Ponzis Pyramids and

Bubbles

An introduction to financial fraud

Professor Russell James Dept. of Personal Financial Planning

Texas Tech University

The core of any Ponzi

Scheme is the HIDDEN reality that payments

come from new investors,

not actual profits

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

What is a Ponzi

Scheme?

Charles Ponzi

https://www.youtube.com/watch?v=vFEMzCMyMXc

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Arbitrage in post office international

reply coupons valued at $.06 in U.S., sold

for $.01 in Spain.

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

50% return in 45 days or 100% return

in 90 days

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

Investors were recent immigrants,

often of his ethnicity

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

“Truly, for an immigrant, I did not look the part. There was nothing in

my appearance to suggest the bread winner; nothing that could even be remotely associated with the thought of manual labor, of work of any kind; of economic

penury. From tie to spats, I looked like a million dollars just out of the

mint; like a young gentleman of leisure, perhaps like the scion of

wealthy parents on a pleasure tour. And that goes to show that

appearances don't mean a thing. In fact, I was in a jam right then…

Broke right from the start, my entire resources in cash amounting to $2.50.” From his autobiography (pnzi.com)

Charles Ponzi

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core “Broke right from the start, my entire resources in cash

amounting to $2.50.”

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

Early investors were paid as promised

(from new investors’ money) leading to an enormous demand

from new and repeat investors.

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

Lasted 8 months. Took in a total of $15

million before collapse.

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Charles Ponzi

New Era Philanthropy • HIDDEN reality that

payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

https://www.youtube.com/watch?v=dfIz9_Pw_tk

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Gave donors a chance to double their gifts to

charity allegedly from a group of wealthy

“anonymous donors.” Later, non-profits were

told that their funds would be matched by the anonymous donors and

returned after a three-to-nine month holding

period in a “semi-escrow” Prudential Securities

account

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Claimed to have six anonymous donors

providing matching funds. The founder was friends with John M. Templeton,

Jr., son of John Templeton, Sr., the famous investor

and philanthropist. Used Prudential Securities

account.

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Gift or deposit was doubled after 6 months,

later 9 months.

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Founder was Philadelphia Christian businessman,

started with his philanthropic Christian

friends and expanded to Philadelphia area

churches & non-profits (before mushrooming to national nonprofits in the

last year)

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors? • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Although beginning with friends and then local

Philadelphia nonprofits, eventually expanded to including Philadelphia

Public Library, University of Pennsylvania,

Philadelphia Orchestra. Then mushroomed before

collapse including many national charities and

universities.

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Original credibility from relationships with other Philadelphia Christian

businessmen.

Later, credibility came from others who had

invested and the plan’s longer duration 1989-

1995.

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Grew exponentially. Started with personal acquaintances in 1989 with $5,000 minimum

donations, then $25,000 minimum donations. In

1994 opened to non-profit deposits. At collapse

had raised $345 million.

New Era Philanthropy

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

https://www.youtube.com/watch?v=s68FR1MXT8Q http://video.pbs.org/video/1122731028/ http://www.hulu.com/watch/59463

Bernie Madoff

Bernie Madoff • HIDDEN reality that

payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

“The essence of his scheme was to deposit

client money into a Chase account, rather than

invest it and generate steady returns as clients

had believed. When clients wanted their

money, "I used the money in the Chase Manhattan

bank account that belonged to them or

other clients to pay the requested funds," he told

the court.” http://www.reuters.com/article/2010/12/02/us-madoff-

jpmorgan-idUSTRE6B153220101202

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Fake trades were “recorded” after the fact

to match indicated returns.

Because he operated a trading company and was

former chairman of NASDAQ, some assumed

he had insider trading ability. [E.g., “front

running” where stockbroker buys ahead of

customer’s large buy orders then sells

immediately afterwards]

Bernie Madoff

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Provided above market returns with essentially no variance in a hedge fund

for many years.

Offered only about 10.5% annual returns, but

returns were always up. Harry Markopolis notes, “Only 4% of the months

were down months.”

Bernie Madoff

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

No mandatory delay.

Targeted private foundations as they need only pay 5% of assets per

year, thus few redemptions.

Because the investment

opportunity was “exclusive,” investors were

wary of removing their money from his fund, in case they could not get

back in later.

Bernie Madoff

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Started and grew with wealthy Jewish investors and nonprofits. New York Post reported that Madoff

"worked the so-called 'Jewish circuit' of well-heeled Jews he met at country clubs on Long

Island and in Palm Beach.“

“The major firms on wall street had no money with

Madoff.” – Harry Markopolis

Bernie Madoff

http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

• Started firm in 1960 • Former chairman of

NASDAQ • Financial inquiry

foregone by some investors perhaps because presumption of insider trading (front running) to create profits

Bernie Madoff

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi Core

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Because of his low return rates (app. 10.5%) the

collapse could have come more slowly (after his

death). But, the financial crisis caused a massive

run of redemptions.

Bernie Madoff

How is a pyramid scheme different from a Ponzi scheme?

Each passenger pays $5,000 to the captain to join the pyramid. Once a 8 passengers have paid ($40,000), the captain is retired, the co-pilots become captains, etc. The goal is to become a captain. The pyramid can become a scam when the promoter fills in the top three levels with phony names (all paying him).

Example Pyramid Scheme (not “Ponzi”)

Pyramid Scheme • REVEALED reality that

payments come from new investors, not actual profits

• True story • Unknown returns • Much variance • Unknown delay

• Maybe • Yes

• Maybe

• Slows/stops instead of

collapse

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

How is a market “bubble” different from a Ponzi scheme?

Housing price-to-rent (price-to-income) ratios

Andre, C., Gil-Alana, L., Gupta, R. (2014). Testing for persistence in housing price-to-income and price-to-rent ratios in 16 OECD countries. Applied Economics, 46 (18), 2127-2138

S&P 500 historical price-to-earnings ratio To December, 2014

From http://www.multpl.com/

Bubble • REVEALED reality that

growth comes from new investors, not actual profits

• Yes • Yes • High variance • No

• No • No

• No

• Must collapse IF supply is

unlimited

• HIDDEN reality that payments come from new investors, not actual profits

Common Features

Ponzi

• “Plausible” story • Above market returns • No returns variance • Mandatory delay for

investment return • Targets affinity group • Less sophisticated

investors • Social credibility v.

audited credibility • Collapses when growth

slows/stops

Protecting yourself

from Ponzi schemes

Why me?

Why do they need MY money? If this investment is so great, wouldn’t it be easier to get more money in larger chunks from sophisticated institutional investors? If the investment is so great, why does it require paying this promoter to sell it to me?

Great investments don’t come looking

for you.

Beware of investments that look “too good”

High return, low variance investment results are a statistical red flag for fraud.

Bollen, N. & Pool, V. (2012) Suspicious patterns in hedge fund returns and the risk of fraud. Review of

Financial Studies, 25 (9), 2673-2702

Question it

Get outside advice. Verify with outsiders (not affinity group members) such as state securities regulators, SEC, technical professionals in the field. Pay for quality advice. Start by Googling it. Don’t be rushed.

Show me the audit. Review CPA audited financial statements. Is this a large CPA firm? Why not? Can the assets actually be sold for their stated value? Remember, profit is opinion – cash is reality.

Watch the reaction to hard questions. Defensiveness? Socially inappropriate? Threatened with being left out?

Year of Discovery

Name/Alleged Investment Amount

2014 Nationwide Automated Systems; ATMs $123MM

2014 KGTA Petroleum; Reselling crude and other oil products $20MM

2013 Yost Development - Tunisia $40MM

2012 Zeekler penny auction website $600MM

2012 Contract emu farming $28MM

2012 Gold - Genneva Malaysia Sdn Bhd $330MM

2012 Bitcoin Savings and Trust (BTCST) $250MM

2011 Risher “private equity funds” $21MM

2010 Justin Laurin Prather – Lubbock, TX; bridge loans for golf carts $12.5MM

2010 Sale of promissory notes – World Financial Group $14.8MM

2010 Oxford Group - Minnesota $194MM

2009 Benny Judah– Lubbock, TX $59MM

2009 Green energy investments (Mantria Corp) $30MM

Not So Rare: Example Reported Ponzi Schemes