How to not get buried by pyramid schemes
Charles Ponzi, the father of pyramid schemes
By Garett Sloane
If your money manager operates out of a secret office you may be in a Ponzi scheme.
Or if he uses a two-bit accountant to audit his $50 billion books you may be in a Ponzi scheme.
Even if hes a respectable member of the Wall Street elite you may be in a Ponzi scheme.
The $50 billion fall of Bernie Madoff is the most spectacular of pyramid-scheme collapses and perfectly illustrates how these classic frauds long have been perpetrated. The most famous case began in 1919, when Charles Ponzi first duped investors with the promise of doubling their money in 90 days.If its too good to be true, then it is, said Michael Goldberg, a Florida-based attorney and Ponzi- scheme expert
Thats rule No. 1 to prevent fraud: Start to ask questions when an investment seems too perfect, as Madoffs alleged scam did. Madoff offered investors about 12 percent a year return on their money a not-so outlandish rate but when you couple that with the consistency of his performance the scheme becomes apparent.
Madoff reported that his portfolio only suffered five months of losses out of 156 months.
What you should get suspect at, is how steady it was, Goldberg said. Nothing is that steady.
Madoffs alleged scam operated like the traditional pyramid scheme, which pays investors with money from other investors.
As long as you have a steady flow of money you can keep the plates spinning in the air, said Charles Ross, head of a Manhattan law firm with extensive experience handling fraud cases.
And when the money dries up and during these economically strapped times its a desert out there the pyramid collapses.
Usually the flow of money into pyramids comes from elderly people on the verge of retirement.
Goldberg called Florida the ground zero of Ponzi schemes. In the Madoff case, however, the victims werent naÃ¯ve retirement community types, but some of the most sophisticated individuals and institutions from Steven Spielberg to HSBC Bank.
These supposedly savvy customers could have picked up on any of the clear signs, but as with any Ponzi scheme, the success depends on the greed of investors.
Its human nature, said Andrew Lo, an MIT finance professor and expert in the psychology of pyramid schemes. Its fear and greed.
The economic exuberance that led to the financial crisis we are seeing today is the same that allowed a player like Madoff to thrive, Lo said. In good times smart people dont ask questions when they should, he said.
Here are some signs that experts say expose a scheme for what it is after the too good to be true test, of course:
The operator uses suspect financial partners from banks to accountants. In Madoffs case, his accountant operated out of a tiny storefront in Rockland County, when a $50 billion fund should require the top accounting firms in the world.
Secrecy is the hallmark of Ponzi schemes. Madoff ran a shadow office on the 17th floor of a midtown office building, and he also reportedly kept investors in the dark about how he made such steady returns.
If the investment minimum to join suddenly drops, which reportedly happened with Madoff.
If there is a discrepancy in the investment strategy. Madoff appears to have been investing in different types of securities than he said he was, Lo said.