A Ponzi Scheme for the Rest
of Us
By
At this point there are probably very few people out there who haven’t heard the term “Ponzi” and the name Madoff. However, I’m not convinced that the average person has made the connection between the Madoff media madness and their own pocketbooks.
“How could anyone be so stupid!” is a comment I often hear. “It’s about time the greedy Wall Street types got theirs,” another common comment but it’s still focusing on the other guy getting caught up in a financial scam. The reaction is understandable as the respect and trustworthiness status of the financial advisor seems to have dropped to the range of lawyers and local TV news reporters (the ones that ask the woman in tears who just lost a relative in an automobile accident: “Can you tell us what you’re feeling right now?”).
For those who are still not quite sure what a “Ponzi” scheme is, here’s a quick refresher. When you give someone your money to invest for you (this could be a bank, mutual fund, investment company) you are paid interest or dividends based on the earnings that are generated by the money you invested. Rather than the $1,000,000 and more that Bernard Madoff was dealing with, let’s use $1,000 for our example and keep it simple. A 10% annual return will give you annual earnings of $100.
When everyone managing money is able to generate a 10% return (in a really good market) the only way to truly make your firm stand out is to demonstrate that your investment strategy is better than everyone else so you advertise that you can earn 12% for investors ($120 instead of the $100). However, since you really aren’t any better than everyone else, and may be actually worse, you decide to make up the $20 you promised to your investors in another way.
Since the manager of the investment company is really better at selling than investing (lets say he now has five customers that have given him $1,000 each) he doesn’t invest all of that new $4,000 but uses part of it, in this case $100, and gives each of his customers that extra $20 to confirm the 12% earnings he promised. Having started on this path there is now no way out.
Each year he targets and delivers on that 12% return, even when everyone else seems only to be able to earn 8%. He is now an investment genius and his own customers are his best sales staff. Everyone now wants that steady 12% return.
The problem is that each year he needs more and more new investors to pay that extra $20 to $40 per account (actually he needs a lot more since some of the accounts actually have no principal left, since it has all been used to pay the non-existent earnings he has been crediting to customers’ accounts). As long as the economy is chugging along everything runs smoothly, after all the stock market is a sure thing – that’s where we’re supposed to put all our Social Security and IRA retirement investments – well, not so fast. The first major downturn and everything collapses. No new money coming in and people wanting to take money out to cover losses elsewhere only to find out the investment company has no cash left.
As a side note, the name Ponzi Scheme
comes from one Charles Ponzi whose
Why would somebody do this you might ask? I recently came across a quote from The Confessions of St. Augustine that seems to fit the time and the situation, even though it was written in the 4th century.
“For what thief will abide a thief? not even a rich thief, one stealing through want. Yet I lusted to thieve, and did it, compelled by no hunger, nor poverty, but through a cloyedness of welldoing, and a pamperedness of iniquity. For I stole that, of which I had enough, and much better. Nor cared I to enjoy what I stole, but joyed in the theft and sin itself.”
Ponzi schemes are not new to the modern era but variations have existed down through history. Ponzi just got caught at the dawn of mass communications.
Variations of Ponzism are all around us. A good case could be made for how the FICO credit scoring system is manipulated. When one pays off a credit card balance, principal and interest, by means of opening a new credit card account with a larger credit line, thereby using the money from the new account to make it appear the old account has been satisfied, is not Ponzi smiling somewhere?
Your credit score goes up because your records now reflect that you have completely satisfied a credit account and have a new account with a larger credit line, thereby giving your account more credit capacity. This enables you to take out a second mortgage at little interest (for the first year or so) and instead of paying off the credit card debt, you go out and buy that new car, since you’ve managed to fool the credit scoring system, is it really all that different?
Somewhere out there is