What exactly is a Ponzi Scheme and how is it detrimental?

Question

Say if Madoff were never caught...what would be the ultimate fate of his company?

Answer 1

A Ponzi scheme is one where the "investment" of new members is used to pay out the profits to existing members.



As a result, the scheme can work only for as long as a continually growing stream of new money is brought in. Since the growth has to be exponential to keep paying profits to more and more members, eventually you can't keep attracting new members, so you can't pay the profits you have promised to existing members, and when people try to take their money out they can't, because it's all been paid out to others already. THe whole scheme, when the end comes, generally collapses very very fast indeed.



Richard

Answer 2

A Ponzi scheme is a technique whereby the returns achieved by investors are paid by the principal of their own investments or investments made by later investors, rather than the actual results of the investments. An example: John says that he has a great investment opportunity that will earn 5% per month -- 60% per year. Impossible. However, A, B and C each invest $100. After one month, John pays each of them $5 -- a total of $15. This money doesn't come from John's investment opportunity; it comes from the $300 they invested. A, B and C are happy and tell their friends, D, E and F, who also invest $100 each. The next month, the same thing happens --- A, B, C, D, E and F each receives $5 return on their investments. All of this comes from the principal of the money invested. Now, $600 has been invested and $45 has been paid out, leaving $555. However, at the rate of $30 per month, the money will run out in less than two years. Then there will be no return, no money and no investment. The scheme can only continue for any period of time if John keeps finding new investors to put up money to pay the promised returns to the existing investors.



Ultimately, what happens is that the whole thing collapses. The scheme keeps working so long as new investors can be found to put up the money to pay the later investors. Sooner or later, the promoter runs out of new investors and there is insufficient money to pay the promised return. At that point, people start asking questions, and they discover that John doesn't have any real investment and has just been running a pyramid scheme. John goes to prison, and the later investors sue John and the earlier investors to get their money back. (Remember that the earliest investors probably made a profit.)



Why do people do this? Two reasons. First, the true crooks run the pyramid scheme just long enough to obtain a substantial amount of cash. Then they take off for parts unknown with the money. Second, and most commonly, investment managers have overpromised and made unsuccessful investments. They try to hide their failure by paying nonexistent returns. They hope that their investments will be successful in the future and they will be able to cover their deception. This almost never works.

Answer 3

All Ponzi schemes MUST eventually crash.



In simple terms, Ponzi's are chain letters taken to the next level, the pyramid scheme.



You sign up. You get 2 people to sign up, they get 2 people to sign up, etc.

You invest some money, your friends invest some, their friends invest some.

You get paid back - using your friends' money. They get paid - using THEIR friends' money. And so on.



Eventually, there is not enough money to pay the people at the bottom of the pyramid. When that time arrives, the people on the top pull away with everything they have been able to scam from the other poor suckers - and run for the hills. Done right, the person at the VERY top - gets pretty much ALL of the money. Even those in the 2nd and 3rd tiers often lose money because they REinvest funds over and over - and eventually NEVER get anything back and lose all that they invested as well.

Answer 4

A Ponzi scheme is another name for a Pyramid Scheme.



Essentially, the people at the bottom of the pyramid pay those at the top.



For example:



I start the scheme. I'm the top of the pyramid. I recruit 5 people underneath me. They each "invest" $5,000 which means I just got $25,000. Then each of those 5 people recruit 5 "investors" who pay $6,000 to get in. $5,000 goes to the people on the 2nd level, and the other $1,000 goes to me. So now I have $50,000, the people on the 2nd row are currently even, and the newest people are out $6,000.



So then those 25 people recruit 125 more, each paying $8,000 to invest. $6,000 goes to the 3rd row people (so they're now even), $1,000 to the 2nd row people (who each get $5,000) and I get another $125,000 ($1,000 from each person). But the people at the bottom are out $8,000 and there's no money "invested" to pay them off unless more recruits are found.



Now you can see how the people at the top get rich while the people at the bottom go broke.



If Madoff had never been caught, he would have left with a lot of money and the people in the pyramid would have left with little or nothing. There would have been lawsuits against Madoff, but he would have left for some other country to avoid that fate.

Answer 5

Ponzi scams ultimately fail because there is a finite number of investors. Social Security is a Ponzi scam also.



Here is how it works....I will keep it simple. You are promised that if you pay in $1000 today, you will get back $2000 six months from now. So you pay in. A lot of people pay in. Then in six months, he uses the money that was paid in to start paying back the original investors. Let's assume you were one of the first so you get paid first. You now have $2000. You tell your friends and family what a good deal it is. So they pay in $1000. And you might actually put your $2000 back in with the idea that in six months you will have $4000. It keeps going on and on, with money from later investors paying off earlier investors. But it is totally dependent upon more and more investors coming into the system. Now the guy who RUNS the scam knows it is going to fail. So when it hits a peak for investors coming in, he grabs the money and runs.



Social security is the same thing. People pay in with the promise they will get MORE money back when they reach 65. Since the pay in to the reward period is so long, most just do not catch on that it is a scam. Those getting money today are getting money from those who are paying in today. It will only last for as long as the population keeps growing but with the retirement of the boomers and the drop in the birth rate, it is going to collapse. But since it is a federally mandated program, you can not just say it is a scam and quit. So best bet, you make your own plans for retirement that are not dependent upon social security.

Answer 6

A ponzi scheme is when someone gives you money and you tell them to find more investors, when the new investors invest, you give the original investor some of the money from the new investors, and the cycle repeats with each new group of investors finding more guinea pigs and getting a portion of their money.



If Madoff's scheme would have kept growing indefinitely, he would have acquired the world's money. It's detrimental because when the scheme is uncovered, the later investors never get money.

Answer 7

http://en.wikipedia.org/wiki/Ponzi_scheme



Madoff was going to be found out at some point. It might, however, have been after he left the country with all the money he hadn't already stolen.



The thing is that he was not really investing the money. He was pocketing most of it, and keeping enough liquid so that if a couple of people wanted to withdraw, he'd be able to pay them off. But because he reported really good returns, most people would keep reinvesting with him because they thought they were making a lot of money. His victims had no clue that their only profits were completely fictitious and that, in fact, their original investments were gone.



There would have come a day when more people might want to withdraw their money than he could deal with (without breaking into his "own" money.) It would have hit the fan then.



It's unclear why the SEC did not uncover the fraud earlier. http://en.wikipedia.org/wiki/Bernard_Madoff