: an example of a real and recent Ponzi scheme that ran for more than a decade.
posted by JB at 18.1.10
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