A History of the Ponzi Scheme

Joel Anderson |

While the banking industry was in the midst of a horrifying collapse in 2008, a scandal broke that managed to make even the most over-leveraged, sub-prime exposed hedge funds and investment banks look good. Bernard "Bernie" Madoff horrified the public with news that his entire investment company was a giant Ponzi Scheme, defrauding its investors to the tune of $18 billion. Including fabricated gains, the total amounted to $65 billion. It's difficult to believe that so much money could have been sunk into a scam with a premise so simple, or how Madoff could have kept it going for decades without anyone realizing what was happening. Even as the entire financial industry was being shook to its core by the housing crisis, Madoff's scam shook things even harder.

However, Madoff's scam was really a continuation of a grand America tradition of sorts. Of all the classic cons, from selling the Brooklyn Bridge to "pig in a poke" (the phrase "let the cat out of the bag" actually dates back to a medieval con in which one would sell a cat to an unsuspecting mark by concealing it in a bag and claiming it was a suckling pig), the Ponzi Scheme may be the one that's the most notorious. The mere fact that it reached so large in size speaks to the nature of the con. There have been many famous Ponzi schemes over the years, none as large as Madoff's, and they all trace back to a single Italian immigrant living in Boston in 1919.

The Original Ponzi Scheme

Charles Ponzi arrived in Boston in 1903 with $2.51 in his pocket. He would move to Montreal where he became a bank manager. It was there that Ponzi discovered that his superior was falsifying gains and paying investors with newly opened accounts. His superior would ultimately flee to Mexico with the gains, but it foreshadowed Ponzi's destiny. Ponzi would go to prison twice before returning to Boston, once for forging checks and again for attempting to smuggle illegal immigrants into the United States, but he landed in the city again in 1918.

Amazingly, the origin of the first Ponzi scheme was not, in fact, a scam. Ponzi actually identified a loophole in the way international postage functioned that could create massive profits. Ponzi discovered postal reply coupons, which allowed people in one country to purchase postage in the other country at a fixed rate, had left open a huge arbitrage opportunity. Ponzi realized, because of inflation in his native Italy following World War I, the cost of postal reply coupons (PRCs) there was far lower than the redeemable value for American stamps.

By using relatives in Italy to buy PRCs and have them sent to him in America, he had a simple method for making big profits. Ponzi found that, after exchange rates, his profits on each transaction were in excess of 400 percent.

A Fine Idea Ruined by Scale

Where Ponzi ran into trouble was in selling it to the public. Ponzi opened a company called the Securities Exchange Company (ironically, the very similarly named to the Securities Exchange Commission that fell asleep at the switch on Bernie Madoff so many years later). He promised investors that he could double their money in 90 days, a claim that wasn't unreasonable based on the loophole he had discovered. By May of 1920, Ponzi had made what would today be the equivalent of over $4.5 million and the people of Boston, particularly the working class immigrants, were scrambling to invest with him.

Ponzi ran into trouble, though, when the loophole that created his profits closed. As Ponzi accumulated more and more capital from eager investors, it became impossible for him to purchase PRCs, cash them in, and sell the American stamps he received. However, Ponzi continued to use money from incoming investors to pay off his older investors. As local newspapers began investigating, Ponzi's scheme eventually collapsed as panicked investors made a run. In the end, Ponzi's past in Montreal was exposed and his scam collapsed under its own weight. Ponzi, who was revealed to have difficulty adding, ended up in prison and lost his investors the modern equivalent of some $225 million.

Notoriety

Over the years, Ponzi's brand of con has become a classic scam that has been repeated hundreds of times, in some cases with hundreds of millions and even billions of dollars on the line. It remains a fascinating facet of American history (for those who have never fallen victim to one), particularly because the executor of the scheme rarely, if ever, manages to escape in the end. For Charles Ponzi, though, it must be noted that for a humble immigrant who arrived on American shores with next to nothing, his notoriety in the end represents its own, infamous brand of the American dream.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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