Ponzi Schemes
With the media attention given to Bernie Madoff recently, a lot of Americans find themselves wondering what, exactly, a Ponzi scheme is. You've no doubt read in the news about how Madoff tricked old ladies and celebrities alike (including Kevin Bacon and Sandy Koufax) out of billions of dollars, but you may be wondering how he was able to get away with it for so long, and how a Ponzi scheme works.
How It Works
Ponzi schemes (named after their first practitioner, Charles Ponzi) are a form of investment fraud in which the person running the scheme offers unrealistically high returns on initial investments. This is normally the red flag for fraud. The old adage is true: if it's too good to be true, then it probably is. Ponzi schemes operate by paying back the initial round of investors with the money generated by a second round of investors.
Say that you get ten initial investors who each give you $1 million, and you are offering a 20% return on the investment. The word of mouth surrounding the high investment returns will bring in more investors. Let's say that the second round has twenty investors, who each give you $1 million. You pay back the first ten investors their $1.2 million, which means you now have $8 million in surplus. As long as you keep getting more and more investors, you can keep increasing the amount of money you have in your surplus.
However, by their very nature, Ponzi schemes are doomed to collapse. Because you need more investors to pay back the earlier investors, you will eventually run out of new money to pay back the old. However, as we saw with Bernie Madoff, these schemes, when run well, can last years and years, and end with innocent people losing massive amounts of money.
Because the people who run Ponzi schemes obtain and steal money on false pretense, these schemes are considered very serious financial fraud, the punishment of which can be very severe.
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