Just before he was arrested on charges of federal securities fraud Thursday, fund manager Bernard L. Madoff is alleged to have told his employees that his firm was "basically, a giant Ponzi scheme."
Vinny Catalano, president of the New York-based investment firm Blue Marble, says a Ponzi scheme involves borrowing from Peter to pay Paul. But it doesn't stop there.
"A Ponzi scheme is what they call a fraudulent investment," he says. For an investment fund, the process starts when a fund manager approaches potential clients for money to invest. The clients loan the manager a certain amount, hoping to make a profit in the market.
The hedge fund manager indeed begins sending the clients a regular check -- but the money isn't coming from profits in the market. Instead, the manager has gone to other clients and asked them for loans under the guise of investing in the market. He or she uses the new money to pay the old clients, making it look as though the initial investment is doing well. That's an illusion.
"The actual returns to the investor come from new money that's raised," Catalano explains. "So you borrow from Peter, you pay Paul. Then you borrow from John to pay Peter. It just keeps going on and on, until the whole thing collapses of its own weight."
One way Ponzi schemes unravel is when individual investors unwittingly interrupt the chain by asking for their money back. Only then do they realize they've been lied to about the source of their returns. The Ponzi schemer has put them in the position of lending to others without knowing they were taking that risk.
The scheme gets its name from Charles Ponzi, a swindler in the early 1900s.
How can people protect themselves from Ponzi schemes? Catalano advises researching fund managers and double-checking the paperwork involved. "Frankly, there's a fair amount of trust that goes into it," he says.