Madoff's Ponzi Scheme

We all have heard of Bernard Madoff and his recent massive fraud scheme. He was the former non executive chairman of NASDAQ stock exchange. His massive fraud scheme was operating a Ponzi scheme which was the largest investor fraud committed by any single individual. Now before I go on to explain how Madoff duped so many people with his Ponzi scheme, I would like to elaborate more on the Ponzi scheme.

Ponzi scheme was named after Charles Ponzi, an immigrant to the Unites States. Charles Ponzi made profits on postal reply coupons. This was considered to be a major swindle of money in 1920’s. Charles Ponzi after his arrival in the United States was seeking for jobs and various other types of employment. One day he found a weakness in the International reply coupon system and also a way to earn profit. The use of Postal reply coupons is to allow somebody in one country to send it to a correspondent in another country, who could then use it to pay the postage of a reply. If the costs of postage in these two countries were different, one could use it to their advantage. After the World War I, the cost of postage in Italy expressed in US dollars decreased so the postal coupons can be bought at a lower price in Italy and sold at a higher price in the United States. This kind of business where you buy an asset from a market at a low price and selling it in another market at a high price is not illegal.

Charles Ponzi decided to take advantage of weakness in the system and asked many of his relatives in Italy to buy the IRC and send it to him. He had to face many rules and regulations but undaunted he went to many of his friends and ask them to invest in his scheme explaining them that due to the high value of IRC’s, the returns would be great and that he would double their investment in 90 days. Some people invested and were paid off nicely initially. As words spread, he had more people investing and he started his own company “Securities Exchange Company” and people started investing more on his company and he soon made profits. People started investing more. As long as money was flowing in, the existing investors were being paid off with new money. This new money was the only way to pay the existing investors as Ponzi made no effort to generate legitimate profits. He started living luxuriously.

As Charles Ponzi began to make huge profits, there were suspicions in the minds of various financial analysts. It was observed that even though Ponzi was offering great returns, he never invested with his company. An investigation revealed that, the securities exchange company to cover their investments should have around 160 million postal coupons in circulation but in reality only 27,000 were in circulation. People became more suspicious and demanded their money back but Ponzi was deep in debt and could not pay their money and was sent to prison.

My uncle was a victim to a Ponzi scheme in India. My uncle was investing his money with an individual who was doing remarkably well with his new investment strategy. He did pay high returns and allowed people to withdraw money whenever they wanted to. Everyone including my uncle started investing more with him. After a couple of years, the guy vanished into thin air. His strategy all along was paying off the existing investors with the new money and he did not invest in anything useful. All the investors lost a good deal of money. This was a typical Ponzi scheme.

Now Madoff’s scheme is probably the largest Ponzi scheme exposed and he has international investors from Europe, Middle East, China and mostly the United States. The facts which make me wonder is how this scheme went on for over 2 decades without being exposed sooner. How so many sophisticated people could have fallen for this scheme which had no clear indication on where the funds were coming from even during the bad times? The answer for this question is that these people had obviously thought the previous investors have investigated this scheme and must have thought since many people are investing in the scheme, it should be legal. Also, Madoff made the scheme appear as if it is a hedge fund shop. Now one also has to consider Madoff’s reputation. He was the former NASDAQ president and very well known in the financial community. He has advised the government in the past on many economical and financial issues. He dint allow everyone to invest in his scheme, he rejected some people from investing, so people who were actually allowed to invest thought they were privileged to invest with him.

Due to the economic slowdown, people started withdrawing money and Madoff could not pay off his clients. Once he was exposed the victim’s number grew and everyone is shell shocked. Some of his top notch clients were Steven SpielbergSteven Spielberg, Carl Shapiro, many wealthy retired people and many people from the Jewish community. The court had asked Madoff to forfeit $170 billion. We have to wait and watch what happens next.