What is a Ponzi Scheme?

Online Stock Trading - What is a Ponzi Scheme?

What is a Ponzi Scheme? And what is the difference between a Ponzi Scheme and a Pyramid scheme?

According to Bernie Madoff his $50 billion financial empire was nothing more than a Ponzi scheme. Similarly the investments made by Allen Stanford were also, according to the SEC, nothing more than a Ponzi scheme, which required 'reverse engineering' to succeed.
Stanford and Davis reverse-engineered Stanford International Bank’s statements each month so that the returns achieved would be in line with a pre-determined target.
“SIB’s financial statements, which were approved and signed by Stanford and Davis, bore no relationship to the actual performance of the bank’s investment portfolio,” the SEC said.

So what is a Ponzi scheme ?
Basically, the fraudster takes money from 'clients' aka 'suckers' with the promise that they will make large returns on their 'investment', but instead of investing the money the person running the Ponzi scheme uses the money to pay investors who are already 'invested' in the scheme. So every now and then the scheme needs to find new investors to pay previous investors, no investing is actually done or if it is then it certainly is not enough to pay the high returns the Ponzi scheme is paying out, the early investors are paid with money obtained from new investors, and so the scheme goes on, for ever if possible, with the constant need to find new investors.

The only problem comes about when investors start asking for their money back. If only a few investors require their money then the scheme can probably absorb it, but if a lot of investors start asking for their money back at the same time then the Ponzi scheme starts running into trouble and eventually collapses. This is the moment when 'investors' realize that they were in fact not investors at all but 'suckers'.

The person running the Ponzi scheme of course hopes this will never happen, at least not while he is still alive. The recent problems with Madoff and Stanford's Ponzi schemes is that the stock market has hit a once in a lifetime pile of sticky stuff.
Everybody is losing money, even legendary investor Warren Buffett aka the Oracle of Omaha has been losing money and he is a very smart cookie and in no way involved with anything nefarious, so when people of the caliber of Warren Buffett see their shares falling by 44% then you know something serious is happening.

When the stock markets start tumbling of course people find they need cash and so go to their investment managers and say give me some cash, in the case of a Ponzi scheme however, there is not enough cash to go around, as the terrible stock market conditions mean that no new investors can be found.

This is what happened to Bernie Madoff who announced that his $50 billion fund was all based on hot air and there was not enough money for investors, there was barely enough for himself. He is still living in his $7 million dollar penthouse suite in New York by they way and recently tried to send a few million dollars worth of goodies through the post for safe keeping to some buddies, but some of his 'investors' have lost every penny they had and have had to go back to work - one at age 90!

Allen Stanford appears to be slightly different as he was caught by an FBI investigation. But his scheme has also been classified as a Ponzi scheme.

Why are they called 'Ponzi' schemes. Quite simply because they became famous thanks to a certain Charles Ponzi, who ran such a scheme back in the 1920s supposedly buying and selling 'international mail coupons' and making money on the difference in exchange rates. At its height during a 3-hour period in 1921, he took in $1 million ( a million dollars was worth something back in those days) but when his scheme finally went belly up it was discovered he had only ever bought $30 worth of mail coupons. Charles Ponzi was not the first to run a Ponzi scheme but his name lives on.

A Ponzi scheme is not a pyramid scheme. In a Ponzi scheme money is obtained from new investors and passed on to old investors. In a pyramid scheme new investors do actually buy something from the old investors, which they then attempt to sell to more new investors. A further and important difference is that a Ponzi scheme tends to be run by one or two people at the top who pretend to be an investment fund but are in fact a Ponzi scheme, they lie to their clients, saying that they are an investment fund when in fact they are a Ponzi scheme. They lie because if they told the truth then nobody would invest in their scheme.
A pyramid scheme relies upon a network of willing people who are generally not being lied to and who know that they are in a pyramid scheme.
This raises the question of whether the whole of the financial world is a Ponzi scheme. Have the banks been making money by using money from new clients to pay old investors? There certainly are similarities, and the way nearly every major bank in the world has collapsed seems to suggest that maybe it all was just a giant Ponzi scheme. Somebody decided to stop investing and asked for his money back and that sent the whole system into freefall, an interesting thought.

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