Explaining the Ponzi Scheme

Every time I hear about Bernard Madoff and his arrest, this term is always attached to his name: the Ponzi scheme. Who or what in the world is that? But before that who is Bernard Madoff?

Bernard Lawrence Madoff is an American businessman and former chairman of the NASDAQ stock exchange. He founded the Wall Street firm Bernard L. Madoff Investment Securities LLC in 1960. His firm was one of the top market maker businesses on Wall Street. In fact, it is the sixth-largest in 2008. Madoff was also a prominent philanthropist serving in several non-profit organizations and funding research studies specifically about lymphoma (his youngest son was diagnosed with lymphoma).

Madoff was arrested after investigators said he confessed to his sons that he had swindled investors of a mammoth Ponzi scheme in which early investors are paid with money raised from new investors. The scheme collapses when there is no money to repay the last investors. Madoff allegedly took $50 billion dollars of his investors' money.

So now, back to my first question, what is a Ponzi scheme?

According to the US Securities and Exchange Commission, a Ponzi scheme is a type of illegal pyramid scheme that pays returns to investors from their own money or money paid by subsequent investors rather than from profit. It usually offers abnormally high short-term returns in order to entice new investors. A Ponzi scheme usually has this "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.

The scheme was named after Charles Ponzi who became infamous during the 1920's as one of the greatest swindlers in American history. He was able to earn money quickly by using a vagary of the postal system. In those times, it was common for letters abroad to include an international reply coupon - a voucher that could be exchanged for minimum postage back to the country from which the letter was sent.

As explained in cnn.com, Ponzi started buying and selling postal reply coupons using agents in his native Italy. Unfortunately, he got greedy so Ponzi started to recruit investors into his system with the promise of 50 percent returns in just a few days. Investors would pay their cash in, and sure enough, Ponzi would get them the promised return.

Everyone was happy with the results, and word started to spread about this Italian financial wizard. Within two years, he had employees all over the country recruiting new takers for this foolproof investment strategy and Ponzi was pocketing millions raking in $250,000 a day. He became a celebrity investor, almost like the Warren Buffett of his day.

Soon enough when financial head Clarence Barron looked into his business and realized that the whole thing was a scam, Ponzi's business started to fall into pieces. Though many did not believe Barron's report, Ponzi eventually went to trial, pleaded guilty and served jail time. Upon his release, Ponzi was deported back to birth country Italy and spent the rest of his life in poverty. He died in Rio de Janeiro in 1949.

As to why Bernard Madoff did what he did...that's a question many people would like to hear him answer. Many lives were affected (and perhaps ruined) by his 21st century Ponzi scheme. But whatever Madoff's reason is, his victims (if proven guilty) deserve all the justice they can get.