Avoiding Ponzi Schemes

AVOIDING PONZI SCHEMES, such as the one run by Bernie Madoff, depends not on knowing the details of a particular scheme but on knowing the two elements that the perpetrators depend on to make their schemes work: ignorance and greed. Without these magic two, they would be dead in the water Notice that I didn’t say stupidity, but ignorance a lack of specific knowledge. Both are perfectly illustrated in a personal encounter that I had a few years ago.

It began when I met an attractive lady, who was a mathematics professor with a graduate degree from an Ivy League college, and certainly not a stupid person. She seemed to think that I would be the perfect person for her once she had rearranged me, including my finances. When she learned that I played a few options but that my nest egg was in US Treasures and that for ready access I kept a smaller amount in FDIC insured money market funds, she immediately said, “Oh you’re such a dork. I’m getting 12% guaranteed on my money.”

Since interest rates in 2003/4 were nowhere near that level, this did not make sense. It turned out that she had her life saving invested with a company that sold “investment certificates” in $1,0000 denominations and used the money to buy mortgage-backed securities from Citi Bank [C]. A reality check showed that nobody was paying 18-20% for mortgages in 2003 (12% for her investment + 3% for the bank + a conservative 3% for the broker). The numbers simply didn’t work. I said, “You’re the mathematician, show me how the numbers work.”

She replied, “I don’t know how the numbers work, but I’ve been to their offices in Boca Raton, FL, and I checked with the BBB, they are listed on the NASDAQ and I even checked with Citi Bank [C], and they ARE investing in Citi mortgages. Besides, they always pay the interest. There is no problem.”

We soon parted ways. A couple of years later, while cleaning out files, I came across the paper work that she had given me. I decided to go on line and check on the company. It turned out that their Ponzi scheme had collapsed. It seems that they would collect a hundred million dollars in investor funds, buy ten million in mortgage securities for appearances sake, and use the remaining ninety million to pay the 12% to investors and line their own pockets. I later learned that my acquaintance had lost her life saving of $35,000.

Why would a smart, educated person fall for what should have been such an oblivious scheme? First, ignorance, but more importantly it was “willful ignorance.”

That brings in the second element: greed. The prospect of making four times as much money as was available in most money market accounts blinded her to the simple reality that the numbers did not work.

The victim was assisting the predator.