Slate's field guide to financial scams.

Answers to your questions about the news.
Dec. 16 2008 6:53 PM

Slate's Field Guide to Financial Scams

Ponzis, pyramids, and bucket shops.

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Federal agents arrested Bernard Madoff on Thursday and charged him with what may be the biggest scam in Wall Street history. The list of wealthy victims includes Elie Wiesel, Steven Spielberg, and the Gift of Life Foundation. News reports are referring to Madoff's fraud as a "Ponzi scheme." What makes a scheme a Ponzi?

Short-term returns are paid out with cash from new investors. The scheme is named after Charles Ponzi, an Italian immigrant who swindled thousands of New Englanders in the early 1920s. Ponzi claimed he'd found a weakness in the postal system (wherein he'd send agents to buy international postal-reply coupons in Italy on the cheap, exchange them for U.S. stamps at a higher value, then sell them) and promised his investors a 50 percent return in 45 days or a 100 percent profit in twice that time. Initially, Ponzi suckered his friends, who spread the word; then he hired agents to find new investors, creating a frenzy. In one spectacular three-hour period, he took in $1 million, and he averaged $200,000 per day in new investments. For a short time he lived in luxury, buying a mansion in Lexington, Mass., but about six months in, the Boston Post started running stories questioning Ponzi's strategy. He was arrested shortly thereafter.

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Madoff's scam worked a little differently. Peter J. Henning argued in the New York Times that it deserves its own moniker since Madoff 1) preyed exclusively on very wealthy investors and 2) offered steady returns of 10 percent a year rather than a quick, spectacular gain. Still, Madoff seems to have financed his scam in the same basic manner as Ponzi.

A pyramid scheme functions like a peer-to-peer version of a Ponzi scheme. Instead of funneling payments to a single person—such as Ponzi or Madoff—investors pass the money among themselves. Each new participant must recruit several others to perpetuate the scheme. Eventually, the pyramid collapses because it gets harder and harder to find fresh blood. As this clever SEC chart demonstrates, a pyramid scheme that starts with six people will, after 11 levels, require more members than the U.S. population and, after 13 levels, more than the world population. Albania learned this the hard way. In the mid-'90s, about two-thirds of the population invested in a series of government-endorsed pyramid schemes. When the schemes failed, Albanians took to the streets and more than 2,000 people died in the ensuing riots.

Lots of schemes are stock-market specific. There's the pump and dump, in which the perpetrator boosts the price of a stock through false or exaggerated statements, then sells his position at an artificially inflated level. And front-running, in which a broker buys himself shares of a stock right before his brokerage buys a much larger block of shares (or recommends the stock as a good prospect). In the jitney game, brokers trade a stock back and forth to give the impression that it's a hot commodity. Bucket shop is a common term for a brokerage that defrauds its customers, usually by selling worthless or highly speculative stocks that it wants to offload. In Season 2 of The Sopranos, Christopher runs a bucket shop, selling phony stocks to senior citizens then pocketing the cash.

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Juliet Lapidos is a staff editor at the New York Times.