How to Protect Yourself from the Bernard Madoffs of the World: Ponzi Schemes Revealed p1/2

In January 1920, an Italian immigrant discovered an arbitrage potential in international reply coupons – IRC. By purchasing IRCs for stamps in Spain, and then exchanging them for postage in the USA, he could net a profit. Forming a corporation called “Securities Exchange Company”, he decided to raise capital by selling investment coupons with a guaranteed 50% rate of return in only 45 days. Investors lined up. A required $1,000 dollar investment returned $1,500 for a gross of $500. Investors were so pleased from the results that they re-invested their earnings. Over the better part of 1920, approximately 15,000 people invested, and reinvested. Investors used their life savings; homes were mortgaged and assets were liquidated. People continued to reinvest their profits. Money was being made hand over fist. After only 5 months, the Securities Exchange Company had made several million dollars.

Yet the future did not bode well for the company. A financial analyst noted that there simply were not enough IRCs available in Spain for the Securities Exchange Company to be making its profits. Further investigation showed things were too good to be true: no IRCs had ever been collected. Investment returns were being paid out of new investors’ monies. In August, after having taken in tens of millions of dollars from thousands of investors, the man behind it all was federally indicted.

The Italian immigrant was none other than Charles Ponzi. Not only did the scheme’s magnitude make him one of most notorious con men of all time, the scheme also had the dubious distinction of being named after him. Since the 1920s, many have attempted to reproduce the initial success of Charles Ponzi. Most recently, Bernard Madoff, a trusted and respected securities official, was accused of operating a Ponzi scheme.

The Scheme Revealed

Here’s how a Ponzi scheme works:

1. Investors buy into a new investment plan, usually something obscure, complex, or a secret, which generates a very high rate of return.

2. A portion of the funds is used to pay out the returns, which are usually reinvested.

3. Word of mouth about the success draws new investors at an increasing rate.

4. Eventually the scheme must collapse; since the money is never actually invested, there is nothing to cover the returns.

Madoff’s Scheme

Madoff’s Ponzi scheme was based on a false tactic of using stock option puts and call options to garner small gains that accrued rapidly. Using the prestige of his position to gain access to an elite clientele, he promised them moderate yet consistent gains (10%) via a strategy too complex for outsiders to understand. This extended the duration of the Ponzi scheme over a much longer period than most until its collapse in December 2008. It is possible that Madoff executed the largest financial fraud in the world’s history.

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As with the original Ponzi scheme, there were warning signs. Analysts attempting to recreate Madoff’s gains by executing similar trades on historical data found it impossible. During a down turn Madoff reported increased gains although overall, the stock’s performance was down by more than a third. Madoff’s accounting practices were questionable and several fund managers advised clients not to invest with him. Despite all these red flags, wealthy investors continued to provide Madoff with millions. Madoff himself estimates the losses to be about $50 billion.

Easy Money at a Price

The thrill of guaranteed money can lure even the most seasoned investors. If it’s too good to be true, it is. Performing a financial analysis of a fund prior to investing large amounts should always be considered, and if it doesn’t seem right, protect yourself and your money. One never knows where the next Ponzi or Madoff is lurking. We’ll discuss more about how to avoid and protect yourself against Ponzi schemes in the 2nd part of this two part series.

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[tags] Italian, IRC, Spain, Securities Exchange Company, Charles Ponzi, Bernard Madoff, financial analysis, fund [/tags]