Ponzi schemers

In 2008, Bernie Madoff acquired the distinction of having run the largest Ponzi scheme of all time. In a Ponzi scheme, investors are promised outsized returns to attract money into a pool. Early investors are paid their returns from the contributions of the latecomers, because there are no underlying investment assets earning anything.

Madoff’s genius, and one reason his scam lasted so long, is that the returns he promised were not remarkably high. Rather, they were remarkably steady, and thus seemed safe to prospective investors. Madoff-generated losses are estimated from $21 billion to $50 billion. Why the wide range? In part because the profits taken out by the early investors are still being “clawed back,” to put all the duped investors on an equal footing. Also, losses of phantom income from the fictitious account statements are not quite the same as losses of contributions to principal.

As bad as Madoff “made” the year 2008, by some measures, 2009 was even worse for investors. In 2008, 40 Ponzi schemes collapsed, while in 2009, more than 150 fell apart, according to an analysis by the Associated Press. More than $16.5 billion evaporated in 2009 from such frauds.

The surge in failing Ponzi schemes may be due in part to heightened awareness and investigations. The FBI boosted the number of agents working on securities fraud from 429 to 651 in 2009. They opened 2,100 securities fraud investigations in 2009, up 20% from the prior year. The SEC now dedicates 21% of its enforcement workload to Ponzi schemes, compared to just 9% as recently as 2005. The result has been an 82% jump in the number of restraining orders for securities fraud cases.

The recession also contributed to the failure of Ponzi schemes. In down times, it becomes harder to attract new investors, and early investors may increase their demand for withdrawals, putting the scam into a vice. Warren Buffett observed that, when the tide goes out, we get to see who has been swimming naked. Those who run Ponzi schemes are the most naked of all.

However, the first line of defense needs to be educated and skeptical investors. As the attempted bombing of an airliner at Christmas reminds us, the government can’t provide the entire solution for any problem. Investors need to be aggressive in investigating those to whom they plan to entrust their money. For example:

• Don’t take promises of extraordinary investment returns at face value. If the promoters knew an easy way to make a fortune, why would they share the secret?

• Don’t be hustled by high-pressure tactics. The investment world is not going to run out of good opportunities in the next 20 minutes.

• Beware of those who claim that they’re doing you a favor because you’re a member of a certain organization, church or professional group.