Happy Ponzi Day!
100 Years of Ponzi Schemes
With my history of exposing Ponzi schemes and similar scams, why would I ever say “Happy Ponzi Day!“? I’m saying it today for one simple reason. Today is the 100th anniversary of Charles Ponzi being arrested for the type of financial scam that now bears his name. That’s right. Charles Ponzi was arrested for running his Ponzi scheme on August 12, 1920.
What is a Ponzi Scheme?
The shortest and simplest definition is that a Ponzi scheme is an investment scam that uses money from new deposits to pay unreasonably large returns to existing clients. The scammer literally “robs Peter to pay Paul.” If you want to read a more detailed example, you can find it in this article.
Who was Charles Ponzi?
Let’s take a trip back and see how Charles Ponzi got so famous (actually, infamous – Charles Ponzi was one of the most notorious scammers of the 20th century). Charles was an Italian immigrant to the US who was always looking for a way to make money. Some were legal and some weren’t.
At one point Mr. Ponzi ended up working at a Canadian bank that was in financial trouble. To attract new deposits, it offered higher annual interest rates than other banks, but was having trouble with defaults on real estate loans it made. The bank started using money from new depositors to pay interest owed to existing depositors, exactly like a Ponzi scheme. The bank failed and the owner ran off to Mexico with the rest of the money. There had been a few other similar schemes that Charles Ponzi was very likely aware of. Seeing this kind of scam happen right in front of him likely sealed his fate to give it a try at some point.
How Did Ponzi’s Ponzi Begin?
After quite some time of varying success and failure in jobs both legal and illegal, Charles came up with something new. It was an amazing plan to make large profits. The original plan was both safe and legal, but it wasn’t going to stay that way.
Unlike all the other get-rich-quick schemes, the idea Charles Ponzi had to make money actually worked. If he hadn’t gotten greedy, Charles could easily have kept doing this as a side job or even possibly made enough to support a very nice lifestyle. Instead, he spent a number of years in federal and state prisons on an assortment of charges both for his initial Ponzi scheme and for a real estate scam he started while on the run. He was finally released and deported to Italy in 1934. He died poor and without family in 1949.
But wait. If Charles Ponzi had a real way to make easy money, why didn’t someone else do it? I’m sure a few did, but the rules were eventually changed. Back in 1919, if you mailed a letter to someone in another country and really wanted to be sure they’d write back, you could buy an international reply coupon and put that in the envelope with your letter. The recipient could take the coupon to their local post office and trade it for enough stamps to send a letter back to you. The trick was that you could buy the coupons very cheaply in some countries compared to the face value of the stamps the recipient could get in other countries. In some cases, the ratio was over 4:1. Imagine being able to buy $100 in coupons, redeem them for $400-$500 worth of stamps, and being able to sell those stamps back to the post office for cash. This is true arbitrage – having a market to buy something for less than you are sure to be able to sell it for on another market.
There were expenses. Mr. Ponzi had to send money to people in other countries to buy the coupons and mail them back to him. Then he either had to go to the post office or pay someone else to go. Trading in a stack of coupons for stamps. Then, trading in the stamps for cash took time. It was a sure way to make money. but international mail was slow. Lines in post offices are also slow. People in the countries sending the coupons had to be paid. Charles Ponzi himself would have to spend more and more time at the post office counting coupons and stamps or would have to hire more people. Charles opened a company in January of 1920 He showed off his foolproof money making system and then used the concept, as well as a promise to pay 50% profits in 45 days, as bait to bring in investors. Then there were more investors and even more investors.
From the lack of actual effort in doing more than small test exchanges of international reply coupons, it appears that Charles was already thinking of using new investor money to pay off previous investors when he brought in his first investors. When those investors saw the promised profits, word spread fast and the number of investors grew rapidly, becoming the source of cash to pay the fake profits owed to previous investors. Near the end, new investments were approaching a million dollars each day. In total, Charles collected about $15 million in deposits (maybe more – for a guy who once worked in a bank, he wasn’t very good at keeping detailed financial records).
One financial writer pointed out that it was impossible for Charles Ponzi to make the money needed to pay the promised amounts to all of his investors using reply coupon arbitrage. Back then, the law placed a much greater share of the burden of proof on the writer and publisher, with no way for any demand of audited records from Charles Ponzi’s company. Since only an actual audit can 100% prove even the most obvious Ponzi scheme absolutely really is a Ponzi scheme, Charles won a $500,000 judgement and the critics kept quiet for awhile. Winning the lawsuit made it even easier for Charles to promote his scheme. Modern Ponzi schemes often make threats of legal actions against people who point out flaws with their claims, but current law gives the defendant in such a suit more power to ask for evidence and also draws the attention of regulators who have the power to force audits.
How did Ponzi’s Ponzi End?
Another newspaper ran articles in July of 1920 showing that what the company claimed was impossible and pointed out that Charles Ponzi wasn’t even investing in his own scheme. The US Postal service reported that there weren’t enough coupons in circulation to cover the amount of money being paid to the earlier investors and there was no sign of any large and growing arbitrage in the coupons.
Many investors panicked, but Charles Ponzi told them everything was fine. Many pulled out some or all of their money, but most listened to Charles. He assured them that the magical profits would continue to roll in, if they only would dismiss facts and believe in him.
Charles Ponzi hired a publicist, which seemed like a very good idea at the time. But from inside the company, the publicist could see it was all just a growing scam doomed to eventual collapse. The same newspaper running the series of articles about the fraud paid the publicist to write an article, which showed Charles was about $4 million dollars short of what he needed if all investors decided to cash out.
Things spiraled out of control quickly. On August 12th, 1920, Charles Ponzi was finally arrested.
While he was serving his time in prison, some people wrote to Charles asking if they could still invest with him. Sadly. I’ve seen this same level of blind devotion given to some modern Ponzi schemes. At least Mr. Ponzi had some evidence of a small functional scheme to make money, even if it wasn’t practical on a large scale. Most modern Ponzi schemes just use stacks of investing and trading buzzwords that can usually quickly be dissected to show they are obvious lies. It’s too bad some people just can’t control themselves when presented with the idea of a magical money machine, even years after it’s been audited and proven in court to be nothing more than a pathetic fraud.
Lessons to Learn
If you want to make yourself much more resistant to Ponzi schemes and other types of financial fraud, memorize this phrase and keep saying it to yourself when you are looking at any investment:
If it sounds too good to be true, it probably is too good to be true.
It’s hard to resist the lure of free money with no risk, so here’s one more thing to repeat until it’s burned into your brain:
There’s no such thing as free money.
You should also question any investment. If international reply coupon arbitrage was super-easy and extremely profitable, Charles Ponzi could have kept reinvesting the profits from his first few test runs and scaled up. In a worst case scenario, he might have wanted one or two investors to help speed up hiring a network of employees to handle dealing with the coupons. There would have been no rational reason to pay any investor a return of 50% in 45 days.
So, please join me in wishing Mr. Ponzi a very unhappy arrest anniversary! We can all be happy to celebrate the anniversary of Karma pushing his magic money train off the rails. Oh, and on a personal note, thank you Charles for giving your name to this scam. It’s a lot quicker to write Ponzi Scheme than Robbing Peter to Pay Paul Fraud.
If you want to learn more details about the life and crimes of Charles Ponzi, I recommend the following sources:
To see an example of how a Ponzi scheme could operate and to learn more about these schemes (and their evil little cousins called HYIPS) go ahead and check out my article here: