How Ponzi Schemes Work

Ponzi Scheme Basics

People often compare a Ponzi scheme to building a house of cards. It must collapse eventually.
People often compare a Ponzi scheme to building a house of cards. It must collapse eventually.

Though it landed him in jail, Charles Ponzi's infamous scam spawned many imitators. The get-rich-quick scheme has proved too alluring for other scoundrels to pass up. However, these imitators need not use the front of international reply coupons to make it work.

The basic framework of a Ponzi scheme can be applied and reapplied in countless contexts. The scheme revolves around the process of paying old investors with the money you get from new investors. The central method remains the same. All one has to do is hook a few investors who are willing to get in early on a once-in-a-lifetime business venture. The details of the investment don't matter too much. What suckers people in is the promise of fantastic returns on investments.

After the schemer has convinced a handful of investors to fork over money, those funds can bankroll a nice car -- or, if the schemer is truly sneaky, he or she can use it to rent office space and buy some fancy furniture. These props will help con the next round of investors. Now, he or she is ready to find more investors. This time, the schemer takes a slice off the top for himself or herself and uses the rest to pay off the first rung of investors with some initial returns. (Some liken this to robbing Peter to pay Paul, but it's not quite the same, as we'll see.)

Eventually, the second rung of investors will need its payout. This is a simple matter of wash, rinse and repeat: The money from a newly recruited third rung of investors can pay off the second rung and deliver more returns to the first rung.

But as the cycle goes on, it gets more complicated. Earlier rungs of investors will get suspicious if they don't continue to see returns. New investors will have to be paid back their initial investment, and the schemer will have to appease them with regular returns. This means that new investors will have to be added to the Ponzi scheme continuously in order to pay all the previous rungs. The schemer is under an enormous amount of pressure to keep adding investors, and one person can only do so much. (This is why the most successful schemes typically involve accomplices, but this merely delays the inevitable.) The scheme will eventually become unsustainable. The upside-down house of cards the schemer has built will finally collapse.