What is a Ponzi scheme?
A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned.Ponzi scheme usually in order to entice new investors, provide short-term returns that are either abnormally high or unusually consistent. The system is destined to collapse because the earnings, if any, are less than the payments.

The scheme is named after Charles Ponzi who was born in Lugo, Italy, in 1882 .Ponzi developed a number of money-making operations based on defrauding innocent individuals. He operated a vast pyramid scheme where each group of new investors merely paid off the former group.
His basic premise was to purchase standardised IRCs in international currency,excahange them for U.S. stamps,then resell the local stamps for a value higher that what the IRCs had cost him abroad.It was essentially foreign exchange arbitrage.But the catch here was that only $56000 worth of IRCs had been printed in 1919 though Ponzi had $15 million of investment money.
Dubbed as “robbing Peter to pay Paul” Ponzi Schemes still run today. Bernie Madoff is one of the more modern Ponzi Schemers who promised investors high returns and was eventually caught when new investor money ran dry. A fund supposedly based on “put-call option arbitrage” turned out to be a $65-billion Ponzi scheme with its investors including some respectable banks and hedge funds..
The most important and talked-about example in this context is the Sub prime crisis. Sub-prime mortgages, mortgages worth 100% of the value of a property, became a hot market in finance in 2000. Mortgage lenders competed to loan money to the riskiest borrowers, which was deemed a safe and profitable act, due to the securitization of the loans. As more individuals bought houses with sub-prime mortgages, the housing market boomed, which encouraged more sub-prime lending.
The housing bubble, however, had the same architecture of a Ponzi scheme, and was doomed to collapse. Individuals inevitably began to default on their loans, and the value of real estate plummeted, which resulted in enormous losses for global financial institutions.
‘Eliot Spitzer,’ the former governor and attorney-general of New York has called the Federal Reserve — the quasi-autonomous body that controls the US’s money supply — a “Ponzi scheme” that created “bubble after bubble” in the US economy.
Ponzi schemes are not new for India’s financial sector. The country’s first mutual fund scheme — US64 managed by UTI — which ran into a crisis in mid-2000 was seen as being operated like a Ponzi scheme. So is the employees pension scheme.
Take another example of Satyam. To start with, it was supposed to be a productive company that actually converted investor money into valuable goods and services. In years of faltering profits too,Satyam gave returns to old investors from the funds of new investors,hence mixing productive activity with Ponzi.
How can one forget the case of self-proclaimed ‘GODMAN’ of Gujarat,Ashok Jadeja,who swindled hundreds of people by promising to triple their money. The modus operandi was relatively simple. He would take Rs. 200 from people and assure them of Rs. 600 in three days.
In the Indian context ,some of the other famous Ponzi schemes were Anubhav Plantations scam, chit fund scams, Ashok Sheragar schemes in Mumbai , non-banking finance company scams, etc. The intention of these schemes was to defraud investors, i.e. take their money and run.
Inspite of knowing the flaws and moral hazards of Ponzi scheme, the irony is ”Just as there is no easily detectable time when a heavy drinker becomes an alcoholic, the start of corporate budgetary crime is difficult to pin down. The investor is so enticed by the
attractiveness of the scheme ,that cannot prevent himself from participating in it. Only when time passes by, does he realise that he has been duped and robbed of his most precious asset-his money.
So,how does one save himself from this trap?
The first step is to ask a simple question-is this so good that it’s probably too good to be true? And if it seems as if it is, there well may be something wrong.
Number one, they promise very high returns and very regular returns ? sometimes 25 percent over 90 days and 40 percent over a year ? and they keep delivering those returns in good times and bad, or at least they tell you you’ve earned your money on paper and almost no investment delivers so. Number two, they dont generally have a proven track record ,a name that’s known, and especially, books that are open to the proper regulatory authorities to look to see if that assets are really there, that they’re really being traded and that the returns that are being reported are really happening.Many of these types of schemes go by the name of ‘Doublers’, ‘Triplers’, “Bubbles”, “Cyclers”, “Gifting” and other variants,however,this does not suggest that all schemes using the name’doubler’ are ponzi schemes.
When a Ponzi scheme collapses, everyone who invested last loses their investment with a new program.Even the most avidly promoted Ponzi will collapse when the number of new investors required to sustain the program becomes unachievable.
So,If you are tempted to speculate on these programs, please remember that the money you receive comes ultimately from the people that lose their investment. If you involve yourself with a Ponzi scheme with full knowledge of how they work, you are giving your approval to a fraudulent operation that is tantamount to theft.

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This entry was posted on Monday, October 26th, 2009 at 5:58 am and is filed under Mukesh Dedhia's published articles. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.