Accumulate! Accumulate! That is Moses and the Prophets!

Karl Marx, Grundrisse

Ponzi and his scheme

It’s almost a cliché to mention the signs were evident from the start. Charles Ponzi arrived in Boston in 1903, virtually penniless, an Italian immigrant who’d lost his money to a card shark during his journey, possessing just a ticket to New York to meet relatives in Pittsburgh. His journey led him through a string of clerical and menial jobs, culminating in a stint in a Montreal jail for a banking fraud. He adamantly claimed it was a misunderstanding, blaming a love rival for the ordeal and vowing eventual retribution. Advised to seek fortune beyond Canada, he returned to the USA with a group of illegal immigrants, landing another brief jail term.

He pitched power and light investment schemes, pretended membership in a secret society in New Orleans, associated with medical-insurance fraudsters in Alabama, got married, and eventually settled back in Boston by 1919. His focus shifted to a seemingly genuine venture: publishing The Trader’s Guide, a compilation of valuable trade-related information. He intended to distribute it to global companies involved in import-export trade, hoping to turn a profit through advertising. However, Ponzi’s international trade gazette failed to gain traction. Yet, while promoting it, he stumbled upon a discovery that altered his trajectory.

Upon receiving a request for a sample copy from a Spanish company, accompanied by an International Reply Coupon (IRC) for postage, Ponzi realized these coupons had a fixed exchange rate, differing significantly from market rates, across participating postal systems. Particularly in countries like Italy or Portugal, which had devalued their currencies post-World War I, the IRCs offered advantageous rates.

Conducting a trial transaction, Ponzi sent dollars to a relative in Italy, converting them into lire, purchasing IRCs, and mailing them back to Boston. Exchanging these coupons at the post office yielded US stamps nearly double his initial investment. It appeared to be a money-making machine, requiring more capital. He rebranded his office, shifting from “The Bostonian Advertising and Publishing Company” to “The Securities Exchange Corporation,” preparing to borrow money.

His first “investor” was a furniture salesman to whom Ponzi owed money; he exchanged the debt for a ninety-day note, promising 50 percent interest. Initially skeptical, the salesman became intrigued after Ponzi explained the mechanics of the IRC scheme. Ponzi openly divulged scheme details to potential investors, confident in his exclusive European contacts, essential for buying coupons in bulk. Postal inspectors investigated him for fraud, but his charm convinced them of the scheme’s legitimacy. However, the Universal Postal Union’s regulations provided significant safeguards against speculators exploiting implied exchange rates, which Ponzi overlooked.

More investors joined, enticed by the promise of 50 percent interest in ninety days (later reduced to sixty). Word spread beyond Boston’s Italian American community, expanding into wider New England. He hired commission sales agents, offering them a percentage of raised amounts. Outgrowing his office, Ponzi moved to lavish premises in the city’s business district, living extravagantly.

His expansion, partly by luck, involved employing a former jail mate to establish branches in Boston suburbs and New England towns, attracting thousands of customers. By 1920, Ponzi amassed a substantial customer base and cash float, unable to fulfill his commitments.

Ponzi’s scheme, unlike imitations, didn’t initially deter withdrawals. Investors could withdraw early without interest, reducing Ponzi’s underlying problem while draining his cash sources. Those reinvesting increased his problem size without draining cash. This tactic delayed the scheme’s collapse. However, as Ponzi tried using false assets to acquire real wealth, his downfall neared.

His scheme unraveled when his first investor, observing its success, sued Ponzi, igniting interest in his dubious background. Ponzi attempted to defend himself but lacked transaction records, never having implemented the scheme. He resorted to bribery, using deposits at Hanover Trust as leverage against bankers he perceived as adversaries, attempting to control the bank. The State Banking Commission’s involvement exposed his insufficiencies, and an audit confirmed his inability to honor bonds with 50 percent interest. Eventually, a US marshal arrested Ponzi.

Ponzi’s not accurately portrayed as a fraudster by his eponym. He was more sophisticated than his imitators. Aware he bought time and needed a new idea, Ponzi understood the significance of “assets controlled” for a dishonest actor. But he didn’t pioneer the investment scam or targeting affinity groups. He wasn’t the first Ponzi schemer in Boston, let alone the first overall.

The Boston Ladies’ Deposit Company

In 1878, women who owned property independently faced challenging circumstances. Their ownership outside of marital ties made them distinct but vulnerable, especially if they relied on inheritance or a lump sum, which often meant a modest livelihood with fixed earnings against a backdrop of subtle yet significant inflation. Maintaining social status became a struggle if they stuck to secure investments, and unexpected expenses forced them to dip into their capital, permanently compromising their future income.

Widows and unmarried women were surprisingly open to riskier investments, seeking higher dividends. While Victorian dramas often dramatize deceit on the stock exchange, these narratives underscore the substantial presence of vulnerable women among the villain’s investors. Though not entirely financially naive as portrayed, these women were genuine and not consistently risk-averse.

Enter the Ladies’ Deposit Company launched by Sarah Howe in 1878, causing quite a stir. Howe subtly implied that her bank had Quaker backing, hinting at a charitable mission promoting thrift and virtue. The scheme attracted unmarried women by stipulating they could only withdraw interest from their savings. Word of the Ladies’ Deposit spread, drawing a diverse investor base, from maids to affluent widows, lured by referral rewards and the promise of substantial returns.

However, the lack of a convincing cover story made it evident that this was a scam. An exposé in the Boston Daily Advertiser detailed Howe’s deceitful operations and forecasted the scheme’s collapse within three years. Investigative scrutiny into Howe’s background and the implausibility of a major charity employing a fortune-teller as a financial manager intensified negative attention.

In response to mounting skepticism, Howe rashly altered the rules, allowing dissatisfied investors to withdraw both their principal sum and interest. This move backfired catastrophically, revealing the company’s insolvency, leading to bankruptcy. Howe faced imprisonment, yet astonishingly, she reemerged to execute a similar scam with the Boston Women’s Bank in 1884. Exposed again in 1887 by the Daily Advertiser, she fled to Chicago with investors’ funds, attempting another fraudulent venture until her return to fortune-telling after her 1889 release from jail.

Pyramid schemes

The modern “pyramid scheme” pales in comparison to the elaborate structures devised by Charles Ponzi and Sarah Howe. There’s a stark absence of intricate design and flair, replaced by a high likelihood of collapse in a rather predictable manner, a far cry from Ponzi’s intricate dance of risks and intrigue. The only shared aspects are the promoters’ penchant for flaunting wealth and the schemes’ appeal to specific social groups. These schemes are so prevalent in churches that guides for pastors on identifying and addressing them have been circulated, often quoting biblical references to caution against the allure of promised riches (such as Ecclesiastes 5:5).

At its core, a pyramid scheme functions without exchanging goods, akin to the chain letters of yesteryears now proliferating through email and social media platforms. Take the “Infinity Game,” for instance, promoted at self-help and New Age seminars in the 1980s. It operated on a pyramid structure, with participants giving money to those above them, aiming for an eventual payout many times their initial investment. The crux? Ultimately, the scheme relies on constantly recruiting new participants to sustain the returns, an unsustainable model as the pool of recruits dries up.

In these schemes, manipulating the number of recruits and the amount charged governs profitability and longevity. Perpetrators aim to maximize profits while delaying the collapse, akin to managing a fraudulent enterprise, adjusting tactics for optimal gains. The scheme’s inherent self-termination proves beneficial for the criminal, as it spreads to new demographics after initial cash-outs, making tracing the original fraudster challenging for authorities.

These schemes primarily prey on vulnerable individuals who may be lured by promises of financial gain. Intelligent individuals and those aware of the finite nature of populations tend to steer clear. Sadly, such schemes disproportionately affect vulnerable groups; for instance, the Infinity Game targeted seminar attendees seeking fulfillment, and reports suggest a significant number of complaints about pyramid schemes come from churches in impoverished communities.

A more sophisticated iteration involves integrating tangible goods, encouraging recruits to purchase inventory, sell products, and recruit others, earning commissions. This facade masks the pyramid’s essence and could potentially make it appear as a conventional business. Legitimate businesses sometimes adopt similar sales structures, creating a blurry line between legitimate commerce and pyramid schemes, leading to ambiguity.

However, legal validation doesn’t guarantee fairness. For every successful multilevel sales company like Tupperware, there’s an Amway, legally cleared but leaving many disillusioned individuals feeling mistreated. Both pyramid schemes and legal multilevel marketing often cultivate cult-like atmospheres within affinity groups, where faith in the scheme becomes a condition for group inclusion, ostracizing dissenters. While there are success stories, this realm typically doesn’t attract those with quieter or more saintly attributes.

Getting out of hand

The downfall of pyramid schemes encompasses a pivotal aspect present in any enduring fraud—a snowball effect. In the realm of capitalism, money fuels businesses, leading to increased returns through reinvestment, akin to interest accumulating in a bank account. Yet, for fraudsters, compound interest, the catalyst for growth in legitimate enterprises, acts as their adversary.

Fraud lacks the capacity to generate sufficient genuine returns to sustain itself, especially as the perpetrator siphons off funds. At each repayment juncture, the fraudster faces a crucial decision—shut down the scam and escape or expand it, necessitating more extensive deceit to prolong its operation.

Imagine a straightforward investment fraud focusing solely on the investment returns’ mathematics. Suppose you pilfer a million dollars from investors, promising a 25 percent return, but instead pocket the entire sum. A year elapses, and to perpetuate the scheme, you aim to solicit fresh funds from new victims. Armed with an accountant’s “verification” of a 25 percent profit, how much must you seek?

At a minimum, $1.25 million. You’re not only obliged to reimburse investors their initial sum but also the fabricated profits. And it worsens over time. Assuming no further thefts, by the end of year two, those who contributed $1.25 million will expect $1,562,500 back. Continuing for five years implies committing over $3 million in new fraud, rendering the rollover unmanageable, leading to the scheme’s collapse.

Ponzi schemes epitomize this criminal characteristic, visible in frauds necessitating dual bookkeeping. Once funds are siphoned, a disparity arises between the “actual” and “public” accounts, requiring falsification to bridge the gap—either through accounting manipulations or blatant lies about non-existent funds. This chasm invariably expands; public records must maintain a façade of profits and lucrative investments to sustain trust, while the authentic records don’t mirror similar growth due to the disparity between fact and fiction and the criminal’s extraction of valuables.

Involvement of borrowed funds amplifies the importance of compound interest. Loan repayments become a constant concern, and counterfeit money doesn’t settle genuine debts. Fraudsters often take out additional loans to cover earlier payments, escalating the cycle. Credit card frauds exemplify this—a minor fraud with one lender snowballs into a larger scam involving multiple banks. This need to manage ballooning loans drove entities like OPM Leasing deeper into criminality.

Amateurs and novice criminals often stumble here. A shoplifter or a robber might commit a few crimes and lay low, but an embezzler, rogue trader, or tax swindler faces the daunting task of concealing the crime’s existence, leading to a continuous series of escalating offenses. Small-scale white-collar criminals often breathe a sigh of relief upon capture. As expressed by a seasoned long-firm veteran:

Often these businesses, run by people of rare energy and intelligence, could have been very successful. There is nothing sadder in some ways than the managers of a fraudulent firm who then find they have a commercial success on their hands. They try desperately to repay their first plunderings, but the canker in the rose spreads inexorably and eats it all up.

One method to bridge the gap involves taking substantial risks with the yet-untouched embezzled funds. This tactic characterizes how “rogue” traders escalate their concealed losses to catastrophic levels, capable of imploding entire banks. Surprisingly, even a minor embezzler might resort to using company cash at a racetrack or casino, hoping for a last-ditch effort at redemption.

Given the havoc caused by compound growth, how do frauds endure for extended periods? Managing the snowball effect poses a significant challenge for fraudsters aiming to siphon large sums or perpetuate schemes beyond a single billing cycle. Sustaining a significant theft necessitates perpetuating the fraud. Whether without an escape plan or inadvertently involved, the fraud must show growth. Yet, the returns and repayments owed to others compound, demanding ever-increasing fraudulent activities to maintain the status quo. This snowball effect stands as the primary hurdle in handling an ongoing fraud. Contemplating its management raises queries about what truly defines a “Ponzi scheme.”

The misleading name

If you delve into definitions with precision, it becomes apparent that labeling a scheme a “Ponzi scheme” can be frustrating. The term fails to distinctly define a particular form of fraud and is broadly applied to encompass various fraudulent activities. Typically, in financial glossaries and even on the SEC website cautioning investors about pyramid schemes, the term “Ponzi” fraud is often linked to using funds from new investors to pay off previous ones. Yet, this characteristic mirrors any fraud seeking to perpetuate itself over a substantial period. Any scheme beyond a quick hit-and-run operation requires a continuous inflow of funds to sustain, as the fraudulent activity itself lacks the capability to generate sufficient funds.

Applying this criterion widely, entities like ZZZZBest Carpet Cleaning, OPM Leasing, Enron, Women Empowering Women, and Bernard Madoff would all fall under the umbrella of “Ponzi schemes.” However, a term this broadly defined loses its utility as a means of classification.

Furthermore, the SEC’s definition of a Ponzi scheme is so expansive that it encompasses legitimate economic activities that aren’t fraudulent at all. Instances where a family secures a home-equity line to repay a car loan or an individual takes out student loans while making minimum credit card payments fall under this definition. Despite resembling a Ponzi scheme scenario, in these cases, there’s no fraudulent intent, and the debts often get settled using increased future income.

Economist Hyman Minsky highlighted that the “Ponzi model,” involving temporarily acquiring new debt to manage existing borrowings, is prevalent in American business practices. It’s a standard method of financing real estate development and forms the core of Minsky’s economic cycle theory. In prosperous economic conditions, businesses are incentivized to engage in riskier, longer-term projects, leading to the creation of Ponzi-like structures with escalating debt levels. This process heightens the overall system’s riskiness and lays the groundwork for future economic downturns.

The Social Security Ponzi Scheme and other fallacies

This isn’t just a matter of nitpicking definitions; it has enduring and substantial political ramifications because the mischaracterization of a “fund that takes in cash from new investors to pay out to past investors” easily aligns with the Federal Old Age and Survivors Insurance Trust Fund, commonly known as “Social Security.” This mislabeling has been used to advocate for its dismantlement, pushing for alternatives more amenable for financial service industry fees.

This claim gains ground due to widespread misunderstanding about pension economics. Many presume that a government pension scheme operates akin to a standard savings product. Simplifying things significantly and overlooking actuarial science and taxation intricacies, a retirement savings vehicle (like a 401(k) plan) functions by contributions during employment and subsequent withdrawals in retirement. Though various investments are involved behind the scenes, to the investor, it seems like a simple transaction—money goes in, money comes out. This is known as a “fully funded” pension approach, where a visible savings balance corresponds to specific pension liabilities.

Another pension approach, prevalent in developed economies, is the “pay as you go” system—a more archaic model where individuals work until they cannot anymore and rely on the working populace for support through taxes once retired.

However, the catch arises at an economic scale: a fully funded system isn’t feasible. Retirees require goods and services produced by the current workforce, not those produced decades ago. Very little in the economy endures over retirement timescales. Therefore, saving for retirement essentially establishes claims on the future output of workers, and estimations of pension liabilities by governments imply future taxation to fund retiree pensions.

This complexity leads to confusion when accounting for Social Security’s retirement trust fund. Its liabilities estimate future pension commitments, but there’s no corresponding “asset” as these future payments rely on the government’s ability to tax future workers. Consequently, the trust fund’s balance involves the allocation of fictional US Treasury Bonds. But in essence, these bonds mirror the future pension liabilities themselves. Engaging in debates about the Social Security OASDI Trust Fund involves recognizing it more as a public recording of the promise to pay pensions than an actual fund.

Yes, Social Security collects contributions and disburses them to pensioners, without accumulating savings—an implausible feat given its nature. If defining a Ponzi scheme involves this flow of contributions, then Social Security might qualify. However, it’s evidently not poised to implode like a classic Ponzi scheme. Any potential future shortfall wouldn’t trigger a sudden collapse akin to a financial Ponzi; rather, it would signify a deeper economic issue, possibly an inadequate workforce or sluggish productivity growth, leading to an imbalanced worker-to-pensioner ratio. This hypothetical scenario wouldn’t unveil an empty Old Age and Survivors Insurance Trust Fund in one dramatic instance.

The true meaning of Ponzi

So, defining something as a Ponzi scheme solely because it acquires new debts to settle old ones isn’t sustainable. But is there any meaningful aspect to this classification? If there is, it must bear some resemblance to Charles Ponzi’s original scheme and the Ladies’ Deposit Bank.

Certainly, utilizing fresh victims to repay prior ones is a characteristic, yet not the sole significant one. As we’ve highlighted, this isn’t a distinct strategy for a fraudster; it naturally arises from the decision to establish a fraudulent entity that persists over time, with the fraudster consistently siphoning a portion of the cash, unlike instances where the criminal seizes all funds (as seen in Vincent Teresa’s bust-outs).

Why opt for this approach? Initially, seizing everything might seem preferable to taking a fraction, and a fraud that dissolves quickly might appear less risky than one prone to scrutiny. However, this has to be weighed against the fact that such a fraud is limited in scale. Generally, economic entities grow from small beginnings rather than starting as large entities outright. Much like founders of legitimate startups realize, owning a 10 percent stake in something substantial often outweighs owning 100 percent of something limited by the founder’s personal network. To siphon a significant amount via fraud, one often contends with issues akin to legitimate business growth. Therefore, the second key characteristic of a Ponzi fraud is its design to establish an institution that persists indefinitely and expands exponentially, compounded by the need to fabricate returns on embezzled funds.

Another characteristic preserving the essence of the popular Ponzi definition relates to the economic institution it exploits and corrupts, akin to our taxonomy encompassing long firms, counterfeits, control frauds, and market crimes. As previously hinted, many schemes branded as Ponzi schemes aim to undermine one of the “social technologies” crucial in managing business relationships—the institution of “maturity dates.”

Debt, under normal circumstances, maintains an arm’s-length relationship where parties don’t delve deeply into each other’s affairs. But when things go awry, debt transforms into a relationship centered on control and power. This arrangement economizes on information collection, especially for lenders assessing borrower reliability. However, the volatility lies in unexpected changes. It’s not necessarily bad loans that trouble lenders, but good loans that turn sour due to shifting conditions or new insights about the borrower’s credibility.

To grant lenders flexibility, debt includes “rollovers” or “maturity dates.” Loans aren’t typically extended for the entire period needed by the borrower; instead, they’re offered for shorter durations, allowing lenders the option to demand repayment earlier. This practice involves either extending the loan or forcing the borrower to seek a new lender. This normal business practice involving the inflow of new investments to repay old ones contradicts the SEC’s flawed Ponzi scheme definition.

Besides offering lenders an early exit strategy for their funds, maturity dates serve as a protective measure against fraud. At each maturity date, the borrower must reassert their eligibility for the loan from the initial lender or another. Additionally, lenders can influence fund usage by threatening to withhold rollovers. By placing a borrower on a shorter leash, lenders retain control. Conversely, when funds don’t require repayment, control shifts entirely. This scenario, hoped for by Barry Minkow, Mark Morze, and the ZZZZBest group, where an IPO clears all creditors, demonstrates that equity shares without maturity dates relinquish control. While public offerings necessitate stringent checks and explicit public statements, ZZZZBest’s downfall was catalyzed by such public scrutiny, though the IPO strategy initially proved effective.

Straining against the leash

Shortening the leash allows for more opportunities to withdraw funds before things take a turn for the worse. It compels the borrower to respond promptly to inquiries. However, this strategy consumes significant time and effort, potentially distracting the borrower from managing their business effectively. Hence, it’s usually a fallback rather than the initial setup.

In essence, borrowed money typically comes with terms requiring renewal. Thus, any fraud that endures over multiple loan maturity dates must somehow undermine the use of rollovers as a means of oversight and control. This final Ponzi trait delineates a fraud as a Ponzi scheme based on how it manages the financing renewal and persuades investors and lenders to reinvest rather than demand cash repayments. Fraudsters’ strategies to evade this oversight hinge on how investor renewal rights are structured.

The most direct approach to handle maturities is by calendar-based scheduling. Charles Ponzi’s notes matured in ninety days, offering a 50 percent interest payout. Investors could either receive $1.50 for every dollar invested or reinvest in new Ponzi notes. Opting for the latter usually benefits the fraudster in the short term, conserving the need for immediate cash. Barry Minkow and ZZZZBest similarly encouraged investors to roll over restoration jobs, minimizing the necessity for cash, but ultimately accelerating the scheme’s growth and imminent collapse. The risk calculation conducted by an anonymous Boston Herald correspondent forecasted Sarah Howe’s savings bank’s likely collapse date based on this problem.

Another method ties the debt’s equivalent maturity date to the conclusion of a business-related event linked to the funds’ repayment. For instance, ZZZZBest investors funded restoration jobs expecting repayment upon Barry’s receipt of payments from fictitious insurance clients. Agricultural frauds, historically prevalent, operated under similar principles.

The concept of compound interest traces back to ancient times, mirroring the compound growth of animal populations or crops from seed. This understanding influences investment decisions. For instance, the Pigeon King International fraud exploited farmers in Canada by promising high returns on breeding pigeons, which were later revealed to be worthless. Similar scams involving ostriches, orchids, and other seemingly valuable but market-lacking items exploit investors reliant on promoters for anticipated returns.

Regulatory frameworks differ for investment schemes involving physical items like livestock compared to standard investments. Securities regulations typically don’t apply, creating opportunities for fraudulent schemes to evade stringent checks unless noticed by regulators or courts.

The agricultural repayment cycle’s eccentricity limits the potential investor base, inconvenient for legitimate investments but perilous for frauds. Fraudulent schemes reliant on continuous growth collapse when their investor base dwindles. To perpetuate a significant fraud, it’s crucial to present it as a legitimate investment opportunity.

Bernard Madoff’s scheme was a refined form of the Ponzi model, leveraging clients’ behavioral tendencies. Although investors legally could request their funds within ninety days, many left them in the fund longer. Unlike Ponzi or Minkow, Madoff avoided the hassle of regularly paying investors by resetting the clock if no redemption request was received. This method, common in fraudulent economics, cuts checking costs by establishing trust after an initial verification, susceptible to attacks via faked initial verifications or trusted parties turning untrustworthy later on.

Hedge-fund frauds

Madoff exemplified both these failure modes. Initially a (mostly) legitimate securities brokerage, he morphed into a (completely dishonest) investment manager while also falsifying numerous trading records. However, like Ponzi, Bernard L. Madoff shouldn’t exclusively be linked with hedge-fund fraud. Almost a decade earlier, a similar case involving Bayou Capital LLC and its owner Sam Israel had set the stage. Despite their differing personalities—Madoff being a respected community figure and former NASDAQ Stock Exchange chairman, while Israel was a lifelong criminal and drug addict associating with ex-CIA assassins—their approaches were remarkably alike.

Firstly, they controlled information flow. Each had an accomplice—Madoff partnered with Frank DiPascali, while Israel had Dan Marino (not the quarterback). Both were adept at fabricating investment returns and navigating the compliance process. The distinction lay in their methods: DiPascali falsified trading records sent to an inept accounting firm, whereas Marino counterfeited the accounts themselves (credited to a fabricated audit partnership, “Fairfield-Richmond”), timing their dispatch late on Fridays to bury them in the weekend mail, deflecting scrutiny until Monday.

Their second step involved managing fund growth to suit their financial needs. Hedge-fund mechanics involve annually extracting a percentage as a “management fee” from the fund’s assets and a portion as a “performance fee” from any investment profits. Reporting false profits allowed them to tailor earnings to personal needs, albeit every falsely reported profit contributed to the base for future compound returns, enlarging the fraud. This posed a risk, necessitating careful growth management. Ideally, incoming funds from new sales should cover outgoing funds (investor withdrawals, fees, and potential theft), aligning with the first Ponzi principle.

However, managing investors was crucial to prevent unwanted scrutiny. Madoff targeted charities and wealthy individuals initially, causing significant financial damage to Yeshiva University. Later, he involved “feeder funds,” ensuring their dependence on him for business and discouraging inquiries. Bayou Capital, on the other hand, avoided affluent individual investors prone to asking questions. Instead, they targeted money managers, acting as a buffer between wealthy investors and the fraudulent practices at Bayou.

The fraudulent hedge funds’ perceived growth due to consistently excellent published performance numbers influenced investors to maintain their investments. Demanding too many redemptions risked irking the principals, potentially leading to refusal to manage the investors’ money.

The two hedge-fund frauds concluded differently, aligning with their founders’ styles. Israel persisted despite 9/11’s turmoil, driven by a belief in extraordinary investments and advice from a potentially deceitful associate, ultimately faking his death. Madoff, however, let the discrepancy between real and false records widen. Although there were sporadic warnings about statistically improbable returns, these criticisms failed to gain traction. Ultimately, the 2008 crash halted his operation, drying up inflows and forcing him to seek old friends’ favors and borrow money, ultimately leading to staggering amounts of fictitious assets in the Madoff insolvency.

This extreme manifestation of the snowball effect and the sophisticated execution of a Ponzi scheme underscored the power of compound interest. Yet, another misconception tied to the Ponzi scheme’s intuition, with political repercussions, emerges from examining Bayou Capital’s collapse.

Federal Reserve conspiracy theories

During the downfall of Bayou Capital, Sam Israel engaged in behavior akin to many investors, albeit on a grander and less controlled scale. He pursued increasingly risky assets, knowing that exceptional returns alone wouldn’t sufficiently alter his predicament, but a slim chance of substantial gains could rectify everything. If he had invested early in Facebook or a similar venture, this tactic might have succeeded, but instead, he chose a high-risk, high-return asset category known as “prime bank securities.”

The prime bank securities market is purportedly a method through which the Federal Reserve injects money into the economy. Allegedly, a select consortium of private banks, primarily from the large investment banks that collectively own the Federal Reserve System, along with some foreign and global institutions sharing ownership and business ties, fabricates “prime securities.” These are then exchanged among themselves at a significant discount—say, paying $1 million in cash for every $1 billion in face value. Subsequently, the Federal Reserve purchases these securities at face value, yielding significant profits for the owner. Occasionally, a wealthy investor might temporarily participate in this syndicate, acting as a middleman for transactions due to a temporary funding imbalance or discreet dealings, ostensibly reaping outsized profits. However, this narrative is entirely fallacious. The Federal Reserve isn’t owned or controlled in such a manner, nor does it execute monetary policy in this fashion. The depiction of the insiders allowing outsiders into this fictitious market doesn’t hold logical ground.

The “prime bank securities” or “prime bank guarantees” market is a scam preying on affluent individuals and occasionally unsophisticated business treasurers. Fraudsters insinuate their affiliation with parties occasionally allowed to operate within this market, promising access to victims in return for substantial upfront fees. The scammer’s ideal scenario involves getting victims excited about entering the market, often following secretive meetings with powerful “associates,” leading them to transfer substantial funds into a brokerage account where the fraudster has joint signing authority. Predictably, events take a sharp turn soon after. While economically straightforward, prime bank fraud is intriguing from sociological and criminological viewpoints. Despite their criminal actions, prime bank fraudsters appear to genuinely believe in the market’s existence, even reinvesting their fraud proceeds into other schemes. When caught, many insist on their intent to repay victims from an imminent “big deal,” viewing themselves as sophisticated financial operators forced into crime to sustain their prime bank trading business.

This phenomenon serves as a captivating case study for those studying mass delusion and psychopathology. The obscure nature of money contributes to such delusions. While the description of prime bank trading is fallacious, the complexities of genuine Federal Reserve monetary operations, especially in the era of quantitative easing, might not appear drastically more comprehensible or less deceitful. The Federal Reserve System inadvertently feeds conspiracy theories due to certain aspects of its functioning, although claims of it being owned by wealthy families are baseless. Each regional Fed does issue shares to supervised banks and used to pay dividends on these shares. With the gold standard abolished, central banks possess unlimited money-printing capabilities, historically leading to abuses of power and hyperinflation—a phenomenon resembling the compound growth of a Ponzi scheme. Convincing individuals who question the legitimacy of the modern banking system of its authenticity can be quite challenging.

The key lies in grasping the fundamental principle rather than getting caught up in the mechanics. Similar to a rocket ship where the principle is simple while the intricacies involve complex plumbing, money creation in the modern banking system, as stated by J. K. Galbraith, is “so simple that it repulses the mind.” Essentially, it’s just IOUs. Your friends might write an IOU for twenty dollars, mirroring what banks do. Despite seeming different because of the intention to swap it for cash or a bank transfer, it’s essentially exchanging one IOU for another. Money operates on trust, an almost unbreakable system—almost.

See also

• Fraud: The Art of Stealing Wealth and Trust - Cooked Books (Ch. 6)
• Fraud: The Art of Stealing Wealth and Trust - Counterfeits (Ch. 5)
• Fraud: The Art of Stealing Wealth and Trust - The long firm (Ch. 3)
• Fraud: The Art of Stealing Wealth and Trust - The basics (Ch. 2)
• Fraud: The Art of Stealing Wealth and Trust - The way of the world (Ch. 1)