I have been asked a few things about Bernie Madoff’s ponzi scheme so I thought I would put together a general piece on ponzis. My first job out of university was to work on the investigation of one for seven years, so I have some experience here.

In general, setting up a ponzi scheme is an easy thing to talk about, but it has to be done carefully. There have been lots of them throughout history and there will be more in the future. They are simple to explain and if you want to get rich quick (and then poor even quicker), simple to operate. They can be kept going for as long as more people want to put more money in that take it out.

Briefly, you start and investment scheme where the only actual income is from depositors. If people want “their” money back, you pay them with investor’s money, not from the investments you made, as you have not normally made any.

Creating a Scheme

To explain them is also simple. If you want to create one that will last at least a while, do this:

  1. Open a scheme that has a quasi-plausible business model (Ponzi himself used one involving the trading of US stamps in a form of regulatory arbitrage and, in Albania, it was arms smuggling and laundering money). Make sure it sounds good and that you understand the correct language to use to explain it. If you cannot sell this you will collapse early – or not even get going.
  2. At the start, ensure you have enough surplus money lying around that early withdrawals can be met – this is a necessary cost as these things can take time to get going. Having a good business reputation can help here, but if you have good a good sales patter this is not as necessary.
  3. Keep away from actually investing the money in the actual strategy you said you would. You need to keep the money lying around so that it can be repaid. Taking any risks with it means you could actually lose some. This is the main difference from banking in that actually worrying about the investment strategy takes time away from sales. For this to be a true Ponzi scheme you need to ensure that you are never actually going to make enough money out of any investments you actually make to repay the depositors.  If you wanted to operate a bank you would have to do the hard work of actually investing and that is not the idea here. Keep it in cash and/or on a normal deposit at a real bank.
  4. Offer high, but not stupidly high, returns from that scheme.  Ponzi overdid his, offering a doubling every 90 days. Albania was much the same. Madoff’s steady 10% p.a. was much more sustainable.
  5. Make sure your auditors notice the fees you pay them, not your books. Where possible, take the regulators out for long lunches or to the sorts of entertainment facilities that they could not admit to going to. Most regulators are underpaid, so are happy to be made to feel important.
  6. If you do have staff (they are probably needed as you do not want to do all the work yourself and you need to look successful) try to make sure none of the staff have a full picture of the scheme. If they do, make sure they are good at taking stress and are happy to receive good money. Generally, avoid doing this, though. If they ask questions give them the standard snow job and then move them out. Quickly. If possible, only hire staff you can sack for cause at a moment’s notice.
  7. Keep it exclusive so that people do not ask too many questions in fear that they may be excluded. Again, Ponzi overdid this by taking in money from all and sundry. You need people who are not going to want their “investment” back any time soon. Madoff had this down to a “T”. Politicians are ideal investors as they can then influence any regulators not persuaded by the lunches. If the politicians were business geniuses they would not be politicians.
  8. Once your bona fides are established and you keep paying out, cashflow from investors (AKA suckers) will be higher than the amount you need to pay out under most circumstances.
  9. Keep the people’s confidence (i.e. greed) going by sending out regular statements, always showing a healthy, growing balance.
  10. Hope that the suckers never want it back, or that you die before they do ask for it. Most ponzis fail at this step. The higher the return you offer, the faster you get here.

And that is it. Bernie was particularly good as he offered high, but not stupidly high, returns and he played the exclusivity thing well. As usual, though, he forgot about step 10 – but he did keep it going for a long time.

One thing to note is that, at step one, you may actually intend to make money from the scheme – i.e. you may not start out with the intent of committing the crime of fraud (in the case of Albania other crimes were contemplated, but fraud was not one of them). This is fine, most start out that way. It is easier to salve your conscience if you can claim that you did not mean this to happen when you start.

Before you start lying on the statements to investors, though, you have a choice – start down the road marked “fraud” or give up. That is when you make the choice.

Avoiding Losing Money

Generally, if you are a smart investor you can spot these schemes with a few simple rules.

  1. The fund is offering a high, steady return. This is the major pointer. Steady returns are normally low and high returns are normally not steady. Sometimes you will find one that is – and it doing it genuinely. This is very rare. If you find one let me know. Please.
  2. The auditors are questionable or absent.
  3. The sales patter is very, very good – heavy on personal recommendations but light on detail. If you ask too many questions they back away. “Hey, it’s our scheme. Do you want in or not?”

If you get all three of these (or only two) my advice would be to walk away.

Regulators and Auditors

If you are a regulator or auditor, most people are going to be pretty upset if you close one of these down early – if you are concerned about your career my advice would be to take the lunch and then write an ambiguous memo recommending further oversight or more aggressive audit practices. That way you are not going to be the one that spoils the party (and risks your career to do so) but you can later claim you were a whistleblower and therefore cannot get sacked for lax oversight. In any case you get to have good lunches along the way.

Most regulators or auditors that shut these down early get the politicians that were investing in the scheme upset and this can be a serious CLM. Much better to wait until it collapses and then hit the guilty party with a heavy sentence.

Making Some Money

Read this section only if you are happy doing morally questionable things.

Of course a very smart (but not risk adverse) investor may want to get in on the first floor and ride this one to at least close to the top – if you get out before the burst you can make good returns. You may also be able to sue someone if you get caught and get out too late. Not for your risk adverse investor and don’t be too greedy. Make a good return and get out if the economy starts looking even a little shaky. Ponzis normally take at least a few months of economic downturn to collapse.

This strategy will also allow you to look good at dinner parties – “Phew – I got out a few months before it collapsed“. Of course, a person who is listening who knows what this means will know that you are either one of the suckers or possibly complicit – but not many will. Most will think you were just lucky.

Stay Away

My strong advice, though, is to stay away from this whole thing. Remember, things that look too good to be true probably are. If you want to make money, do the work yourself. Do all those things your parents taught you (and Bernie probably told his kids as well).

If you want to make lots of money you need to work hard and take risks. Deal with it.

Comments Warning

If you want to use comments on this thread to talk about how normal banks are actually ponzis I will summarily delete them and any comments that refer to them I will edit to remove that content. There are other threads here that deal with that issue, which, as I have said, is

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