Was Charles Ponzi’s scheme a “Ponzi fraud”?

Mention the subject of financial fraud – especially pyramid schemes – and one name that springs to mind immediately is Charles Ponzi. He has given his name to the kind of get rich quick scheme where early investors are promised impossibly high returns, but are paid these returns with the investments of punters who pile in later as news spreads and the gold rush starts.

There is no doubt that Ponzi was a crook. He spent time in jail more than once for forgery and theft, and spent most of his life planning audacious swindles of one sort or another. But ironically, the fraud that bears his name arose not out of one of these plans but from an attempt by Ponzi to launch an honest business.

The problem was that his honest business was so wildly successful that it snowballed within months into a multi-million dollar house of cards that was beyond anyone’s ability to control. Just how this came about, and how Ponzi’s name came to be associated with such crimes, is a story of exceptional interest.

Ponzi was born in Italy in 1882, spent most of his life as an immigrant to the U.S., and died in Brazil in 1949. He wrote an amazingly candid autobiography in 1936, The Rise of Mr Ponzi in which he described all his frauds in meticulous detail.

After being released from prison in 1918, Ponzi settled in Boston and tried working at several menial jobs. He then hit on a brilliant idea. He rented an office and set up as an agent selling goods made in overseas countries like Italy to U.S. markets. He soon discovered that there were magazines and directories that offered this service and in which overseas manufacturers advertised. He also discovered that these magazines had poor circulations (less than 50,000) but charged high rates for ads – up to $500.

He thought there would be room in the market for a new publication with wider circulation so he dreamed up The Trader’s Guide – a kind of prototype Yellow Pages. This venture didn’t take off but it sparked off his big scheme. Ponzi opened a letter from Spain and found that a Spanish company had written to him asking about ad rates for The Trader’s Guide and enclosing an International Reply Coupon or IRC.

IRCs were the result of a 1906 treaty by the Universal Postal Union, to which almost all countries in the world were signatories. They were designed to enable a person in one country to write to a recipient in another, enclosing an IRC, which could be exchanged at the destination post office for a return stamp. Each IRC bore the wording “This coupon may be exchanged at any post-office of any country in the Universal Postal Union for a postal stamp of the value of 25 centimes, or its equivalent.”

What Ponzi now noticed was that – because of the difference in exchange rates between the U.S. dollar and Spanish Peseta – the IRC from Spain could be exchanged for U.S. stamps worth more than their Spanish equivalent. That there was a price difference in IRCs that he could arbitrage.

In the case of the Dollar versus Peseta the margin was only 10%. So he mailed a $1 bill to friends in Italy, France and Spain, asking them to buy stamps and send them to him so he could find the best country to target. The biggest difference he found was with IRCs from Italy, where the gross margin was a whopping 230%.

Although contrary to the spirit of international agreement and cooperation, there was nothing illegal about Ponzi’s scheme. Every government was bound by law to print and offer IRCs at their currency equivalent of 25 centimes. No Post Office could refuse to redeem the coupons by international law. They were not intended to be used as currency, but there was nothing to prohibit it.

Unable to resist a touch of blue-sky blather, even with a legal scheme, Ponzi incorporated “The Securities Exchange Company” and began using every dollar he could earn or borrow to send to relative and friends in Italy, asking them to buy IRCs and mail them back to him for redemption at the U.S. Post Office for U.S. stamps, which could then be sold.

Ponzi had found a fool proof way to make a lot of money honestly, just by buying and selling postage stamps. His problem was that he had no capital of his own to invest and no credit record. He solved this problem by asking friends and relative to invest small sums – typically $10 – as an experiment. Ponzi describes himself what happened next.

“People gambled with me as I thought they would. They gave me ten dollars as a lark. When they received fifteen at the end of 45 days, all sense of caution left them. They plunged in for all they were worth. They brought their friends along. The legion of my investors grew by leaps and bounds. Each satisfied customer became a self-appointed salesman. It was their combined salesmanship, and not my own, that put the thing over. I admit that I started a small snow ball down hill. But it developed into an avalanche by itself.”

At this stage, the scheme was still legal and really was a license to print money. Soon Ponzi was besieged with offers of money. Up until January 1st 1920, Ponzi had 18 investors who invested a total of $1,770. One month later, in the first week of February, Ponzi paid these early investors $2,478 – around 40% profit.

Five months later, at the end of July 1920, Ponzi had 30,219 investors who had pumped some $15 million into the company, against a promise of a 40 to 50% return within 90 days.

Word spread rapidly in Boston of what Ponzi himself called his “50 per cent racket” and questions began to be asked by police and city officials. Ponzi says he was able to explain the legitimate nature of his transactions satisfactorily and no action was taken. However, he also as good as says he was paying off the police to turn a blind eye – a practice that in 1920 was commonplace, especially where confidence tricksters were concerned.

Ponzi needed somewhere to stash the avalanche of money pouring into his office (reportedly peaking at $250,000 per day) and he settled on the Hanover Trust Bank of Boston, a small local bank catering mainly to Italian immigrants. He also set about buying up shares in the bank so that before long he had a controlling interest. His banking transactions thus became hidden behind a bank that he himself controlled.

The Local newspaper, the Boston Post, although initially writing favourably about Ponzi, began to investigate his affairs. It asked Clarence Barron, the financial journalist who headed the Dow Jones company to look into the scheme. Barron noted that to cover the investments made with the Securities Exchange Company, 160 million postal reply coupons would have to be in circulation. However, only about 27,000 actually were. The United States Post Office said that postal reply coupons were not being bought in quantity at home or abroad.

To help combat the bad press he was now attracting, in July 1920 Ponzi hired a top Public Relations man, William McMasters who had handled PR for several prominent public figures, including Calvin Coolidge.

At first, McMasters delivered a major PR coup for his new client, arranging a positive interview with the Boston Post. The paper splashed the story of Ponzi’s promised high rates of return on the front-page on July 24, 1920, under the headline “Doubles the Money Within Three Months.”

In private, though,. McMasters was starting to have his doubts. “I have never heard of such steady returns on any investment,” he wrote. He started going carefully through all company records and came to the startling conclusion that “the only money [Ponzi] had in his hands as of right now was money taken from investors,” adding, “The huge profits that he discussed so glibly were mythical and non-existent.”

“Once I had reached that conclusion,” McMasters said, “I knew that I was faced with a duty that I owed to the public if I expected to stay in business for the rest of my life.” That night, he said, “I decided to write the exposé of his fantastic story.”

McMasters sold his story to the Boston Post for an astonishing $5,000 plus a $1,000 bonus if the story went down well and increased circulation. In fact, it won the Post a Pullitzer Prize the following year.

The news that Ponzi was “robbing Peter to pay Paul” ought to have finished off Ponzi’s IRC scheme and his Securities Exchange Company. When the news broke, there was a run on the company and wild crowds gathered outside his office demanding their money back. But, confident and bright as ever, Ponzi paid out $2 million in three days to the crowds. In scenes reminiscent of Frank Capra’s It’s a Wonderful Life he spoke to the crowd, passed out coffee and donuts, and assured them they had nothing to worry about. Many changed their minds and left their money with the company.

But if the punters were still happy, the government was becoming increasingly nervous. The story attracted the attention of Daniel Gallagher, U. S. Attorney for Massachusetts. Gallagher commissioned Edwin Pride to audit the Securities Exchange Company’s books – no easy task given Ponzi’s habit of bookkeeping by simply writing investors’ names and details on index cards.

The end came in August 1920 when Massachusetts Bank Commissioner Joseph Allen investigated Ponzi’s Hanover Trust bank. Allen found nothing illegal in Ponzi’s banking practices but he feared the consequences if major withdrawals exhausted Ponzi’s reserves, bringing Boston’s banking system to its knees in a domino effect. Allen was also suspicious when he found out a large number of Ponzi-controlled accounts had received more than $250,000 in loans from Hanover Trust. This indicated that Ponzi was getting large loans from the bank he effectively controlled and made his financing suspect. He ordered two bank examiners to keep an eye on Ponzi’s accounts. On August 9, they reported that enough investors had cashed their checks on Ponzi’s main account there that it was almost certainly overdrawn. Allen then ordered Hanover Trust not to pay out any more checks from Ponzi’s main account.

Massachusetts Attorney General J. Weston Allen released a statement that there was little to support Ponzi’s claims of large-scale dealings in postal coupons. State officials then invited Ponzi customers to come to the Massachusetts State House to give their names and addresses for the purpose of investigating Ponzi’s affairs. On the same day, Ponzi received a preview of Pride’s audit, which revealed that Ponzi was at least $7 million in debt.

Ponzi threw in the towel at this news and surrendered himself to Federal authorities. He was charged with 86 counts of mail fraud because of the letters he had sent to customers informing them of bogus investments and earnings. He went to jail and was deported as an undesirable alien in 1934.

The failure of Hanover Trust brought down five other banks. Ponzi’s investors received less than 30 cents to the dollar and in total lost around $20 million in 1920 dollars (around $225 million in today’s money.)

Given that his whole scheme was initially legal and capable of producing huge profits, what really went wrong? The fatal flaw in his idea seems to be that the effort and overhead of processing hundreds and then thousands and then hundreds of thousands of individual International Reply Coupons was too expensive and time consuming to be financially viable. Ponzi and his staff were overwhelmed with cash and paperwork: they chose to deal with the cash and neglect the paperwork.

But there was a second contributory factor that to my mind is the most interesting aspect of the Ponzi scheme. In the early stages, when the scheme was legal and working well, Ponzi tried to pay out his investors. But – because they saw him as having the Midas touch – they refused to take their dividends and, like many gamblers before and since, insisted on re-investing with him, on letting their money ride. They weren’t content even with 40% or 50% return, but wanted even more. Investors were forcing their money on Ponzi and refusing to let him pay them out.

The great irony is that schemes where the later investors are defrauded at the expense of the early investors are called “Ponzi frauds” Yet in Ponzi’s case, it was the early investors who lost out – because they insisted on reinvesting their hard earned cash with the man they considered a financial genius.


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