Home History of Financial Crises Charles Ponzi (1920)

Charles Ponzi (1920)

by internationalbanker


2020 marked 100 years after Charles Ponzi was charged for committing what some have referred to as the “fraud of the century”. Indeed, there are not many criminals who have their work named after them. But such was the case with the Ponzi scheme, a confidence scam that fraudsters continue to commit to the present day.

Simply put, a Ponzi scheme is a fraudulent investment scheme in which existing investors are paid with funds collected from new investors. Typically, the scheme unravels once the number of new investors declines, meaning insufficient funds are available to pay everyone. In terms of the history of this particular scam, it actually pre-dates Charles Ponzi, with the first known schemes of this type traced back to the latter half of the 19th century in both the United States and Germany. Charles Dickens even described such a scheme in his 1857 novel Little Dorit.

Charles Ponzi was born in Lugo, Italy, in 1882. At the age of 21, having already worked as a postal worker, Ponzi decided to set sail for the US in pursuit of a better life—although somewhat infamously, he arrived on American shores with only $2.50 to his name, having gambled the rest of his money away on the ship.

Having arrived in the US, Ponzi soon moved to Canada, where he became an assistant teller at the recently established Banco Zarossi in Montreal. It was there that he first witnessed in action what would later become known as the Ponzi scheme. The bank was in serious financial trouble on the back of a number of real-estate loans that went sour. As such, founder Luigi “Louis” Zarossi attempted to remain afloat by funding the interest payments using customer deposits from newly opened accounts. The bank failed, however, and Zarossi fled to Mexico with much of the bank’s money.

Falling on tough times shortly after the bank’s failure, Ponzi then attempted to forge a cheque he made payable to himself and was duly caught and imprisoned in Canada for almost three years. Upon his release in 1911, he returned to the US, where he became involved in a new criminal scheme of smuggling illegal Italian immigrants across the border. But again, he was caught and imprisoned for another two years.

By 1919, Ponzi was living in Boston, where he began devising various schemes to make money. It was here that he first discovered the international reply coupon (IRC). Created by the United States Postal Service (USPS), this coupon allowed a sender to pre-purchase postage and include it in the letter being sent. The recipient in another country could then exchange the IRC at a local post office for airmail postage stamps that could be used for sending the reply correspondence. According to Ponzi’s autobiography, he first encountered the IRC in a letter he received from a business correspondent in Spain who purchased the coupon for 30 centavos. In the US, the same IRC could be exchanged for five cents—significantly more than its value in Spain, especially with the Spanish peseta weakening against the dollar at the time.

As such, Ponzi figured out that purchasing massive quantities of coupons from weaker European economies and selling them for higher prices in the US could net him huge sums of money. Indeed, Ponzi was claiming at the time that such a scheme could generate net profits of up to 400 percent. Of course, this method of arbitrage—whereby an asset is purchased in one market and sold in another market at a higher price—was completely legal and remains so today. And had Ponzi simply confined himself to such an operation, he would have remained in the clear.

Instead, however, he turned his business into a scam, setting up his Securities Exchange Company in early 1920 and persuading people to invest in the business in return for an additional 50 percent in interest within 90 days. Such eye-watering returns were too enticing to pass up, and interest from investors mounted. Ponzi also lied to investors by telling them that he had amassed an elaborate network of agents throughout Europe able to purchase the coupons in bulk for him and that he could easily turn these coupons into financial gains back in the US.

Ponzi, however, did not use this growing pile of new investor funds to purchase more IRCs but rather kept some of the money for himself and paid the rest to longer-standing investors, many of whom were so thrilled with their returns that they reinvested their earnings back into Ponzi’s scheme, thus inadvertently helping to keep the scam going. Whenever he was asked to reveal the inner workings of his operation, he simply said that he needed to conceal such information from the public to prevent competitors from emerging.

But as Ponzi enjoyed a meteoric rise in wealth and fame, suspicion over his dealings soon followed. He sued a financial writer for claiming that it was impossible for him to guarantee such high returns over a short period of time. And although he won the lawsuit as the writer failed to prove his allegations, Ponzi began to come under increasing scrutiny. Another unsuccessful lawsuit filed against Ponzi by a Boston furniture-maker only ensured that even more eyes became fixed on the workings of the Securities Exchange Company, including those of The Boston Post’s publisher at the time, Richard Grozier, who asked reporters in July 1920 to investigate Ponzi.

Financial journalist Clarence Barron questioned the legitimacy of Ponzi’ scheme in an article which ran in The Boston Post in July 1920.

One reporter, financial journalist Clarence Barron, found that Ponzi himself was not investing in his purported scheme, despite offering such exorbitant returns for his customers. Instead, Ponzi had previously told journalists that he invested his own money in real estate, stocks and bonds, which thus begged the question: Why did he prefer traditional assets that would yield him 5-percent maximum returns to his own scheme that claimed to offer 50-percent returns? Barron also calculated that covering the volume of investments made through Ponzi’s scheme would have required around 160 million coupons to have been traded, and yet only 27,000 coupons were in circulation.

Much of Barron’s findings were included in a front-page article run by The Boston Post in July 1920. And although many investors still chose to side with him, Ponzi must have realised that his scam was slowly unravelling. He hired publicist William McMasters to shore up his public image; but having realised that his client was full of lies, McMasters instead chose to denounce Ponzi in the press. “The man is a financial idiot. He can hardly add…. He sits with his feet on the desk smoking expensive cigars in a diamond holder and talking complete gibberish about postal coupons,” was McMasters’ assessment of Ponzi as reprinted in James Walsh’s book You Can’t Cheat An Honest Man.

The following month, Ponzi’s office was raided by regulators. An audit of his business revealed that he was in possession of a grand total of $61 worth of postal coupons. The Post also ran another front-page story about Ponzi, this time detailing his criminal activities in Montreal and his role at Banco Zarossi. Ponzi eventually surrendered to authorities and was charged with mail fraud by the federal government. He served three and a half years in prison plus an additional nine years on state charges. After serving his whole sentence, he was deported to Italy upon his release and spent the remainder of his life in poverty. He died in Rio de Janeiro, Brazil, in 1949.

While Ponzi was certainly held accountable for his actions in the end, his example hasn’t stopped others from carrying out similar schemes in the hundred years or so since then. Most recently—and perhaps most notable of all—was the Ponzi scheme run by Bernard Madoff, who again used new investor funds to pay existing investors in his investment company. In 2008, Madoff was convicted for his scam and sentenced to 150 years in prison. He died earlier this year.

Despite being decades apart, however, the similarities between the two schemes run by Ponzi and Madoff are quite remarkable. Both offered their customers guarantees of consistently high returns with little risk, irrespective of market conditions; both survived for extended periods of time by their creators pretending that they were too complex in nature to explain and that revealing too much would erode returns as a result of competitors entering the market; and ultimately, both collapsed when the number of investors wishing to remove their money was too much for the schemes to cover their requests.

Further viewing

Here is an excellent documentary to watch on Charles Ponzi


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