Ponzi Schemes

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American Fraudsters - Ponzi Schemes

The now-infamous Ponzi Scheme, made famous by Charles Ponzi in 1920, involves the schemer successfully soliciting investments into a fabricated business venture, then using new investments to pay the debts of older investors when they call them in, while keeping a percentage as profit. Ponzi schemes are still common today, and their prevalence can be explained by the psychology both of the scammer and the victim. Below, we have provided an overview of Ponzi's biography, the scheme he perpetrated, and his legacy, as well as an explanation of the psychology that drives Ponzi schemes' continued relevance.

The Ponzi Scheme's Namesake: Charles Ponzi

  • The now-infamous 'Ponzi Scheme' is named after an Italian-born swindler, active in the early 20th century, named Charles Ponzi.
  • Ponzi was born in 1882 in Parma, Italy. In 1903, he made the voyage to America, landing in Boston "with $2.50 in cash and $1 million in hopes," according to a later interview with the New York Times.
  • After working several odd jobs, he moved to Montreal and worked as a bank teller at Bank Zarossi. However, the bank soon went bankrupt due to bad loans, and Ponzi, impoverished, "was sentenced to three years in a Quebec prison after he was caught forging a bad check."
  • After being released from Canadian prison, Ponzi's contempt for the law escalated, now smuggling Italian immigrants into the United States illegally. He was caught doing so, and served two more years in an Atlanta prison.
  • Ponzi returned to Boston in 1917, where he wooed Rose Gnecco, a "small, pretty woman from a modest background" that he met in a streetcar, and married her in 1918.
  • Then, Ponzi took over the Gnecco's family grocery business and promptly proceeded to "make a mess of it." Eventually, he was forced to find another way to make money.

Ponzi's Scheme: Robbing Peter to Pay Paul

  • Ponzi's next idea to make a living was to found an international trade journal, with which he believed he could earn substantial advertising revenue.
  • His loan application to start the journal was rejected, but the idea nonetheless indirectly sparked Ponzi's most significant venture. A business associate in Spain sent him a letter inquiring about the journal, enclosing "an international reply coupon" (IRC), which was a small slip of paper purchased in Spain that could be redeemed for a postage stamp in the United States.
  • Ponzi's correspondent had simply meant to repay Ponzi in advance for the cost of responding to his letter, but the IRC gave Ponzi other ideas. He realized that, in theory, one could purchase an IRC in one country and, with the requisite knowledge of currency exchange rates, could redeem them in another country for a profit.
  • He further reasoned that "purchasing coupons in countries with weaker economies could increase that margin substantially... [and he could] make a financial killing by buying huge quantities of these coupons in certain overseas countries and redeeming them in countries with stronger currencies."
  • The idea was compelling — and that was all that he needed. He called the business idea the Securities Exchange Company to give it an air of legitimacy, and began to seek investors.
  • He told investors that, through a network of agents in foreign countries, he could purchase large quantities of IRCs, which, after being redeemed in the United States, could offer returns on investments of up to 50%.
  • Ponzi never actually established any international IRC network, but he convinced thousands of investors that he did. He successfully solicited investments from individuals from nearly every walk of life — politicians, police officers, priests — but the majority of his investors were "ordinary working-class people investing as little as $10 at a time."
  • The structure of his scheme — his real scheme, not the IRC hoax — is simple: "money taken from today's investors is used to pay off debts to yesterday's investors." The key that made the system profitable is that he "needed only enough money to pay off those people" who sought to cash out, and "with the prospect of increasing their savings exponentially every couple of months, few ever redeemed anything."
  • In this state of affairs, he simply accepted all the investments he could, knowing he'd only ever have to pay out a small fraction of them, and began earning eye-popping sums. He took in $5,290 in February 1920, over $140,000 in April, over $440,000 in May, over $2.5 million in June, and almost $6.5 million in July, acquiring about 30,000 investors in that period.

Ponzi's Downfall

  • Despite the grand scale of Ponzi's machinations by the summer of 1920, he had not garnered any press. That all changed when Joseph Daniels filed $1 million suit against him, claiming that he was owed some portion of Ponzi's wealth due to an old, unsettled debt between the two.
  • Newspapers caught wind of the lawsuit for what was then a very substantial sum, and began looking into Ponzi's business in greater detail than they had bothered to before. The Boston Post ran a story on July 24 detailing his ascent and his business, with the headline "DOUBLES THE MONEY WITHIN THREE MONTHS; 50 Per Cent Interest Paid in 45 Days by Ponzi—Has Thousands of Investors."
  • The immediate effect was that numerous new investors lined up in front of his office; the Post had given him the gift of free publicity. That gift soon turned out to be a curse, however, when he came under increased scrutiny from legal and postal authorities, and eventually by the Post as well.
  • After a government audit, Ponzi was convicted on federal charges of "using mail to defraud." He served 3 and a half years on these charges, received parole, then was convicted on state fraud charges. He fled but was captured in New Orleans, returned to Massachusetts, and jailed until 1934.
  • Upon his release, he was deported to Italy. His days of scheming were over, but he found a new career with "an airline doing business between Italy and Brazil." He made good money until the airline went out of business in 1941, and did odd jobs thereafter until his death in 1948.

Ponzi's Legacy

  • Ponzi was not the first to execute the scheme that now, in popular parlance, bears his name. In fact, he likely got the idea from "William "520 percent" Miller, a young Brooklyn bookkeeper who in 1899 fleeced gullible investors to the tune of more than $1 million."
  • What set him apart from earlier perpetrators was, to a large degree, the scale at which he operated. In a mere six months, he took in about $10 million dollars (which in today's dollars is about $122.8 million). He defrauded tens of thousands of investors. He flaunted the trappings of immense wealth, such as "a 12-room mansion in upscale Lexington; servants; a couple of automobiles, including a custom-built limousine; and fine clothes and gold-handled Malacca canes for himself, and diamonds and other baubles for Rose."
  • Aside from the ostentatious nature of his crime, the media frenzy that followed the Post's initial report on Ponzi was one for the ages. Ponzi toyed with federal investigators, ostensibly working with them while feeding information to connections at major newspapers. One notable headline in the Washington Post read "POSTAGE STAMP' KING DEFIES FEDERAL GOVERNMENT TO LEARN HOW HE PROFITS."
  • The press was not all good in this period: the Post aggressively reported on Ponzi's history, revealing his prior stints in prison, and enlisted his publicity agent to provide an insider exposé of Ponzi's operation, claiming that he was "hopelessly insolvent." Nevertheless, these articles increased Ponzi's fame (or infamy) — and they also won the Post a Pulitzer Prize.
  • Thus, the scheme now bears Ponzi's name not because he invented it, but because he made it famous. Still, one question that remains is the question of why the scheme remains successful to this day — which it does, not just in the form of massive scams like the one perpetrated by Bernie Madoff, but in many smaller forms across the United States.
  • Psychology can help unpack this question, from the point of view of the schemer and the victims. In the schemer's case, he or she may be narcissistic, or have an antisocial personality disorder that causes them to "believe that not only do societal rules not apply to them, they also have no empathy for other people."
  • Scammers with no clear mental illnesses may simply "make a small compromise or act unethically in a way that isn't much of a big deal, no one really cares or notices, and they get away with it," then repeat the process on an increasingly large scale. This was the case with Madoff, whose multi-billion dollar Ponzi scheme was constructed gradually over several decades.
  • From the victim's point of view, the immediate impetus is more obvious: the scammer promises quick, easy, and substantial returns on investment with little or no risk. The real question is why people continue to fall for Ponzi schemes, and the answer is that the devil is in the details. Ponzi schemers will use an appearance of propriety (like Ponzi himself did when he created a fake business named Securities Exchange Company) and utilize seemingly credible co-schemers to make investors think the scheme is legitimate.
  • Victims of Ponzi schemes can also fall prey to the so-called Halo Effect, wherein "the positive character traits of the person offering an investment carry over to the investment itself." Thus, a schemer who is likable and charismatic can more easily swindle unsuspecting victims.
  • There are several other tricks of the trade, so to speak, that entice investors to trust a Ponzi schemer with their money. In the social consensus strategy, the schemer suggests that "other savvy investors have already bought into the opportunity." Schemers may also create a false sense of scarcity, making prospective investors believe the investment is a one-time offer, or utilize reciprocity, offering to cut their own commissions so that investors earn more.

Your research team employed the following strategy:

To research the origin of the Ponzi scheme and its namesake, we reviewed several sources regarding Charles Ponzi, synthesizing their findings to provide a biographical overview and an explanation of his scheme. In this portion of the research, we utilized one source, a Smithsonian article, that was published outside of the two-year range of acceptability we typically employ for source materials, but because the article concerns Ponzi's life in its entirety, and as such is concerned solely with events of the early 20th century, the information it provides is not out-of-date. After completing this portion of the research, we conducted additional research regarding the prevalence of Ponzi schemes in the intervening years since Ponzi perpetrated his own scheme, as well as the reasons for this prevalence. We utilized information provided by financial news outlets such as Forbes, as well as the law firm DKR, to provide an overview of this subject.
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