The $50 billion Ponzi scheme allegedly masterminded by former Nasdaq
chairman Bernard Madoff punctuated a miserable year for Wall Street in the
worst possible way: by underlining, yet again, that savvy market-makers can
harness arcane financial instruments as weapons of mass destruction. Left in
Madoff’s wake are bankrupt investors, mortified
regulators and a raft of unnoticed red flags. Madoff’s methods previously had been
investigated by the SEC, and in 2001, a prescient article raised questions
about his inscrutable strategies: “Madoff’s investors rave about his
performance — even though they don’t understand how he does it,” wrote
Barron’s Erin Arvedlund, who quoted a “very satisfied investor” as
conceding, “Even knowledgeable people can’t really tell you what he’s
doing.” But for investors pocketing windfalls, the lure of easy money
outstripped suspicions raised by Madoff’s shroud of secrecy. When that shroud was lifted, however, Madoff’s investment fund stood revealed as a classic Ponzi scheme: a con game in which the illusion of solvency was created by paying off early investors with capital raised from later entrants. As long as new investment continued to come in the door, the earlier adopters reaped fat rewards; once markets tumbled and investors withdrew, however, the whole thing collapsed like a house of cards.
Though a Boston businessman named Charles Ponzi was the scam’s namesake, he
wasn’t its original practitioner. According to Mitchell Zuckoff, a Ponzi biographer, the reigning king of the “rob Peter to pay Paul” scam was a New York grifter named William Miller, who bilked investors out of $1 million — nearly $25 million in today’s dollars — in 1899. After drumming up interest by claiming to have an
inside window into the way profitable companies operated, Miller — who
earned the nickname “520 percent” due to the astonishing rate of return he
promised investors over the course of a year — salted his scam by paying
out the first few investors. After his racket was exposed by a newspaper
investigation, he was sentenced to 10 years in prison. According to Zuckoff,
his creditors got just 28 cents back for every dollar they’d invested.
Ponzi was a charismatic Italian immigrant who, in 1919 and 1920,
coaxed thousands of people into shelling out millions of dollars — including
a staggering $1 million in a single three-hour period — to buy postage
stamps using international reply coupons. This strategy, Ponzi promised, enabled one to purchase postage at European currencies’ lower
fixed rates before redeeming them in U.S dollars at higher values. “For
instance,” Zuckoff explained in a Dec. 15 article for FORTUNE, “a
person could buy 66 International Reply Coupons in Rome for the equivalent
of $1. Those same 66 coupons would cost $3.30 in Boston,” where Ponzi was
based. But there weren’t enough coupons in circulation to make the plan
workable. The ploy bore the hallmarks of both Miller’s scheme and others to
follow it: it trumpeted the possibility of massive gains , parried questions about its legitimacy by
paying out the first few investors, and collapsed when Ponzi couldn’t rustle
up enough fresh marks to keep up with the money going out the door.
Ponzi, who was released from prison and deported back to Italy in 1934, set the standard in the
genre. But the golden age of Ponzi and pyramid schemes didn’t arrive for
decades. In the boom years of the 1980s and
’90s, as traders developed increasingly
sophisticated investment vehicles, the cons cropped up with increasing
regularity. In 1985, a San Diego currency trader named David Dominelli
was revealed to have fleeced more than 1,000 investors to the tune of $80 million. During the 1990s, a
Florida church called Greater Ministries International bilked nearly 20,000
people out of $500 million in a pyramid scheme hatched by leader Gerald
Payne, who claimed God would double the money of pious investors. The spate of
incidents wasn’t limited to the U.S., either. When communism crumbled in Eastern
Europe, one of the earliest side effects of free-market capitalism was the
proliferation of people looking to get rich quick. In Albania, under Communism the poorest nation in
Europe, citizens sank some $1.2 billion dollars into pyramid schemes in
1996. When they collapsed the following year, investor outrage brought down
the government.
This ignominious group has had some high-profile recent
entrants, including Democratic fundraiser Norman Hsu, who was charged in
October with operating a $60 million Ponzi fraud, and former boy-band
impresario Lou Pearlman, who in addition to foisting N’Sync on an unsuspecting public
also stole $300 million in investor capital over two decades. Earlier this month, Minnesota businessman Tom Petters was indicted by a federal grand jury on 20 counts of fraud, conspiracy and money laundering stemming from his alleged role in a 13-year, $3.5 billion Ponzi ring. Still, the $50 billion fraud Madoff allegedly perpetrated is the most egregious Ponzi
scheme to date—unless you subscribe to an argument advanced by financial
consultant Janet Tavakoli. In a neat summary of the anger millions of people
are channeling toward Wall Street, Tavakoli wrote on her company website: “The largest Ponzi scheme in the history of the capital markets is
the relationship between failed mortgage lenders and investment banks that
securitized the risky overpriced loans and sold these packages to other
investors—a Ponzi scheme by every definition applied to Madoff.” By
comparison, she wrote, the fallen fund manager is just “a piker.”
