Shams, Scams, and Frauds: The Ponzi Scheme

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An earlier post looked at the “Pump and Dump” scam.  Now we’ll look at a gimmick of equally long pedigree in the world of fraud and theft, one made famous not too long ago by so-called financier and criminal, Bernie Madoff.  Unlike the pump and dump, the Ponzi scheme is harder to detect — so much so that Mr. Madoff and others who perpetrate such frauds frequently do so for years (decades in Madoff’s case) without any action or even suspicion by the Securities Exchange Commission (SEC) or other agencies that police financial markets and practices.  In Madoff’s case, the market found him out before the SEC even looked his way.

How Does the Scheme Work?

Named after Charles Ponzi, who ran a particularly famous version of the scam in the 1920s, this fraud really only looks like investing.  Little investing is involved.  The schemer presents impressive but fake investment returns in order to con new victims, whose money he uses to pay generous “dividends” to earlier investors, after, of course, taking a handsome rake off.  A Ponzi schemer can only keep up the scam as long as he can entice an ongoing money flow from new “investors.”

Ponzi criminals are usually exposed when they can’t get enough new victims to pay those “dividends” to the earlier “investors” or when enough people to try to remove their assets to meet some perhaps unexpected financial need.  At that point, everyone loses out.  The Ponzi scammer goes to jail and, because there are seldom any assets, the victims have no way to recover their funds.

Bernie Madoff

  This was the case with the famous and more recent Ponzi run by Bernie Madoff.  He managed to carry on his show for decades and seduce many presumably experienced financial people who should have known that his dazzling advertised returns were too good to be true. No doubt Madoff succeeded in getting many new clients, because he could boast about all the prominent people he had already taken in and whose money he had already captured.  Madoff not only tricked investors, but he also fooled the authorities and financial journalists who also should have known better.  He was quoted frequently in the financial media and even served for a time as president of the American Stock Exchange.

It all unraveled in the financial crisis of 2008.  The huge financial strains of that time exerted two different pressures on Madoff.  First, fewer people had money to “invest” with him, and second, long-time customers, facing their own financial problems, needed cash and tried to withdraw their funds. Of course, Madoff had nothing for them, especially because he was having trouble finding new “investors.”  When it became obvious that he could not honor their withdrawal requests, the SEC became involved and only then did criminal prosecution begin.  As is always the case with Ponzi schemes, the victims lost everything.  Madoff’s personal wealth, as great as it looked, could hardly cover even a small piece of their losses, and many of his victims lost much of their wealth.  Madoff went to jail.  The authorities moved on — as if they had done their job.

Protecting Yourself

The only defense is to always remember the old Wall Street saw: “If something looks too good to be true, it is.”  No one, not even the most gifted investor, can produce superior investment performance year after year without pause, as Madoff and other Ponzi schemers claim, or can make money in every down market.  If you keep that in mind, you can avoid being taken in, no matter how many of your friends, colleagues, and prominent fools claim the thief’s brilliance, no matter how tempting it is to secure the gains the Ponzi schemer promises which, in the end, he or she can never deliver.


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