Charles Ponzi's Scheme

In the 1920s, whenever a generous person wanted to send a piece of mail overseas, he or she would
probably also buy an international reply coupon. This was handy for the recipient because it was a voucher
that paid for the postage required to reply back to the sender. Because this was a relatively common
system at the time, no one questioned Charles Ponzi (an Italian immigrant to the United States) when he
found an intriguing investment opportunity in the process.

Ponzi's investment idea was plausible: He could buy reply coupons in a different country where they were
cheaper, and then sell them in the United States where they were worth more. The difference was profit
that he could share with his investors. He sucked his investors in by promising 50 percent returns in 45 to
90 days.

However, when he tried to carry through on his business idea, it didn't work out as well in practice as it
did in theory. The mechanics of conducting business overseas, transporting the coupons and exchanging
them for cash caused delays and extra costs that prevented him from paying investors as quickly as he'd
promised. Nevertheless, he kept the bad news to himself. Every day, new, excited investors who heard
about the idea wanted in and handed over their savings. Ponzi decided to take the money, but not run.
He kept up the ruse by paying off his initial investors with some of the new money that was pouring in
and pocketed some for himself. Because his early investors were making money, no one was complaining.

He wasn't clever enough, though. The whole thing fell apart after a few months of Ponzi living lavishly on
the millions he had made. People started wondering how he was buying and selling what must've been
160 million reply coupons out of the 27,000 that existed in the world. Eventually, authorities busted him.

Charles Ponzi wasn't the first to implement such a scam. However, he stood out from the rest of the petty
crooks because of the amount of money he raked in -- which totaled millions of dollars -- and number of
people he swindled.

Ponzi scheme Basics

People often compare a Ponzi scheme to building a house of cards. It must collapse eventually.

Though it landed him in jail, Charles Ponzi's infamous scam spawned many imitators. The get-rich-quick
scheme has proved too alluring for other scoundrels to pass up. However, these imitators need not use
the front of international reply coupons to make it work.

The basic framework of a Ponzi scheme can be applied and reapplied in countless contexts. The scheme
revolves around the process of paying old investors with the money you get from new investors. The
central method remains the same. All one has to do is hook a few investors who are willing to get in early
on a once-in-a-lifetime business venture. The "investing strategies" used are vague and/or secretive,
which schemers claim is to protect their business.

After the schemer has convinced a handful of investors to fork over money, those funds can bankroll a
nice car -- or, if the schemer is truly sneaky, he or she can use it to rent office space and buy some fancy
furniture. These props will help con the next round of investors. Now, he or she is ready to find more
investors. This time, the schemer takes a slice off the top for himself or herself and uses the rest to pay
off the first rung of investors with some initial returns.

Eventually, the second rung of investors will need its payout. This is a simple matter of wash, rinse and
repeat: The money from a newly recruited third rung of investors can pay off the second rung and deliver
more returns to the first rung.

But as the cycle goes on, it gets more complicated. Earlier rungs of investors will get suspicious if they
don't continue to see returns. New investors will have to be paid back their initial investment, and the
schemer will have to appease them with regular returns. This means that new investors will have to be
added to the Ponzi scheme continuously in order to pay all the previous rungs. The schemer is under an
enormous amount of pressure to keep adding investors, and one person can only do so much. (This is why
the most successful schemes typically involve accomplices, but this merely delays the inevitable.) The
scheme will eventually become unsustainable. The upside-down house of cards the schemer has built will
finally collapse.

So, to summarize why Ponzi schemes aren't usually very sustainable and the setup eventually falls apart
are when:

(1) The operator takes the remaining investment money and runs.

(2) New investors become harder to find, meaning the flow of cash dies out.

(3) Too many current investors begin to pull out and request their returns.

Bernard Madoff’s scandal:

A well-respected financier, Madoff convinced thousands of investors to hand over their savings, falsely
promising consistent profits in return. He was caught in December 2008 and charged with 11 counts of
fraud, money laundering, perjury, and theft.

Here's how Madoff conned his investors out of $65 billion and went undetected for decades:

Madoff used a so-called Ponzi scheme, which lures investors in by guaranteeing unusually high returns.
Madoff set up his portfolios to look like he was matching the returns of the S&P 500. This strategy
prevented him from needing to pay too much to existing investors, but it still made his purported holdings
appeal to new targets. And he remained under the radar by doing everything he could to keep his scheme
low key. He targeted specific, elite groups of investors, keeping his victims close and the SEC off his back.
He also stayed off the grid by keeping his paperwork up to date and consistent. While most other Ponzi
schemes operate by giving out large returns and then collapsing, Madoff was able to tread water with his
smaller returns and keep his scam going for years.

Madoff did very little to arouse suspicion among his victims. As investors, they believed they could
withdraw their money almost immediately, so they had no reason to think anything was wrong. Some
analysts, however, felt that something was off when they tried to replicate his performance. Tracking the
funds, one of them argued to the SEC that his firm couldn’t possibly have boasted the returns Madoff
claimed. The SEC ignored these claims, even though Bernard Madoff Securities had already been
investigated.

In Madoff's case, things began to deteriorate after clients requested a total of $7 billion back in returns.
Unfortunately for Madoff, he only had $200 million to $300 million left to give.

Another reason Madoff managed to fly under the radar for so long (despite multiple reports to the SEC
about suspicions of a Ponzi scheme), is because Madoff was a well-versed and active member of the
financial industry. He started his own market maker firm in 1960 and helped launch the Nasdaq stock
market. He sat on the board of National Association of Securities Dealers and advised the Securities and
Exchange Commission on trading securities. It was easy to believe this 70-year-old industry veteran knew
exactly what he was doing.

Madoff really only made off with $20 billion, even though on paper he cheated clients out of $65 billion.
That's hardly any consolation for his thousands of investors.

The 150-year sentence, more symbolic than literal, was followed by other convictions related to Madoff's
scheme. In March 2014, five of Madoff's employees were found guilty for their part in the Ponzi scheme.
Most recently, Madoff's accountant and lawyer is also facing up to 30 years in prison for his role.

There are several other notable Ponzi schemes in history, including Allen Stanford's which stole $8 billion
and Tom Petters' that cheated investors out of $3.7 billion. But as far as scale goes, Madoff wins by a
landslide.