Tuesday, March 1, 2011

"Vice Pioneers" : Ponzi Scheme

Namesake: Charles Ponzi

Charles Dickens: pre-Ponzi take on the crime

Bernard Madoff: ultimate hustler

White collar crime is so widespread these days, you barely flinch when you hear news that another executive or company has been partaking in naughty behavior. Nothing makes a crime easier to get away with than a nice suit and fancy lifestyle. After catching an episode of "American Greed" on CNBC the other night about Ponzi schemes, I thought I'd look into the matter. Before Madoff, there was very little interest in the crime and most people probably had no idea what it was. Here's a brief look into what it is--more of a summary of how it works and unravels than a history, but informative nonetheless.

From Wikipedia: "A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors, not from any actual profit earned by the organization, but from their own money or money paid by subsequent investors. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments to investors. Usually, the scheme is interrupted by legal authorities before it collapses because a Ponzi scheme is suspected or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases. While the system eventually will collapse under its own weight, the example of Bernard Madoff's investment scandal demonstrates the ability of a Ponzi scheme to delude both individual and institutional investors as well as securities authorities for long periods: Madoff's variant of the Ponzi scheme stands as the largest financial investor fraud committed by a single person in history. Prosecutors estimate losses at Madoff's hand totaling roughly $21 billion, as estimated by the money invested by his victims. If the promised returns are added, the losses amount to $64.8 billion, but a New York court dismissed this estimation method during the Madoff trial.

The scheme is named after Charles Ponzi who became notorious for using the technique in early 1920. Ponzi did not invent the scheme (for example Charles Dickens' 1857 novel Little Dorrit described such a scheme decades before Ponzi was born), but his operation took in so much money that it was the first to become known throughout the United States. Ponzi's original scheme was based on the arbitrage of international reply coupons for postage stamps, however he soon diverted investors' money to support payments to earlier investors and himself.

Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational economically if there is a reasonable expectation that government or other person or organisation will bail out those participating in the scheme.

Ultimate unraveling of a Ponzi scheme
The catch is that at some point one of these things will happen:
***The promoter will vanish, taking all the remaining investment money (minus the payouts to investors).
***Since the scheme requires a continual stream of investments to fund higher returns, once investment slows down, the scheme will begin to collapse under its own weight as the promoter starts having problems paying the promised returns (the higher the returns, the greater the risk of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
***External market forces, such as a sharp decline in the economy (e.g. Madoff and the market downturn of 2008), cause many investors to withdraw part or all of their funds; not necessarily due to loss of confidence in the investment, but simply due to underlying market fundamentals. In the case of Madoff, the fund could no longer appear normal after investors tried to withdraw $7 billion from the firm in late 2008 as part of the major worldwide market downturn affecting all investments."

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