Ponzi Schemes --How do they End

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By CATHERINE RAMPELL
Published: December 20, 2008
So, what’s the exit strategy?

'Ponzi's Scheme,' by Mitchell Zuckoff: His Last Name Is Scheme (April 10, 2005)

Mathematically speaking, Ponzi schemes are doomed. They work by bringing in new investors to pay off old ones. In pure form, there’s never any actual business activity; the money just rolls backward from ever-increasing numbers of investors to keep up the appearance of profits. This means the scheme requires an infinite supply of new suckers.

Anyone sophisticated enough to concoct a Ponzi scheme — and con experienced investors and government agents, as the New York financier Bernard Madoff is accused of doing — must also be sophisticated enough to do the math here.

So how can Ponzi perpetrators possibly expect to extricate themselves from their ploys? Based on historical examples relayed by a few biographers, historians and finance experts, the exit strategies seem to fall into four general categories:

CUT AND RUN These Ponzi schemers, a subset of the “Music Man” breed of professional swindler, are the small-time crooks, the snake-oil salesmen. They plan to rip off everyone in River City, hop on a train, change identity, and then start over, from the top, in the next town.

Few big-time Ponzi schemers go this route, however. That’s because big Ponzi schemes usually exploit the trust of a tightly knit social network. Mr. Madoff is accused of victimizing wealthy Jews. The Foundation for New Era Philanthropy, a Philadelphia-area scheme that collapsed in 1995, preyed largely on Christian religious organizations.

If you’re well enough connected to create a large-scale Ponzi scheme, though, you’re probably too well-connected to be able to, or perhaps even want to, cut yourself loose. Charles Ponzi himself passed up chances early in the 20th century to sneak back to his Italian homeland unnoticed.

“He was bringing his mother over to Boston, from Rome,” says Mitchell Zuckoff, a professor at Boston University who wrote “Ponzi’s Scheme: The True Story of a Financial Legend.” “He was canceling the honeymoon he’d planned to take to Italy with his new wife. He could have taken the money and run, but instead he chose to put down roots.”

TURN (OR RETURN) THE BUSINESS INTO SOMETHING LEGITIMATE This group is likely to have started out with some hope for legitimacy. They solicit seed money for a brilliant investment idea, but the idea falls through. Rather than declare failure, they recruit new investors to pay off the old ones.

The fraud is just temporary, the swindlers tell themselves. They delude themselves into thinking they’ll come up with another, better idea some day.

This appears to have been Mr. Ponzi’s strategy; he had grand plans for international postal arbitrage but couldn’t make the logistics work. “He truly thought he could eventually turn around and go legitimate,” Mr. Zuckoff said.

This exit strategy pretty much always fails because the schemers are looking for the big scalp — and there’s never an investment profitable enough to fill that deepening pocket of debt.

NO EXIT These schemers, usually from relatively humble backgrounds, are deeply insecure. They have felt like impostors their whole lives, whether in the country club or on the trading floor, says James Walsh, author of “You Can’t Cheat an Honest Man.” Expecting exposure for something, sometime, somewhere, they rationalize their fraudulent behavior. They delay the inevitable as long as they can — and live well until they get caught.

GET ELECTED TO PARLIAMENT After scamming millions of Russians in the 1990s, Sergei Mavrodi promised his investors a taxpayer bailout if they elected him to the Duma. Upon election, he received parliamentary immunity from prosecution.

Admittedly, this exit strategy has limited applicability. It didn’t even work very long for Mr. Mavrodi, who landed in prison when his immunity was revoked.

The details of Mr. Madoff’s scheme are unclear, though he is accused, in court documents, of having described it as a Ponzi scheme. Some experts guess that, given his business’s longevity, he may have hoped to return to legitimacy one day.

Most Ponzi schemes last a year at most, says Utpal Bhattacharya, an Indiana University finance professor. (Ponzi’s lasted just nine months.) So it seems likely that Mr. Madoff, an investment manager since 1960, started out legitimate or semi-legitimate. People in that position sometimes foolishly think they can hide a one-time loss with new investors’ money, and make up for it with a big gamble later.

In other words, Ponzi schemers don’t necessarily start out as such, and as sophisticated as they are, they may not consciously recognize that they have created one. They delude themselves into thinking the ploy is just a stopgap measure, an attempt to hide a loss until they can — once again — dream up something brilliant.