Friday, December 19, 2008

Ponzi Scheme - Bernie Madoff

In my original post on Bernie Madoff, I simply referenced his arrest and made some general commentary about his alleged money management firm. Today, let's take a closer look at what exactly a ponzi scheme is considered.

According to Wikipedia, A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business. It is named after Charles Ponzi. The term "Ponzi scheme" is used primarily in the United States, while other English-speaking countries do not distinguish in colloquial speech between this scheme and other forms of pyramid scheme.

The scheme usually offers abnormally high short-term returns in order to entice new investors (Madoff seemed to consistently show annualized returns of 8%-12%). The perpetuation of the high 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 there are little or no underlying earnings from the money received by the promoter. However, the scheme is often interrupted by legal authorities before it collapses, because a Ponzi scheme is suspected and/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 was not the first to invent such a scheme, 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 later investors' money to support payments to earlier investors and Ponzi's personal wealth. Today's schemes are often considerably more sophisticated than Ponzi's, although the underlying formula is quite similar and the principle behind every Ponzi scheme is to exploit investor naïveté. However, it has been shown that entering a Ponzi scheme can be rational even at the last round of the scheme if a government will likely bail out those participating in the Ponzi scheme.

I think the 'Madoff Scheme' (as it now should be called) came crashing down after running into the current bear market. It's easy to generate decent returns in a bull market (makes me think of the expression 'don't confuse brains with a bull market'). Any shortfalls in investment returns were simply supplemented with new investor money. However, when new money became hard to obtain and the bear market cut into the portfolio principal, the house of Madoff came crashing down. There was simply not enough money to return to meet shareholder redemption's. How it lasted this long defies logic.

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