2009 - The Year of the Ponzi Scheme Collapse

2009 was a bad year for Bernie Madoff, Allen Stanford, and Scott Rothstein. The government targeted all three as perpetrators of massive Ponzi schemes -a form of pyramid fraud that targets investors looking for a fast turnaround on their dollar. Unfortunately, thousands of investors also lost billions in 2009 as the pyramid schemes unraveled.

Ponzi schemes promise abnormally high or abnormally consistent returns that they cannot deliver. Returns do not come from any actual profit. Earlier investors are paid high returns generated from investments of later investors. If left to run indefinitely, the system inevitably collapses under its own weight because it never earns more than it is obligated to pay. It relies on a constant infusion of new investors to pay returns to the older investors.

As the Ponzi scheme collapses, one of four things will usually happen:

1. The fraudster will disappear and take all available investment dollars with him or her.
2. The fraudster will have difficulty paying the promised returns; investors will begin to panic, and the scheme will start to collapse under its own weight as revenue dries up.
3. The scheme is exposed by legal authorities.
4. External market forces cause investors to withdraw their funds, decreasing the revenue stream to the pyramid.

Ponzi schemes are named after Charles Ponzi, an Italian immigrant, who took in $15 million in fraudulent investments between 1919 and 1920. Charles Ponzi modernized an old fraud scam, previously referred to as "Robbing Peter to pay Paul" schemes.

"My business is simple," said Ponzi in his last interview. "It was the old game of robbing Peter to pay Paul. You would give me one hundred dollars and I would give you a note to pay you one-hundred-and-fifty dollars in three months. Usually I would redeem my note in 45 days. My notes became more valuable than American money... Then came trouble. The whole thing was broken."

In his 1857 novel, Little Dorrit, Charles Dickens described the "rob Peter to pay Paul" scheme. Commentators note an eery resemblance between Dickens's Mr. Merdle, the fraudster in Little Dorrit, and Bernie Madoff, whose Ponzi scheme resulted in his incarceration in 2009. Both were hailed as financial geniuses before being unmasked as thieves; both had wives who displayed their wealth openly and ostentatiously; both had legions of investors who wanted to entrust them with their dollars.

The Associated Press reports that Ponzi collapses in 2009 nearly quadrupled over those in 2008, deriving its numbers from counting criminal prosecutions and administrative actions taken at state and federal levels. AP states that 150 Ponzi schemes collapsed in 2009, compared with only about 40 in 2008.

The Madoff Ponzi scheme collapse has generated increased vigilance at the federal level, but the 2009 recession was more likely the driving force behind the collapse of these old style pyramid schemes. As dollars got tighter, investors withdrew their funds and wanted to put them into more conservative and safe investment options. Sources of new investors, and revenue, dry up, resulting in less money becoming available to pay off old investors. The pyramid collapses.

Most new federal cases have not yet resolved, and investigations are ongoing. The FBI opened 2100 securities fraud investigations in 2009, about 350 cases more than were opened in 2008. The SEC opened about 6% more investigations in 2009 than in 2008.