"There's something real important I wanna talk to you about. It is an investment opportunity, it's really exciting, and I wanna get you in on the ground floor with me. And it’s not a pyramid scheme. A lot of people thinks it is a pyramid scheme. But it's not. It's almost guaranteed you can double your money —maybe even triple it in the first year alone.”
So says earnest-but-dimwitted Randall Hertzel to his future father-in-law, Warren Schmidt (played by Jack Nicholson), in the 2002 film "About Schmidt." Of course, it is indeed a pyramid scheme, and as usual, the victims don't recognize it until their money is gone.
Finance guru Bernard Madoff has allegedly admitted to the largest investment fraud in history, possibly making off with $50 billion. While his Wall Street wizardry seemed like so much arcane money-making magic over the past decade, it boils down to an old pyramid swindle called the Ponzi scheme.
The original Ponzi
It seems that Madoff followed in the footsteps of Charles Ponzi, the master of the scheme. Ponzi, an Italian immigrant living in Boston, found he could make a small profit exploiting the difference in international currency exchange rates using postal reply coupons. Using that as a premise for an investment business, he started his own company and issued promissory notes for as little as $10, payable in 90 days with 50 percent interest.
The public took notice of this self-assured self promoter. On Jan. 1, 1920, 18 people had invested. When he repaid those investors as promised, news of his money-making ability spread like wildfire by word of mouth. By August 1920, more than 30,000 people held notes of $15 million in his company. He became a hero to the working class as his fame spread and his fortunes rose. Police turned a blind eye to any questions about how exactly the business worked, and many police officers themselves invested in Ponzi.
Finally an intrepid editor at the Boston Post began questioning Ponzi's spectacular profits. Experts said it was unlikely that Ponzi could make such high profits from international reply coupons; thousands of dollars, perhaps. But millions? Impossible. Ponzi, ever calm and smiling, reassured the public that the experts were wrong, and he'd forgotten more about investing than his critics ever knew. ]. But it was the beginning of the end. Ponzi had been paying early investor's high returns, not with profits made from his brilliant investments but instead from money given to him by later investors.
Investors demanded their money back, but few got it. Homes and fortunes were lost, pensions evaporated. Most of the money went to Ponzi's lavish lifestyle, but some of it had gone to the early investors. Ponzi was jailed several times and eventually died destitute in a hospital in Rio de Janeiro, Brazil, in 1949. While Ponzi didn’t invent the scam, he perfected it and was its most successful practitioner; his name and crime are immortalized in the dictionary.
Bernard Madoff was arrested last Thursday for his own Ponzi scheme, though on a much larger scale. Like Ponzi, he is accused of reporting fabricated profits and paying off earlier investments with cash raised from others. Madoff has reportedly admitted his crime, after draining perhaps $50 billion from hundreds of investors including HSBC, the Royal Bank of Scotland, and Steven Spielberg's charity the Wunderkinder Foundation.
The Ponzi scheme, like Madoff's or any pyramid scheme, cannot go on forever. The number of new investors that must be found to keep the earlier investors paid off increases exponentially. When you're robbing Peter to pay Paul, Peter still needs to be paid, and if Paul is happy with his return and re-invests, then you need to rob perhaps a few Patricks to pay Peter and Paul.
Just as Ponzi's scheme finally crumbled, Madoff's scam couldn't continue.
With both Ponzi and Madoff, there were red flags that something wasn't right. The Securities and Exchange Commission received a tip from whistleblowers back in 1999 that Madoff was running a scam, but nothing was done. As in Ponzi's time, no one wants to look too closely at the goose that's laying the golden eggs — until the jig is up, the goose is cooked, and the investors' nest eggs are gone.
If the charges are proven true, Madoff may be the 21st century’s Ponzi, and the phrase "Ponzi scheme" may be replaced by "Madoff scheme" in the next generation of dictionaries.
Benjamin Radford is managing editor of the Skeptical Inquirer science magazine. His books, films, and other projects can be found on his website. His Bad Science column appears regularly on LiveScience.