Ponzi schemes

Definition: Fraudulent investment plans that offer a fast, high return on a seemingly low-risk investment but typically benefit only the promoter and some early investors
Significance: Since Charles Ponzi perpetrated his scheme on a large scale in Boston in 1920, many others have defrauded investors through what have become known as Ponzi schemes. The story of the scheme shows how easily individuals can be attracted by promises of large profits and serves as a cautionary tale for naïve investors.
Charles Ponzi’s scheme was based on a simple and seemingly credible way of making money with little risk. The idea that he sold to investors involved international reply coupons, created in 1906 as a way of sending return postage to someone in another country. The coupon could be bought in one country and redeemed for postage stamps in another. Due to changes in exchange rates following World War I, Ponzi discovered that he could exchange a dollar overseas to buy international reply coupons, which could be sent to the United States and redeemed for stamps worth more than one dollar. However, he did not have a way to convert the stamps back into dollars.
Undaunted, Ponzi set out to find investors willing to finance his idea. With an offer of 50 percent interest in ninety days, which he later changed to forty five days, he was able to attract a few people willing to gamble modest sums on his scheme. As word spread that initial investors received the promised 50 percent, more investors, some willing to invest large sums, began to appear. Ponzi noticed that relatively few of the investors actually took their money at the end of the forty-five-day period, preferring instead to reinvest the initial sum and the interest earned. With increasingly more money being invested each month, very little of it being paid out, and none of it being used to buy International Reply Coupons, money began to accumulate, and Ponzi became a millionaire. Ponzi had started with nothing in December, 1919, and had, by the end of July, 1920, been entrusted by investors with nearly $10 million.

The Downfall

For Ponzi’s scheme to continue to work, money from new investors had to cover the withdrawals of previous investors. Until July, 1920, that had not been a problem, as new people continued to invest, and relatively few withdrew their investments. Questions arose early in July, 1920, when a furniture dealer from whom Ponzi had rented furniture sued Ponzi for $1 million, claiming that he was entitled to some of Ponzi’s profits for having loaned Ponzi money in December, 1919, at the outset of Ponzi’s enterprise. Although the lawsuit was without merit, it aroused suspicions at the Boston Post, which began investigating how the Italian immigrant had come to enjoy such a meteoric rise.
In the midst of the Post’s allegations that his business was a fraud and the attendant scrutiny he came under from a number of government agencies, Ponzi offered to close his business to additional investors until he had been fully investigated. His plan was to claim assets of the Hanover Trust, a bank he had come to control, as his own to prove that he was solvent, buying him time to devise a plan that would allow him to pay off all the investors. He was thwarted when the Massachusetts Bank Commissioner, Joseph Allen, took control of the Hanover Trust, and an audit of Ponzi’s business, the Securities Exchange Company, revealed that his obligations to investors exceeded his assets by about $3 million. By the middle of August, 1920, Ponzi’s house of cards had collapsed.

Ponzi’s End

For his crime, Ponzi spent almost four years in a federal prison and seven years in a Massachusetts state prison before being deported to Italy. The man who had made getting rich quick look so easy died in the charity ward of a Rio de Janeiro, Brazil, hospital in 1949. Investors in his scheme who had not gotten their money out of his business before it was closed ended up with about 37 cents for each dollar they had invested. Ponzi was not the first to perpetrate this type of fraud, but his name continues to be linked to it.