style="font-size:15px;"> The Ponzi Scheme
This scheme is often at the root of many investment scams today.
Charles Ponzi (pronounced “pon-zee”) was born in Italy in 1882 as Carlo Ponzi. He grew up there and emigrated to the U.S. in 1903 at the age of twenty-one.
His first stop? Canada. He went to Montreal, where he was convicted of forgery in 1908 and sentenced to three years in prison. After his early release for good behaviour he was soon arrested on immigration charges for trying to assist five other people get into the U.S. illegally. He was jailed again in 1910.
After his release, he spent time in several cities and held various jobs, including dishwasher, waiter and office clerk. He eventually settled down in Boston in 1917, where he worked in clerical office jobs.
On December 26, 1919, Ponzi established a company called the Securities Exchange Company. He had hit upon an idea to make himself rich. It had to do with postal international reply coupons (IRCs). These are coupons that can be exchanged for one or more postage stamps for the minimum postage for an airmail letter to be returned to any other country that is a member of the Universal Postal Union. The purpose of an IRC is to send someone a letter in another country with sufficient postage for them to send a reply. For letters in the same country you can simply use a self-addressed stamped envelope, but for mailings to other countries, using an IRC does away with the need to use foreign postage or currency.
Ponzi claimed that he could make money by taking advantage of different postal and exchange rates in different countries. For example, he claimed he could send $1 to Italy and with the IRC he could buy $3.30 worth of stamps in Boston. He promised a 50 % return in 90 days. In the beginning he actually did pay that rate of return – often in only forty-five days.
To many people, it sounded like a good idea. The money started to flow in.
Within a few months people began lining up at his company’s door. Thousands of people invested their hard-earned savings. At its peak the company was bringing in more than $1 million a week, and that was in the early 1920s.
The problem was that he never really bought the IRCs or even attempted to make any money for the investors. He simply paid the return out of the money that other investors had put in, and he just spent the rest.
It was so devastating that even the U.S. Securities and Exchange Commission (SEC) devotes a page to it on its website.
Here’s what it says:
Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40 % return in just 90 days compared with 5 % for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period – and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons.
Decades later, the Ponzi scheme continues to work on the “rob-Peter-to-pay-Paul” principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.
How could people fall for a scheme that promised such huge returns in so little time? Well, they did, and they continue to do so.
If you look up Charles Ponzi in Wikipedia, under “Similar Schemes” you’ll see a new name: Bernard Madoff – Bernie to his friends.
Bernie Madoff
Bernard L. Madoff was arrested on December 11, 2008 by U.S. Federal authorities in New York City on charges that he perpetuated a massive securities fraud on the investors in his investment hedge fund. Estimates of the losses ranged up to US$65 billion. We now know that this was the total inflated market value of the investors’ money. According to recent federal filings Bernard L. Madoff Investment Securities LLC, the firm Madoff started in 1960, actually held $17 billion in over two dozen funds.
A New York Times article dated December 11, 20081 quotes an associate director of enforcement for the U.S. SEC as calling it “a stunning fraud that appears to be of epic proportions.”
The funds had been widely marketed to wealthy investors, hedge funds and other large institutional investors for decades. In fact there were approximately 77 “feeder funds” all over the world bringing in money that was forwarded to Madoff. Madoff’s funds were popular because they promised high returns with low fees.
It seems that part of the reason that this scheme lasted so long was that the returns promised and reported seem to be high but not outrageously so. For example, one of Madoff’s funds, the Fairfield Sentry Limited Fund, reported assets of US$7.3 billion in October 2008 and claimed to have paid more than 11 % interest each year during its fifteen-year track record, according to the Times article.
I guess Bernie learned his lessons from Charles Ponzi well.
How did he do this? How did he convince dozens of sophisticated investors and financial institutions to trust him with their funds?
Well, one of the reasons is that he appeared to be a nice guy, with little or no ego. He used to tell interviewers that he got his initial earnings to start his firm in 1960 by working as a lifeguard at city beaches and installing underground sprinkler systems.
In fact, I just watched a thirty-four-minute video of Madoff that was posted on YouTube, entitled “Bernie Madoff on the modern stock market.” It was a roundtable discussion on October 20, 2007, shortly after the subprime mortgage crises started in the U.S. with stock markets riding high. One of his employees, a computer programming expert, sits beside him throughout.
During the video, he exudes charm. He said he employs highly educated MBAs, but he himself was “happy to graduate college.” At one point he hired engineers from MIT to help with the computer trading models the firm employs but they “think too much.” That gets a laugh from the audience.
He seems to know what he is talking about. He comes across as an expert. He never interrupts anyone. He’d be the kind of guy you’d want to introduce your kids to if they wanted to get into the investment industry. Well, except for the fact that you now know that he is a consummate con artist.
A couple of the most interesting comments actually come at the end from the audience. One individual in the investment industry makes the point that most people who invest big money in the stock market actually made their fortune somewhere else – in an actual business – and bring the money to the market in an attempt to make more. They did not become wealthy by buying stocks!
His employee, a guy who at the time made his living investing, makes the point that the market is fuelled by greed and fear. He goes on to talk about greed being a slow process, and fear happening fast. When markets are going up month by month, year by year, people get in. Some start early, some late. Some invest a lot, some not so much. When things go bad, the “herd mentality” causes people to panic. The fear of losing money causes everyone to act. They all sell. Markets crash, and they crash quickly.
Yeah, we know.
I realize that
