Beware of Charles Ponzi, Bernie Madoff

Piggy’s Trading & Investing Tips:Batanai Matsika

THE attraction of Ponzi schemes never ends as this has been confirmed by reports last year that police have been searching for the directors of KWD Digital Marketing, a company running a suspected Ponzi scheme in Harare.

Scores of gullible participants of the scheme were reported to have been flocking to 147 Freedom Legacy Way to deposit up to US$10 000 each after being promised that they would receive twice as much back after four weeks.

Detectives, alongside the Reserve Bank of Zimbabwe (RBZ), launched an investigation into the operation, with initial charges being contravening the Banking Act.

In his Theory of Gullibility, Greenspan (2009) considers gullibility to be a sub-type of foolishness. He defines a foolish act as “one where someone goes ahead with a socially or physically risky behaviour despite danger signs, or unresolved questions which should have been a source of concern for the actor. But the real question is: what are Ponzi or Pyramid schemes and how can one identify these?

The fact is that Ponzi or Pyramid schemes are not complex tools of thievery. They are fraudulent investing scams promising high rates of return with little risk to investors. A Ponzi scheme simply generates returns for early investors by acquiring new investors. This is similar to a Pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers.

With Ponzi schemes, investors give money to a portfolio manager. Then, when they want their money back, they are paid out with the incoming funds contributed by later investors. With a Pyramid scheme, the initial schemer recruits other investors who in turn recruit other investors and so on. Late-joining investors pay the person who recruited them for the right to participate or perhaps sell a certain product. However, when markets hit a rut and investors withdraw, the whole scheme collapses like a house of cards.

Generally, Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. It is interesting that the term “Ponzi Scheme” was coined after a swindler named Charles Ponzi in 1919.

Charles Ponzi’s original scheme in 1919 was focused on the US Postal Service. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply.

Charles Ponzi promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of investing the money, Ponzi just redistributed it and told the investors they made a profit.

However, the actual postal system substantially lacked in quantity of the amount of money he dealt with. The scheme lasted until August of 1920 when Ponzi was arrested and charged with several counts of mail fraud.

Readers might also be aware of Bernard Lawrence “Bernie” Madoff, an American financier who executed the largest Ponzi scheme in history. Despite claiming to generate large, steady returns through a genuine investing strategy, Madoff simply deposited client funds into a single bank account that he used to pay existing clients who wanted to cash out.

He funded redemptions by attracting new investors, but was unable to maintain the fraud when the market turned sharply lower in late 2008. The Securities Exchange Commission values the total loss to investors to be around US$65 billion.

Madoff has also been described as “the modern face of financial evil” given that his personal and business asset freeze created a chain reaction throughout the business and philanthropic community, forcing many organisations to at least temporarily close, including the Robert I Lappin Charitable Foundation, the Picower Foundation and the JEHT Foundation.

In 2009, Madoff was sentenced to 150 years in prison and forced to forfeit US$170 billion.

There are lessons to be taken away from the saga. Firstly, Madoff cultivated an image of exclusivity, often initially turning clients away. This model allowed roughly 50% of Madoff’s investors to cash out at a profit. He also offered consistent and above average returns of 10% to 20% per annum. Secondly, he was a “master marketer” who, throughout the 1970s and 1980s, built a reputation as a wealth manager for a highly exclusive clientele.

What allowed Madoff to steal as much as he did for as long as he did simply was due to who he was and what he represented. Madoff marketed himself as a co-founder of Nasdaq and had served as its chairperson; he was a prominent New York philanthropist and a member of numerous industry and private boards committees.

Because of this reputation, no one wanted to believe Madoff was running a lie. Not even the government. Through his brand name and his guise, he was able to dupe not only investors, but some of the best and the brightest.

Thirdly, it is also reported that Madoff utilised his religion to take advantage of his fellow Jewish people. The ability to find a certain group to target allowed the scheme to commence and grow. That said, while Madoff pleaded guilty in 2009 and will spend the rest of his life in prison, thousands of investors lost their life savings and several reports detail the harrowing sense of loss victims endured.

Piggy is concerned that economic constraints in Zimbabwe have exposed households and individuals to unfit investment vehicles. Zimbabweans have experienced an economic recession, rising costs on basic commodities (food, electricity and fuel) as well as persistently high levels of unemployment. This has culminated to limited economic opportunities (particularly for youth) and low-income levels. As a result, households in Zimbabwe are now resorting to channelling their hard-earned money to unfit “investment vehicles” such as Ponzi schemes and gambling activities.

Government efforts should be focused on improving financial literacy levels within the general populace and increasing the participation of locals in investment markets. Piggy maintains that the stock market offers a viable option for both retail and institutional investors to preserve and grow value.

Piggy likes export-oriented companies and regional players like ART Corporation, Simbisa Brands, Padenga Holdings, Hippo Valley and Seed Co International.

Matsika is the head of research at Morgan & Co and founder of piggybankadvisor.com. — batanai@morganzim.com/ batanai@piggybankadvisor.com or +263 783 584 745.

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