Published: Sunday, April 26, 2009
Ponzi schemes can be elusive
APonzi scheme is more than just an ordinary swindle. It has a very real business side, and at the heart of its business model there is pure math. Understanding the math is the key to how these scams work -- and why sometimes they can be difficult for investors or financial regulators to detect.
The schemes are named after Charles Ponzi, who immigrated to America and brought with him an irrepressible dream -- first, of getting rich, then of getting rich quick. His financial scam, launched from a Boston office in 1920, operated on a grand scale -- seeking and receiving immense amounts of media coverage that made him a celebrity. Offering a return of 50 percent in 90 days, he accepted funds from investors who believed they were participating in arbitrage transactions -- swapping international reply coupons for postage stamps.
While Ponzi may have had that kind of arbitrage in mind originally, it isn't clear that it would ever have worked. Moreover, it turned out to be a lot easier simply to pay off his initial investors with the funds that were pouring in from the new investors who lined up on the street below his office and around the block -- to make sure they didn't miss out on the opportunity to give him their money.
In its simplest form, a Ponzi scheme has no real source of income; it simply accepts an investor's funds and promises to pay an attractive rate of return -- and pays it out of the invested funds. The rate of return determines the natural life of the Ponzi. If, for example, I were to accept your investment of $1,000 for 10 years and promise you a rate of return of 10 percent on your money, taking nothing for myself, it would be 10 years before the Ponzi ran out of money.
At the 10-year point, though, there would be a problem. You would want your $1,000 back and I wouldn't have it. So I would have to find another investor to put up $1,000 so I could pay you off. If I'm successful, you are happy then, but now I have a new investor, who is looking for his or her $100 at the end of each year, and I don't have any money -- so I need a second investor to cover the annual 10 percent return payments.
With two investors and only $1,000 to play with, though, (the other $1,000 was paid back to you), the scheme will only last five years -- unless I bring in another investor. If I find one, I would then have three investors, $2,000 in my bank account, and annual payments of $300, so I'm good for about 6 years and 8 months.
This simple example is enough to illustrate the underlying math of a Ponzi scheme, which can be kept alive indefinitely if you can keep expanding the number of investors to cover the outflow of funds. The only variables are investor withdrawals, any amounts that I rake off, and the promised rate of return.
With no real investments, you don't even have to worry about the usual market ups and downs or any other losses you might incur.
But wait … maybe your investors do. What happens if they need the money they gave you to cover their other losses in the market? And that is what probably happened to Bernard Madoff, who is now in jail awaiting sentencing. He ran a multibillion-dollar Ponzi scheme that lasted more than 30 years and was, very likely, the largest such scheme ever hatched this side of the Social Security system.
Madoff's Ponzi collapsed because of simple math: The financial market crash caused investor withdrawals that exceeded the replacement rate.
What makes a low-profile, well-managed Ponzi scheme difficult for the authorities to detect is the absence of injured parties. If expected returns and withdrawals are paid to investors, they are happy. And if no one files a complaint, regulators and law enforcement agencies are unlikely to take an interest in the operation. We can see the direct parallel to the Social Security system: There are no complaints from recipients and therefore Congress feels no pressure to act.
It may not seem so now, certainly not to his investors, but from a regulatory sense Madoff did us a favor. We had convinced ourselves that our financial markets were secure and that those who traded in those markets, or pretended to, were licensed, insured, monitored, and regulated to the point where individual investors and institutions could safely ignore what is called "counterparty risk."
This was, of course, a delusion that afflicted both individuals and institutions. Now that we realize it, it's time to incorporate our knowledge into an improved regulatory structure
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
The schemes are named after Charles Ponzi, who immigrated to America and brought with him an irrepressible dream -- first, of getting rich, then of getting rich quick. His financial scam, launched from a Boston office in 1920, operated on a grand scale -- seeking and receiving immense amounts of media coverage that made him a celebrity. Offering a return of 50 percent in 90 days, he accepted funds from investors who believed they were participating in arbitrage transactions -- swapping international reply coupons for postage stamps.
While Ponzi may have had that kind of arbitrage in mind originally, it isn't clear that it would ever have worked. Moreover, it turned out to be a lot easier simply to pay off his initial investors with the funds that were pouring in from the new investors who lined up on the street below his office and around the block -- to make sure they didn't miss out on the opportunity to give him their money.
In its simplest form, a Ponzi scheme has no real source of income; it simply accepts an investor's funds and promises to pay an attractive rate of return -- and pays it out of the invested funds. The rate of return determines the natural life of the Ponzi. If, for example, I were to accept your investment of $1,000 for 10 years and promise you a rate of return of 10 percent on your money, taking nothing for myself, it would be 10 years before the Ponzi ran out of money.
At the 10-year point, though, there would be a problem. You would want your $1,000 back and I wouldn't have it. So I would have to find another investor to put up $1,000 so I could pay you off. If I'm successful, you are happy then, but now I have a new investor, who is looking for his or her $100 at the end of each year, and I don't have any money -- so I need a second investor to cover the annual 10 percent return payments.
With two investors and only $1,000 to play with, though, (the other $1,000 was paid back to you), the scheme will only last five years -- unless I bring in another investor. If I find one, I would then have three investors, $2,000 in my bank account, and annual payments of $300, so I'm good for about 6 years and 8 months.
This simple example is enough to illustrate the underlying math of a Ponzi scheme, which can be kept alive indefinitely if you can keep expanding the number of investors to cover the outflow of funds. The only variables are investor withdrawals, any amounts that I rake off, and the promised rate of return.
With no real investments, you don't even have to worry about the usual market ups and downs or any other losses you might incur.
But wait … maybe your investors do. What happens if they need the money they gave you to cover their other losses in the market? And that is what probably happened to Bernard Madoff, who is now in jail awaiting sentencing. He ran a multibillion-dollar Ponzi scheme that lasted more than 30 years and was, very likely, the largest such scheme ever hatched this side of the Social Security system.
Madoff's Ponzi collapsed because of simple math: The financial market crash caused investor withdrawals that exceeded the replacement rate.
What makes a low-profile, well-managed Ponzi scheme difficult for the authorities to detect is the absence of injured parties. If expected returns and withdrawals are paid to investors, they are happy. And if no one files a complaint, regulators and law enforcement agencies are unlikely to take an interest in the operation. We can see the direct parallel to the Social Security system: There are no complaints from recipients and therefore Congress feels no pressure to act.
It may not seem so now, certainly not to his investors, but from a regulatory sense Madoff did us a favor. We had convinced ourselves that our financial markets were secure and that those who traded in those markets, or pretended to, were licensed, insured, monitored, and regulated to the point where individual investors and institutions could safely ignore what is called "counterparty risk."
This was, of course, a delusion that afflicted both individuals and institutions. Now that we realize it, it's time to incorporate our knowledge into an improved regulatory structure
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
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