Ponzi is a commonly used term when referring to scams and schemes, especially with the recent arrest of Bernard L. Madoff earlier this year when he was caught having stolen an estimated $20 billion over the course of nearly half a century. Most people do not fully understand what a Ponzi scheme is, how it works, or where it started. It is this lack of understanding that leaves the average investor extremely vulnerable to this trap.
What is a Ponzi Scheme and How Does it Work?
A Ponzi scheme is a fraudulent investment operation that often promises unusually high returns from sources or ideas that are seemingly feasible; ie, risky real estate ventures, complex stock trades or illegal enterprises. However, rather than invest any of the money that has been entrusted to the operator, all of the money is held to fund the lifestyle(s) of the fund manager(s) as well as pay out dividends and matured funds to investors. Paying out investors is done with new funds that come in from a growing number of people investing.
A simplified version of this scheme would be the following: Mr. Moneybags has just opened an investment firm. He is a seasoned investor who had worked in the banking industry for 20 years. His investment firm claims that "bad" bank notes (where borrowers have defaulted) are often sold off to interested parties for as low as 10 cents on the dollar. In turn, they could reasonably collect half the loan balance.
Equipped with this knowledge and some of his own money Mr. Moneybags would not only like to make money helping these poor borrowers whose only other option would be damaged credit for a minimum of seven years, he would also like to bring many other people along.
Excited investors fork over thousands of dollars to Mr. Moneybags in their search of the coveted 15% returns he is offering. Skeptical investors observe, reasoning that 'a good idea today will also be good tomorrow.' After only 30 days, Mr. Moneybags contacts his investors and tells them that the loans they've assumed have been honored, and asks if they would like their money, their interest, or for him to roll it all over into further holdings for a compounded 15% gain.
This is where excited investors become true believers, sometimes entrusting their life savings, taking equity out of their homes, or even borrowing from friends. Skeptics, seeing that the idea produced a true return, will begin to invest. Meanwhile, Mr. Moneybags is looking into enhancing his lifestyle while doing his best to estimate how much of the money he is taking in he will need to keep for those who will want to cash out so as to avoid being caught.
Charles Ponzi and International Postage
Charles Ponzi, an Italian immigrant who came to the United States in 1903, was the first person to really strike it rich with this type of scheme, hence it having his namesake. His idea was simple and legal; his operation was not.
Ponzi had discovered that inflation from WWI had lowered the price of international postage in Italy significantly versus the American dollar. These stamps could be exchanged for US postage, and the postage could be sold. This process of buying an asset in one market and selling it in another is called arbitrage. It is legal and was done in 2002 by Warren Buffett when he purchased millions of dollars of foreign currencies that he exchanged for a significant profit in 2005.
Ponzi claimed the stamps had a profit potential of 400%. Ponzi, however, did not engage in the international stamp market with his investors' money. Rather, he engaged in the Massachusetts real estate market when he purchased an air conditioned mansion with a heated swimming pool in Lexington.
Meanwhile, thousands of people began to invest millions of dollars with a promised return of 50% in 45 days. Within the same year that he started his business, the Securities Exchange Company, he was found to be insolvent when it was reported in the Boston Post that in order for him to have run his company on the premise of trading international postage 160 million stamps would have to have been bought. In reality, only 27,000 were in circulation.
Charles Ponzi went to prison and then started a new operation selling tiny tracts of land in Jacksonville, Florida where he promised large returns within 60 days. Upon being released from prison again in 1934 he was deported to Italy where he worked in the government’s financial section.
Bernard Madoff: Proof That we Never Learn
Over the years there have been many Ponzi schemes. The most recent to come to light was that of former chairman of the NASDAQ stock exchange, Bernard L. Madoff.
Madoff ran a securities company since 1960 that had two parts, one legitimate and one not, which sometimes funded the losses of the legitimate areas of the firm. The Ponzi scheme had over 4,800 investors who were “let in” because of their special status. These special people had let consistent double digit gains compound year after year. Among them were, understandably, actor Kevin Bacon and New Jersey Senator Frank Lautenberg as well as, not-so-understandably, New York Mets owner Fred Wilpon and Austria’s Bank Medici.
After 49 years of deception and numerous reports submitted to such people as the Wall Street Journal, the chief of the NY branch of the SEC, and former NY attorney general, Eliot Spitzer, by investment analyst Harry Markopolos from 1999 to 2008, Madoff was not brought down by the numerous federal investigations he had come under. Rather, as reported in Fortune’s May 11 special report, the only reason Madoff was ever caught was because his investors called for $7 billion last December. With no cash to satisfy the calls, and an inability to raise it on such short notice, Madoff was out of business.
And the scams and schemes only become less believable from here.
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