What’s a Ponzi Scheme?
American consumers get wrapped up in Ponzi schemes time and time again due to no fault of their own. Even if you hire a stockbroker from a famous Wall Street brokerage firm, and follow his recommendations to the letter, you can still fall victim to this kind of fraud.
Investors are careful: Reputable investments sold by well-known brokerage firms can sometimes be Ponzi schemes in disguise.
The Worst Ponzi Scheme In History
The worst Ponzi scheme in history was the 65 billion dollar scam run by Bernie Madoff. In a 60 Minutes interview with the Madoff family, his son said when Madoff admitted he’d been running a Ponzi scheme, the first thing his wife asked was this: “What’s a Ponzi scheme?” If you don’t know the answer, keep reading.
Madoff had been collecting cash from wealthy investors for years, paying interest, while pulling the wool over their eyes. Everything seemed to be going fine until his Ponzi scheme finally ran out of assets and the very sad truth came out. Investors lost everything.
How Do Ponzi Schemes Work?
Ponzi schemes usually promise big returns with very little risk, and victims usually hear about them from friends who got in early and made a quick buck. They can be a lot more subtle than that too, i.e., they appear to be a trustworthy investment and even a knowledgeable stockbroker can get fooled (like in the case of certain non-traded real estate investment trusts).
But before we talk about REITs, let’s learn the basics of how a Ponzi scheme works.
Collecting Initial Investors & Cash
Imagine you have 10 investors who each put $10k in a big pot, for a total of $100k. Let’s say the investors are promised an unrealistic 50% annual return. At the end of the first year, the Ponzi scheme works just fine. Everybody gets $5k (i.e., a 50% return on their $10k investment). At the end of the second year, it continues to work, and everybody gets their $5k annual dividend payment again.
However, at this point, there’s no more money left. $100k went in and $100k went out. Furthermore, nothing was done to grow the money. Everyone has received their original $10k back and the $100k pot is now empty. So how will the investors get their $5k return in years 3, 4 and 5?
Getting More Cash To Keep The Scam Afloat
The Ponzi scheme solves the ‘running out of money’ problem by obtaining new investors or ‘victims.’ Let’s say 20 new investors each put $10k in the pot. Now there’s enough cash to keep the Ponzi scheme afloat a little longer.
In year 3, the original set of investors will get their $5k, and so will the 20 new investors. No one is the wiser. The victims think the fund is growing their money through investments, but this is a lie. The fund is only using the new incoming cash to pay the dividends going out.
The House Of Cards Falls Apart
When year 4 comes around, the Ponzi scheme will again run out of cash to pay investors, unless it can obtain fresh investors. If the Ponzi scheme can’t attract new investors, the money in the bucket will run out, and dividend payments will cease…
When the dividend payments cease, victims will start withdrawing their initial investment, and this is when they’ll discover that all the money is gone. For the investors who get in early or get out early, they might be able to withdraw an amount equal to their initial investment. For the ones who get in late (which is the usual situation), they will probably lose everything.
How Do Ponzi Schemes Happen? What Should I Look Out For?
A lot of Ponzi schemes are independently run operations, which happens outside the walls of major stock brokerage firms (like the Bernie Madoff scandal was). Investors get sucked into these after hearing about friends getting incredible returns. Those friends got in early on the deal. It’s likely new investors will get robbed because it’s the new money going in that’s being used to pay dividends out, and the scheme may collapse before they get paid.
A more dangerous situation happens when a Ponzi scheme is disguised as a conservative investment and sold to the customers of a brokerage firm.
When A REIT Goes Bad
Ponzi schemes may take the form of non-traded real estate investment trusts (non-traded REITs) and tenants in common (TICs), which can be dangerously attractive to retirees and conservative investors looking to generate an income. A diligent stockbroker would never recommend these investments to a retiree or conservative investor, but it happens, and sometimes these investments are nothing more than a Ponzi scheme in disguise.
Real estate investment trusts (or REITs) are a way for investors to invest in real estate without actually buying property. REITs pool investor money, invest in real estate property, then pay dividends to investors with the income generated from the property. But sometimes, a dying REIT will turn into a Ponzi scheme to keep itself afloat, using new investor capital to meet the dividend agreements of its investors.
There’s just no pretty way to paint it. When a REIT goes bad… it may transform itself into a Ponzi scheme, lie about its accounting, and new investors will have no idea what they’re getting into. The financial consequences for innocent consumers can be crippling.
DBSI Tenants In Common
Another recent and seemingly reputable Ponzi scheme was created by the company DBSI. Following DBSI’s bankruptcy in 2008, its fraudulent practices were revealed relating to DBSI notes and DBSI TICs (tenants in common). DBSI was creating real estate backed securities offering ‘guaranteed’ dividend payments.
However, DBSI lied to investors, co-mingled their funds, and when real estate investments became unprofitable, they started using new investor capital to pay the dividends of older investors. Eventually, DBSI collapsed and this massive Ponzi scheme was discovered. Now, thousands of retirees who fell victim to DBSI fraud are fighting to get their money back.
If It Sounds Too Good To Be True… Go Back To The Basics
It’s easy for a dishonest corporation to create a Ponzi scheme that pays dividends only slightly above what solid, conservative investments are paying. When a retiree is shopping for an income-generating investment, these schemes look very attractive, like a diamond in the rough that’s paying just a tiny bit more than the competition.
Investors should be wary of investments like REITs, TICs and ‘designer’ investments that they aren’t familiar with. Sometimes, a law will change that allows for a new kind of investment to be created; however, the stockbrokers selling them may not understand the risks involved, and only later is it discovered by the SEC and FINRA that these kinds of investments breed fraud.
By staying with investments that you fully understand, and making an extremely diligent effort to research new investments (independently of what your stockbroker tells you), investors will know what they’re getting into before they risk their life savings on an unfamiliar investment.
Finally, be suspect of anything that seems like easy money. If it sounds too good to be true, it probably is. And if you think you might have gotten wrapped up in a Ponzi scheme, seek the help of an experienced professional immediately.
Contact Us
If you have been injured by a Ponzi scheme, you have been wronged and you deserve justice.
For a free and totally confidential consultation, contact the Consumer Investor Resource Center today.