Creating the Perfect Ponzi

The latest revelation, as you know by now, is that the Stanford Group (beware of venerable name use!) is another Ponzi, this one a mere $8 billion. Obviously, Sir Allen Stanford didn’t figure out the whole feeder thing. Other scams have come to light as well.

All this has had me pondering if it’s possible to get away with a Ponzi scheme. By “get away with,” I mean stand a high probability of dying before being caught. Some argue that Bernie Madoff, because he lived in great luxury for decades, got away with it, but no, that’s not good enough for me. I don’t want to go to the big house, and I’d just as soon be gone from this earth by the time my name became synonymous with evil. So think of this as a mental exercise like how to commit the perfect murder or pull off a big jewel heist. I merely want to know if it can be done. (Hopefully, the SEC is engaging in this same mental exercise as we speak.)

The answer, I think, is yes. The rules are as follows:

1. Never invest or risk the money in any way. Put it all in cash.
2. Don’t be completely crazy-greedy.
3. Don’t claim ridiculous returns.

It all comes down to managing the gap between the assets you claim to have, and the assets you really have. I played with the variables and came up with some parameters that I think work:

1. Claim 10% returns per year.
2. Raise 10% (or more) net new assets from investors per year.
3. Invest all assets in cash.
4. Keep the cash returns for yourself (that would be the illegal part).

On the following page we examine how this scheme would have played out over the last 25 years. I assume a $10 million initial funding.

Sorry, a little hard to read. The “fees” column represents what was earned in cash every year (at actual historical rates) and also what our would-be Ponzster is skimming from the fund. Note that the total theft works out to $182 million. Not Madoffian, but it beats working at a 7-11, or even as a trading grunt for Stevie Cohen.

The key numbers are in the right hand column. This represents the percentage of your actual assets that would have to be redeemed before you ran out of cash. This is the number you have to manage carefully. Note in this scenario it levels off at close to 50%. This means that you could have half your investors redeem and you could still keep the scam going. What are the odds of this? I’d say quite long, since you’ve been posting such reliable returns all these years.

But Madoff posted reliable returns also, you say! Without a doubt, Madoff came closer than any before, (that we know of) to pulling off the perfect Ponzi. I’m reasonably sure, though, that early on he violated Rule 1 – put the money in cash - and possibly rule 2 - don’t be crazy-greedy. While all the details aren’t in, I think it’s likely that Madoff blew some money in the market at some point, maybe in the late 80s or early 90s, and this was probably his undoing. He did run a large broker/dealer, after all, and no doubt thought he knew a thing or two about making money. As for the greedy part, that’s a more interesting question. I mean, of course he was greedy, but it may be that the amount he spent on himself, despite the yachts and villas, was not over-the-top relative to the amount of money his firm was allegedly making. His far-flung homes were – relatively – modest and his apartment in New York is on Lexington Avenue, not an address associated with moguls. I actually think he was more motivated by prestige than money, but I’ll leave that call to others. Let’s just agree to call him a disgusting pig.

What’s relevant was how well he had managed his funding gap. From the available information, he managed it better than anyone else ever has, who’s been caught, anyway. His key insight was his understanding of Rule 1: don’t claim ridiculous returns. Most Ponzsters aren’t particularly bright, or lack patience, so they claim to make 50% every 90 days, or whatever. Most Ponzsters, in fact, break all three of our rules. Madoff, merely by grasping Rule 1, was able to perpetuate his scam for decades.

An interesting question is, what was Madoff’s actual funding gap? From anecdotal evidence surrounding redemption requests prior to the scam being revealed, I’m betting it was close to 75% or 80%. That’s clearly in the danger zone.

Now here's how to get out of the whole thing before you get caught: simply have a terrible year. 2007 was a very troublesome year for many hedge funds. Madoff could have seized the opportunity to say, oops, my models failed me. Sorry, but I lost 75%. I strongly suspect he would have gotten away with this.

So there you have it, a road map. I was going to say you might want to come up with a plausible investment strategy to go along with it, but that doesn’t seem to matter much to gullible investors.

(Note: one key assumption I have made is that the bogus fund raises 10% of new capital each year. Clearly, this number would vary (and occasionally be negative), but I think it’s reasonable, perhaps conservative, given the claimed returns. Also, for simplicity’s sake, I have assumed straight-line 10% returns. The smarter thing to do, post-Madoff, would be to have some variability, but not so much as to scare investors away.)