Thanks to the $50 billion scam recently pulled off by Bernard Madoff, the term “Ponzi scheme” came back into pop culture. It’s one of those side effects of a digital economy that it spread like wildfire and saturated the news and online blogs and forums exposing a whole new generation to the perils of Ponzi. We thought that it would be good to take a deep dive into the origins of the term Ponzi scheme and then circle back to draw parallels to Madoff’s more recent incarnation of this type of graft.
One doesn’t have to look to far anymore to get the definition of almost any term thanks to the free online encyclopedia that we know and love as Wikipedia. They have a great article listed on Ponzi and his scheme which we will summarize and elaborate on. So lets give credit where credit is due and discuss the birth of the Ponzi scheme and it’s Father, Charles Ponzi.
Charles Ponzi immigrated to the U.S. in the early 1900′s and quickly learned English as he picked up odd jobs wherever he could find them. In 1907, he moved to Montreal and became a teller for Banco Zarossi which serviced Italian immigrants. He did well for himself at the bank and eventually rose to the position of bank manager. You would think that the story might end there but this was no ordinary bank. The bank offered double the going rate in interest on bank deposits. Why? Well because the bank had several failed real estate investments and Luigi Zarossi (the bank owner) was covering up those bad real estate investments by using the money coming in from the new deposits. Eventually Zarossi fled the country and went to Mexico with a large portion of the bank’s money. He did however leave behind Ponzi and this little scheme of Zarossi would be a concept that Ponzi would eventually use in several schemes to defraud investors.
Finding himself penniless, Ponzi visited the offices of a former Banco Zarossi customer, Canadian Warehousing and when nobody was looking he stole a check from their checkbook and wrote himself a check for $423.58. He forged a signature and went on a spending spree. When the police visited him after noticing his unusual spending, he admitted what he had done and was sentenced to 3 years in prison. After being released from prison he continued getting into trouble with the law by getting involved in a scheme to smuggle Italian immigrants across the border into the U.S. He ended up serving two more years in prison for his involvement in this smuggling ring. After that, this troubled man found himself in Boston, MA where he married Rose Maria Gnecco and eventually started a business selling advertising in a large business listing/catalog that he created. The business failed as he was unsuccessful at convincing businesses to advertise with him.
Shortly thereafter, something interesting happened that would set the course for the rest of Ponzi’s life. A business in Spain sent an inquiry to him about his failed business listing/catalog and in the envelope had included an International Reply Coupon (IRC) to cover the cost of sending information back to them. At the time, these IRC’s could be bought in one country and then redeemed in another country. Ponzi inquired further and found that he could buy the IRC’s cheaply in Italy and then redeem them for U.S. stamps which could then be returned for cash. He basically found a loophole in the system that allowed him to make a profit by simply buying IRC’s, exchanging them for U.S. stamps, and cashing the stamps. He found a nice little arbitrage opportunity and set out to exploit the loophole.
So Ponzi gathered as much money as he could get his hands on and went back to Italy to buy as many IRC’s as he could so he could exchange them upon his return to the U.S. When he got back he encountered a bunch of red tape with the exchange process and in fact, his scheme actually did not work well at all. Undaunted, he decided to go out and solicit investors to invest in his IRC business and promised them great returns $750 on an investment of $1250. Several people did get a return on their investment and the word began to spread. Interestingly, most people decided to keep reinvesting their profits in the business to make even more money. However, in fact, Ponzi wasn’t buying IRC’s at all instead he was remembering his days at Banco Zarossi and simply paying a few people off from the new investment money he was bringing into his business.
This practice continued for a few years and Ponzi quickly found himself becoming a millionaire with several salespeople carrying out his scam and brining in as much as $250,000 per day into the business. He managed to swindle millions from American investors until a reality check was uncovered by a reporter. He calculated that there would need to be 160 million IRC’s being exchanged in order to generate the amount of money that Ponzi was bringing in and the big problem with that was there were only 27,000 IRC’s in circulation. This led to a downward sprial and eventually a return trip to prison for Ponzi and millions of dollars stolen from investors (estimates of the final dollar amount vary but some say it was as much as $15 million). Undaunted, after his release from prison Ponzi continued to carry out swindle after swindle until eventually meeting his demise again penniless.
Fast forward nearly 100 years and we meet up with prisoner Bernard Madoff who concocted and carried out the largest known Ponzi scheme in U.S. history (estimated at $50 billion). Madoff decided to use the stock market to carry out his fraud. He created an investment firm that had an advantage over others because it had the ability to execute over-the-counter orders from retail brokers. In essence, he could make you more money than you could make anywhere else due to his ability to execute these special orders as well as his ability to make bulk buys that of course an individual investor just had no way of pulling off. Turns out, neither did he. In fact, he actually didn’t execute the over-the-counter orders at all, he simply took in money from investors and made up earnings reports showing them massive returns on their investments which of course, they reinvested in order to keep making even more money. In reality Madoff was using their investments to buy mansions, yachts, jewelry and more for himself and his family. To be fair, he also donated to charities and had the outward appearance of some redeemable qualities (perhaps it was driven from the guilt he felt for his actions).
Though several years separate Charles Ponzi and Bernard Madoff they are both simple criminals that actually didn’t really work that hard to defraud investors. In both cases, their businesses did nothing more than manage cash flow (take in more money than you pay out, it’s that simple). So if someone mentions a scheme to you that sounds too good to be true and all you have to do is give them $1,000 to get back $1,500 in a couple of months, be very skeptical. Verify what they are really doing to make the money to the best of your ability otherwise you may find yourself victim to the next Ponzi scammer.