What is a Ponzi Scheme?

Post date: Jul 30, 2012 4:41:32 PM

Preface: My current law clerk, John G. Bowen, has recently started his own website at www.LawBowen.com. He is about to begin his final year of law school at the University of Illinois and intends to start practicing bankruptcy law after taking (and passing) the bar exam in the summer of 2013. In the meantime, he intends to use his website to write about topics that deal with bankruptcy. Although my office does not currently offer bankruptcy services I do know a couple of attorneys in the area that do. More importantly, it is a service that John plans to offer in the Kansas City area once he becomes a licensed attorney.

The article that follows is a re-post from his website.

I recently read the book “Ponzi’s Scheme” by Mitchell Zuckoff. It came up in conversation a few times and people have been asking me, “So, what is a Ponzi Scheme?”

Charles Ponzi was arrested and served jail time in Canada for check forging. This was years before his famous scheme in Boston.In a Ponzi scheme an individual or company offers investors a high interest rate and pays them using funds coming in from new investors. The schemer usually claims to have found some secret or loophole that allows them to obtain such high returns.

Charles Ponzi, an Italian immigrant, orchestrated such a large scale version of this in 1920 that they named it after him. He was not the first and was certainly not the last to try the old financial swindle. It used to be called “robbing Peter to pay Paul” and surely you have heard of Bernie Madoff.

So how did Ponzi actually pull it off?

Well he got pretty lucky, and was desperate. To get a better understanding of the how it worked, it is important to understand his sales pitch. He claimed to have a method of obtaining astronomical, but low risk returns by exploiting an arbitrage opportunity in international reply coupons.

The international reply coupon was a financial instrument that could be redeemed for postal stamps in any participating country (63 at the time). It was useful if you wanted someone to reply to your letter, but you wanted to pay for it. The coupon price was set every year in each country based on currency exchange rates.

After the recent world war some countries were left with vastly depreciated currency, especially Italy. Country officials had more important things to do than change the price of the coupons, creating arbitrage opportunity.

Ponzi developed a plan. First, he would buy lire (Italian currency) with U.S. dollars. Then he would buy the international reply coupons in Italy at the pre-war price (because officials had not adjusted the price for the depreciated lira). Now Ponzi has many more coupons than he could buy with the original dollars. He would then trade them in at U.S. post offices for U.S. stamps, and sell those stamps for cash.

He explained this plan to potential investors, careful to keep the details a secret. In reality, although the idea had merit (it would work on a very small scale), he never figured out how to pull it off. The coupons and international arbitrage in general were too obscure to the average person for them to question the plan.

Ponzi gave his pitch, filled with charm, and offered 50% return in 45 days. If you invested $100, he would give you a note. In 45 days you could exchange the note for $150. Word spread fast, especially once people were actually paid after the first 45 days (although most reinvested the principal and interest right away).

The money poured in. The whole scheme lasted less than a year and at one point Ponzi claimed to have over $15 million (keep in mind, this was 1920). By the very nature of the scam, Ponzi was always insolvent. Each new investor increased his liabilities more than his assets. Eventually it all came crashing down and Ponzi served jail time and was forced into bankruptcy. Twenty thousand people who held Ponzi notes in the end got back less than 40% of their investment.

If an investment sounds too good to be true, it probably is.

Link to article on John Bowen's site: Ponzi Scheme