Robbing Peter to pay Paul - A Hundred Years of the Ponzi scheme

Riddhiman Kundu
Indian Institute of Management Calcutta
Abstract
One of most brazen scams in finance is the Ponzi scheme. A Ponzi typically involves paying
abnormally high returns to existing investors from funds contributed by new investors. This
article takes a look at the origin and evolution of the Ponzi scheme and how it continues to
thrive despite regulatory measures. Incidentally, our entire financial system is the equivalent of a
gigantic Ponzi scheme. The sub-prime crisis of 2008 was nothing but the unravelling of a
confidence trick system. The sovereign debt-crisis unfolding today is the aftermath of a similar
Ponzi.

About the author

Riddhiman Kundu is a 2nd year PGP student at IIM Calcutta. He holds a Bachelors degree in
Electronics and Instrumentation Engineering from Jadavpur University, Calcutta and can be
reached at riddhimank2011@email.iimcal.ac.in
"Double your money in 90 days"- the offer seemed too good to be true. Your country has just
emerged from a World War, its economy still reeling in the aftermath- inflation running high, the
bank returns abysmally low and a vastly weakened stock market; enough to scare away the most
resourceful and optimistic of investors. But then Charles Ponzi was no ordinary investor. Once
the first people to sign up were paid the promised return on investment more and more people
queued up in Boston to put their money into his „Securities Exchange Company‟. Cash flow
became a torrent. Charles Ponzi had devised the classic fraud: the „Ponzi scheme‟ which would
go down in history as one of the worst white collar financial crimes. It is to be extensively
replicated over the decades swindling millions of hapless investors with varying degrees of
success.
What is a Ponzi?
In the world of finance, describing something as a „Ponzi‟ is a standard form of an abuse. In its
most basic form a Ponzi scheme is simply a structure whereby investors are paid returns not out
of profits of the concerned investment but the money put into the scheme by later investors. It
entices new investors by offering abnormally high short term rates of return which existing
market instruments cannot guarantee. A typical Ponzi would work like this. The originator of the
scheme offers an investment too good to pass up. Investors begin by depositing their money
into the fund where it appears on paper to be making returns as promised. If an investor wishes
to receive a payout he will be paid out of the money put into the fund by other investors and not
of the profit. Profits to investors are not created by the success of the underlying investment but
are derived fraudulently from the capital contribution of other investors. A few people initially
join the scheme and as the news of the offer spreads more join in. And as long as they keep
reinvesting their returns into the fund and new investors keep paying into it, the fraud can
continue for quite some time till it collapses under its own weight. Ponzi schemes are
unsustainable because the underlying asset upon which the investment was based either never
existed or was grossly overvalued. Because they are technically insolvent it can only continue till
the pool of gullible new investors dry up. In the case of Bernie Madoff the fraud was exposed in
late 2008 as the economic downturn caused so many of the investors to try cash out of the fund.
The Curious Case of Charles Ponzi
The Ponzi scheme has a colourful history. Although no one really knows how long this
particular fraud has been around Charles Dickens mentions a scheme of this kind in his novel
Little Dorrit in 1857. One of its earliest practitioners was a New York City grafter named William
Miller who swindled investors out of $1 million in 1901. However the modern Ponzi scheme is
named for its most famous exponent Charles Ponzi, an Italian immigrant to Boston who in 1920
started an elaborate fraudulent practice under the pretext of arbitraging international reply
coupons for postage stamps. Ponzi sold people on the idea that he was purchasing foreign postal
reply coupons, at a discount, in depressed economies and making a profit by exchanging them
here. He claimed to have a network of foreign agents gathering coupons abroad to keep up with
the demand.
Explaining his program for the NY Times he tells his story: "I wrote a man in Spain regarding
the proposed magazine and in reply received an international exchange coupon which I was to
exchange for American postage stamps with which to send a copy of the publication. The
coupon in Spain cost the equivalent of about one cent in American money; I got six cents in
stamps for the coupon here. Then I investigated the rates of exchange in other countries. I tried
it in a small way first. It worked. The first month $1,000 became $15,000. I began letting in my
friends. First I accepted deposits on my note, payable in ninety days, for $150 for each $100
received. Though promised in ninety days I have been paying in forty-five days." [NY Times, Jul.
30, 1920].
Once the flow of investors' money started, he did actually require agents upon agents to handle
the volume, and even paid a tiered commission of 10% down to 5% of the money invested.
Over 10,000 took his "path to easy riches" with many reinvesting the profits as they came due
every 45 days. When bad press and legal investigations started a run on his company, speculators
milled through the crowd purchasing notes from nervous investors at a premium, hoping to
redeem them at the full 50% profit when they matured. He even continued to receive funds
while in jail, from people still convinced of the program. Ponzi was eventually deported to Italy
in 1934 where he died in a charity hospital in 1949.
Ponzi’s successors
Charles Ponzi‟s outrageous scheme spawned off a series of imitators in years to come, albeit with
varying degrees of success. Also, the simple Ponzi scheme underwent a series of transformations
to lure the savvy investor. Here are some of the more brazen Ponzi schemes in the following
decades. Maria “Dona” Branca was a poor Portuguese woman when she decided to open her
own bank in 1970. To make it attractive she offered an interest rate of 10% per month and
coaxed the working poor of her country to deposit their savings. The scheme lasted for 14 years
till the „people‟s banker‟ as she came to be fondly called was arrested and sentenced to 10 years.
The cons have since grown: a Florida Church netted $500 million in 1990 on the pretext that
God would double the money of pious investors. Boy band impresario Lou Pearlman in addition
to foisting „N Sync on an unsuspecting public swindled $300 million out of clients over two
decades. In the early 90‟s a Russian company MMM promoted by one Sergey Mavrodi duped
investors with promised dividends of 1000% and within 5 years took in $1.5 billion from at least
2 million people. When the fraud came to light the guy even managed to get himself elected into
the Russian Parliament to gain immunity. Fortunately for his people the immunity was revoked
and the scammer finally convicted. Unsuspecting citizens poured some $1.2 billion into Albanian
Pyramid schemes after the fall of communism and when the schemes collapsed in 1997 investor
outrage toppled the government.
Decade of the Ponzi
If the Western Calendar followed the convention of Chinese Zodiac the erstwhile decade should
be rechristened as the Decade of the Ponzi. And the most famous or rather infamous of its
perpetrators was a certain Bernard Madoff who is believed to have pulled off the largest as well
as the longest running Ponzi scheme in history with an alleged fraud of $50 billion. For decades
Madoff investors received consistent and steady annual returns through elaborate fabricated
account statements that were provided to convince them of actual investments. Madoff paid the
initial investors „returns‟ with the money provided to him by a steady flow of new investors.
However, in late 2008 as people tried to cash out because of the downturn Madoff‟s scheme
burst- he did not have enough to cover everyone‟s requests. Hundreds of banks, hedge funds
and wealthy individuals parked money with Mr. Madoff, a former chairman of NASDAQ,
impressed by steady returns on offer of 10-15% even in rough times. Banks such as Santander
and HSBC had funnelled no less than $7.5 billion to Madoff. Though his operations resembled a
large hedge fund shop, he was in fact managing money in brokerage accounts within his firm. A
lot of this came from funds of funds and was channelized to him through “feeder funds”. Some
banks like the Dutch arm of Fortis lent heavily to these funds of funds. On June 29, 2009 a
Federal Court sentenced Madoff to 150 years without parole.
A million dollar question
This brings us to a million dollar question- How is it that Ponzi schemes are able to swindle
investors with such regular alacrity? The reasons are telling. According to Mitchell Zuckoff, the
author of “Ponzi‟s Scheme: The True Story of a Financial Legend” the Ponzi schemes put two
human beliefs in conflict with one another. One is that something is too good to be true. The
other is that something is too good to pass up. “If someone gives you a justification that sounds
plausible, it at least raises the question of „Is it too good to miss?‟ More often than not it is better
to take a pass when something seems too good to be true. But only it needs to be just plausible
enough to draw you in.”, says Zuckoff. Ponzi schemes are highly adaptable which makes them
convenient to apply in different settings and to appeal to a variety of investors. It doesn‟t make
sense for investors to receive constant high level returns for a prolonged period of time. But
these schemes always tend to prey upon people who feel they deserve to hit it rich. They often
concentrate on specific cities, types of investors, family members, and church groups. Even as
the Ponzi program eventually starts to collapse there is a fear that that public exposure will create
a run on the promoter and make matters worse. And as the scheme relies on a sense of
community there is a fear of being socially blackballed if you are the first investor to break ranks.
According to reports, some of those who put their faith in Mr. Madoff had a premonition of his
wrongdoings, but not that sort that would endanger their money. They thought he might be
illegally for their own benefit acting on information gleaned by a separate group within his
business which made a market in shares.
A Regulatory Failure?
Apart from its apparent outrageousness and investor gullibility Madoff‟s scheme also exposed a
stunning lack of due diligence and regulatory failure. Even within his own group Madoff‟s
money management business was like a „black box‟. Questions had been hanging over his
operations since the mid 90s with some institutional investors steering clear of Madoff. The
Security Exchange Commission did not get round to examining Madoff‟s books even though he
registered it with the Commission in 2006. In a rare mea culpa Christopher Cox, the SEC
Chairman has called its handling of case „deeply troubling‟ and currently the SEC is undergoing
extensive restructuring.
Hard Lessons
And lastly, an interesting analogy. To the careful observer our whole financial system is one
gigantic Ponzi. Many elements of this system are Ponzi-like in that they depend on confidence-
they would collapse if all the investors demand their stakes back. The health of commercial
banking system depends on the implicit assumption that at any time most depositors will keep
their money in the bank. That allows the bank to borrow short and lend long; earning higher
margins on loans to business. When depositors panic and rush to withdraw money what follows
is an economic catastrophe. The subprime mortgage crisis in US was the unravelling of one giant
Ponzi scheme. Subprime loans were offered on generous terms which implicitly depended on the
rising house prices. The banks that made these loans bundled them up and sold them in the
credit market as complex securities. The housing bubble finally burst and the confidence that
had sustained their balance sheets so far evaporated leaving the banks in dire straits. What
followed plunged the world into its deepest recession since the 1930s. As a matter of fact even
social security schemes like the American public pension system operate on the same principle as
a Ponzi scheme. Paul Samuelson, the last of the great general economists, points out the Ponzi
characteristics eloquently- "The beauty of social insurance is that it is actuarially unsound.
Everyone who reaches retirement age is given benefit privileges far exceeding what he has
paid...Always there are more youths than old folks in a growing population. More important,
with real incomes growing at some 3% a year, the taxable base upon which benefits rest in any
period are much greater than the taxes paid historically by the generation now retired...A growing
nation is the greatest Ponzi game ever contrived."
The world would do well to realise the fact our financial system is a confidence trick. Its roots
are Ponzi-like. There are good Ponzi schemes and bad Ponzi schemes. Good schemes will
funnel more money from the latecomers to the early takers allowing the latter to prosper. And
they will not allow claims to rise too fast. But then no good Ponzi can sustain itself forever. The
pyramid has to collapse under its weight. As we come out of one such collapse in 2010 we
should remind ourselves to tread the path carefully in future. Next time we may not be so lucky.
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