Where does the money go in a Ponzi scheme

Cartoon by Chuck Asay via Liberty News

We had been talking about the Madoff affair when a friend asked me where does the lost money go in a Ponzi scheme. Of course, the answer depends on the specifics of the scheme. And, of course, people who run Ponzi schemes almost always skim off some of the money flowing through the scheme to enrich themselves. It occurs to me that others might be interested in my answer.

Think about a scheme which does no investment. The organizer takes incoming funds and puts them in a big pile. He takes his cut off the top, and then takes funds out of the pile to pay "interest" to the investors. In that case, when the scheme is busted, the money that appears to have been lost has actually gone to the operator and the investors. If the remaining funds are distributed according to the "book value" of the investments -- all the money that the investor paid in -- the earliest investors may still have made money, but the last investor lost lots. Of course, all the investors have also foregone the interest that their investment would have made had they put it in something safe like government bonds.

Assume instead that the operator actually invests the money in the stock market. Say he makes five percent on the investment, but pays out 10 percent to the investors (to make his fund look good compared to other funds). What happens is that the actual value of the stock portfolio steadily falls below the total nominal value of the investors contribution to the fund. The end result is the same as the earlier case. The lost money winds up in the pockets of the organizer and the early investors.

But assume that the Ponzi scheme collects so much money, and invests it in such limited set of stocks that it inflates the value of the cost of those stocks above their true value. Assume further that the movement in the selected stock attracts other speculators and a bubble is created. Of course such bubbles eventually burst. Assume further that the burst bubble results in the crash of the Ponzi scheme, and it sells off its stocks at the final low price. In that case some of the money given to the Ponzi scheme by its investors goes to those who sold the stocks to the Ponzi scheme, and who took profits. Some of course still went to the scheme operator and some to the early investors.

In the Madoff case, there seems to have been one more factor. Other firms apparently collected funds from investors, took a fee off the top, and then gave the money to Madoff to manage with the funds of his direct investors. In this case, of course, some of the lost funds would have wound up in the pockets of the intermediaries.

I hope the explanation helps.