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What is a Ponzi scheme anyway?

Myers' Musings

Posted: September 13, 2008 9:41 p.m.
Updated: November 15, 2008 5:00 a.m.
 

So news broke hot and heavy at last week's end on all local media concerning an alleged financial fraud involving Celia Gallardo and her various Gold Feather companies. I swear, only coincidence led me to write a column on Sept. 7 regarding Vital Express.

While the investigation unfolds, several questions arise. Once again the alleged perpetrator presents herself in a youthful and attractive manner, with many local kudos and awards passed out by politicos and nonprofit organizations.

I guess one needs to do business solely with the dumpy, grumpy and middle-aged. But in the initial reports people used the term "Ponzi" scheme. This begs a more basic question: What constitutes a Ponzi scheme?

The scheme carries the name of Charles Ponzi, an Italian immigrant who originally perpetrated the fraud. The scheme simply involves promising extremely high rates of return and then paying those from the frenzied investments of subsequent investors.

The actual method of the Ponzi varies, but two things always occur in common: First, the Ponzi artist operates NO substantive business, certainly none that could generate the returns promised. Second, and most tragically, the Ponzi artist must rely for success on the extreme naivete of the investors.

Unfortunately, right now constitutes probably one of the most fertile times for Ponzi artists, especially when they prey on the elderly with nest eggs invested conservatively in retirement plans or large amounts of home equity.

Legitimate and wise advisers place these folks in conservative, nonleveraged fixed income investments that at best might yield five to six percent a year in investment return.

Now the Ponzi promoter might promise investment returns of 10 percent per month, or 24 times the return of a safe investment. This requires the threshold of credulity and lack of knowledge.

A savvy investor knows he or she can earn these types of returns only with high risk (the potential of losing the entire value of their investment) or taking on large amounts of debt or leverage (also risky).

When questioned about the exorbitant returns, the promoter might say that wealthy people hide these opportunities from the more modest, and he is in fact providing a Robin Hood-type service by letting them in on the action.

So our Ponzi promoter raises $100,000 from five investors, promising 10 percent per month in returns for a total of $500,000. At the end of 30 days, the promoter dutifully cuts checks for $50,000 for the first month's return and is left with $450,000 (remember, no actual investment or business exists).

This could persist for nine more months as the promoter exhausts the investor funds, and the investors would realize they only received their money back, only losing out on the return.

But a Ponzi scheme does not remain static. The first five investors excitedly talk up to their friends the investment that returns twice as much in one month as their old staid investments.

Even at the rate of just five new investors per month, and paying out the 10 percent return per month, at the end of six months the promoter possesses just under $2 million in investor cash.

Now they make the next move. They convince the existing investors they need to roll over their monthly investment returns to further increase their returns.
Now, with five new investors a month and no cash payouts, in six months the promoter possesses dominion over slightly less than $5 million. Comfortable with the stability of the cash balance and with new investors still coming in, the promoter begins to divert large amounts of the cash to his or her personal use.

This actually helps with the recruitment of new investors because people flock to those showing material success.
What causes the Ponzi scheme to collapse? Two things, and if they occur concurrently, the faster the demise.
First, the pool of new investors drys up. Second, existing investors request their principle.

Unfortunately for the criminal, for the Ponzi schemes targeting seniors, the second happens more frequently. Seniors die and then heirs with professional executors want to liquidate the investment. With no cash available to pay returns, investors become suspicious and requests for payouts spread like wildfire, collapsing the scheme.

Now all Ponzi criminals of late share one thing in common: They possessed some harebrained investment scheme that would eventually come to fruition and pay off all the investors in full.

Before their sentencing they will protest that "with a bit more time" they could make all their promises good.

So in the end, the criminal acts with the same naivete of their investors.

Tim Myers is executive vice president and chief financial officer of Landscape Development Inc. in Valencia. His column represents his own views, not necessarily those of The Signal.

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