The Original Ponzi

Many underhanded people try their hand at fraud, but to be so well known for it that a form of it is named after you takes a special person: meet Charles Ponzi, of the original Ponzi scheme. The roots of his scheme started off honest enough. Ponzi discovered an arbitrage opportunity with international postal reply coupons. The idea was completely legal, but things took a turn for the worst after investors were suckered into investing with a promised 50% return.

Charles Ponzi immigrated to America in 1903 from Italy with $2.50 to his name. He later told the New York Times, "I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me." He bounced around from one menial job to the next while improving his English. He eventually was fired from a server job for short changing customers. He then moved to Montreal, Quebec and took a job at a bank called Banco Zarossi, named after its founder Luigi Zarossi, which was started to service a rush of new Italian immigrants to the city. The bank's owner offered 6% interest on deposits at the bank, almost double what all other banks were offering. Things went sour when bank's real estate holdings faltered and stopped producing enough cash to cover the interest payments. Instead of reducing the rates, Zarossi used the money deposited by others to pay the interest payments. This method of fraud would foreshadow Ponzi's infamous legacy. The bank eventually folded, leaving many shortchanged. Zarossi fled the country with all the money he could gather leaving Ponzi behind.

Ponzi initially stayed with Zarossi's family who was left behind, but without any money there was not much for Ponzi to do. Reaching desperation, Ponzi stole a check from one of Banco Zarossi's former customers and cashed it to himself for a quick $423.58. Ponzi's spending of this newfound wealth caught the attention of authorities and he was sentenced to three years in a Quebec prison.

After being released Ponzi moved back to the US in search of a quick buck. He became involved in a scheme to smuggle Italian immigrants into the country. Again, Ponzi was quickly caught and sentenced to two years in an Atlanta prison.

With his second prison stint behind him Ponzi moved to Boston where he met his future wife, Rose Maria Gnecco. She was unaware of Ponzi's past indiscretions, but even when Ponzi's mother sent her a letter about it, she didn't leave. Ponzi started working in his father-in-law's store, and eventually started a company distributing a business listing catalog which he would sell advertising in. The idea went nowhere, but shortly after giving up Ponzi received a letter from Spain. The letter asked about the catalogue, and inside the envelope was something Ponzi had never seen; an international reply coupon.

An international reply coupon, or IRC, would allow the sender to include a coupon with their letter that could be exchanged for the equivalent amount of postage in the receiving country, so a letter could be returned. The cost of the coupon was equal to the original cost of sending the letter, regardless of how much the return postage would cost. Ponzi's idea relied on the fact that the cost of postage varied greatly depending on what direction it was going. After World War One, the cost of sending a letter to Italy from the US was much less than what it cost to send a letter the other direction (from the US to Italy). Ponzi put his contacts in Italy to work purchasing international reply coupons there and mailing them to him in bulk. He would then exchange the coupons for the more expensive US postage, which he would turn around and sell. Ponzi would pocket the difference between the coupon price and what he could sell the US postage for (usually a slight discount to face value to ensure it sold quick). After paying his Italian contacts a small commission, Ponzi was making virtually risk-free money.

This arbitrage opportunity was completely legal, and equivalent opportunities are exploited everyday in the financial markets. The problem with the plan is that it was hard to expand. Although Ponzi claimed to be making a return of 400% on this scheme, it was hard to scale up to make larger amounts of money. There were only so many international reply coupons available, and exchanging them in huge amounts could draw attention. A company called "Securities Exchange Company" was formed by Ponzi to attract investors to the scheme. After promising a return of 45% in just 45 days, compared to the stock market average of 10% in 365 days, Ponzi snagged some investors. At first, things were good. Ponzi was able to hire agents to purchase the coupons in Italy to keep up with the demand. Once the original investors were paid their interest, more investments flowed in.

In February of 1920 the Securities Exchange Company's total profit was $5,000, about $55,000 in todays dollars. By May of the same year, total profits were over $420,000, about $4.5 million today, a staggering amount. Somewhere along the line, supply of the coupons stopped meeting demand from the investors. Ponzi started paying investor's interest payments with the investments of others. After being unsuccessfully sued by an ex-friend, suspicions arose about how Ponzi got to this position. A run started on the company and some investors withdrew. Fortunately (or not, depending how you look at it), Ponzi had enough money to pay withdrawing investors without the whole scheme collapsing. After the Boston Post printed an article praising Ponzi's success, the run stopped and things were relatively normal.

The Boston Post later became more suspicious of Ponzi and hired financial analyst Clarence Barron, of Barron's Magazine, to investigate. Barron's calculations showed that to generate the returns that Ponzi was generating, 160,000,000 coupons would need to be in circulation. However, only 27,000 existed. Additionally, although the gross profit on each coupon-stamp exchange was large, the handling and processing fees to do it on this scale would result in a net loss.

After the story broke, another run started on his company and he paid out $2 million in 3 days. Ponzi used his charm to convince most of the investors lined up outside his office that everything was fine, and many left without their money. Ponzi was put under arrest on August 12, 1920. At that time he owed $7 million (almost $75 million today) to 17,000 investors. He was charged with 86 counts of federal mail fraud, because he used the mail to notify investors of their balances and performance of their returns. He plead guilty to one charge of mail fraud and was sentenced to a paltry 5 years. After serving only three and a half years, he was released and charged with a barrage of state charges. He jumped his bail and fled to Florida where he tried his scam again. Once apprehended a second time, he was sentenced to 9 more years, which he served in full. Once that sentence was completed, he was deported to his native Italy where he died in 1949. Without a penny to his name to pay for a headstone, he was buried in an unmarked grave.

The Ponzi scheme has been tried many times since the original, but by design it always fails in the end. Bernard Madoff has been the latest to try his hand at the scheme, allegedly milking investors out of an estimated $50 billion, making it the largest scheme ever. It would take a lot to top that, but we doubt we've seen the end of Ponzi.

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