Ponzi Scheme

Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period—and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons.

Decades later, the Ponzi scheme continues to work on the "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses. For more information, please read pyramid schemes in our Fast Answers databank.

A Ponzi scheme is a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned. The Ponzi scheme usually offers returns that other investments cannot guarantee in order to entice new investors, 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 in order to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments. 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.

The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Ponzi did not invent the scheme (Charles Dickens' 1857 novel Little Dorrit described such a scheme decades before Ponzi was born, for example), but his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors' money to support payments to earlier investors and Ponzi's personal wealth.

Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational in the economic sense if a government will likely bail out those participating in the Ponzi scheme.

The Madoff investment scandal occurred after the discovery that former NASDAQ chairman Bernard Madoff's asset management business was actually a giant Ponzi scheme. Alerted by his sons, federal authorities arrested Madoff on December 11, 2008. On March 12, 2009, Madoff pled guilty to 11 felonies and admitted to operating the largest investor fraud ever committed by an individual. According to a federal criminal complaint, client statements showing $65 billion in stock holdings were fictitious, and no stocks were ever purchased since the scheme began in the 1980s.

Concerns about Madoff's business had surfaced as early as 1999, when financial analyst-whistleblower Harry Markopolos informed the SEC that he felt it was legally and mathematically impossible to achieve the gains Madoff claimed to deliver. Others felt it was inconceivable that his growing volume of accounts could be competently serviced by his documented accounting/auditing firm, a three-person firm with only one active accountant.
Sister project Wikinews has related news: Madoff prosecutors want assets from wife and children

Madoff had been under 24-hour monitoring and house arrest in his Upper East Side penthouse apartment since December, 2008. However, after accepting Madoff's plea, Judge Denny Chin immediately revoked his $10 million bail and remanded him to the Metropolitan Correctional Center pending sentencing. Chin declared that because of Madoff's age, wealth, and sentencing prospects, he is considered a flight risk.

Madoff's lawyers filed an appeal, and prosecutors responded with a notice of opposition. On March 20,2009, an appellate court denied Madoff's request to be released from jail and returned to "penthouse" home confinement until his June sentencing. Prosecutors have filed two asset forfeiture pleadings which include lists of valuable real and personal property as well as financial interests and entitities.

Some involved in the case as well as other unrelated observers have opined that the actual loss to investors could be far less than reported. Former SEC Chairman Harvey Pitt estimated the actual net fraud to be between $10 and $17 billion, because it does not include the fictional returns credited to the Madoff's customer accounts.

The SEC came under fire for not investigating Madoff sooner, despite complaints from Markopolos and others. In testimony before Congress after the scandal broke, Markopolos claimed it was very easy to prove mathematically that Madoff was running a scam. He said it took him five minutes to make an initial assessment of the fraudulent nature of Madoff's purported high investment returns and about four hours to work the detailed math calculations.

Reference:
http://en.wikipedia.org
http://www.sec.gov