Bernard Madoff was the head of a multi-billion dollar hedge fund on Wall Street. Today, he was arrested for running a Ponzi Scheme.
For financial beginners, I’m going to break this down to the very basics because this arrest is one of the biggest financial frauds in American history, and the ramifications are potentially enormous. People need to be informed.
First some definitions:
A Ponzi scheme is loosely defined as a fraudent investment scheme that involves promising high returns to early investors out of the money paid in by later investors. Basically, in a Ponzi scheme, the business only makes money by suckering more and more investors into pouring money into the fund. This is illegal because investors think they are investing in an underlying business that will generate profits and revenue and lead to long-term returns to the investors. The head of the scheme knows this will never happen.
A Hedge Fund is a private investment fund open to a limited range of investors that is allowed to engaged in a wider range of risky activities than most investment funds (i.e. your 401k, which is heavily regulated). Hedge funds are able to use methods not available to other investments, like short selling (borrowing shares to sell immediately on the open market), derivative contracts, and leverage (borrowing money to buy securities). Using these different methods allows the fund to “hedge” the risk, like a gambler “hedges” his bets by making a variety of bets.
Complicated? Yes, it is. As a matter of fact, very few people outside of Wall Street understand what hedge funds do and how they make money. There are very few regulations governing hedge funds because they are so complex. Also, generally, the Securities and Exchange Commission only lets really rich people invest in hedge funds.
