"Mundus vult decipi - ergo decapitur: The world wants to be deceived, let it therefore be deceived." --Charles Kindleberger

It only seems fitting these days to discuss the origination of the term "ponzi scheme." While not all would agree that current market conditions warrant using such a harsh term, your author thinks certain segments, particularly in the IPO area where insiders are selling their interests at record rates, are worthy of it. And market history is full of ponzi schemes, from the South Sea Company bubble to John Bennett's New Era Philanthropy scam.

Charles (Carlos) Ponzi is the man we can thank for the term. In the Boston of September 1919, Ponzi was a 42-year-old ex-vegetable dealer, forger, and smuggler, who decided he would become a wealthy financier. Described as handsome and quick-witted, he had only $150 in cash to his name and lacked any real connections. But he had a scheme.

"Ponzi finance" is defined by one expert "as a type of financial activity engaged in when interest charges of a business unit exceed cash flows from operations." Another explanation is when "a borrower who has some control over the price in the market in which he issues his own personal debt will want to play the 'ponzi game of financing,' that is, the repayment of debt with the issuance of new debt." [Source: Charles Kindleberger]

In Charles Ponzi's case it was sort of like a chain letter in which he would borrow money without collateral, promising to pay $15 for every $10 left with him for 90 days.

What Ponzi told his would be lenders (mostly Italian immigrants) was that he would be buying International Postal Union reply coupons overseas, and then send them elsewhere to be redeemed. As Sobel writes in his book, "The Great Bull Market: Wall Street in the 1920s," "In this way, (Ponzi) could take advantage of differences in currency quotations to make profits." At least that's what he told his investors.

Ponzi was to purchase lire, francs, and drachmas at low market prices and sell them at higher official prices (in theory). He started a firm, The Old Colony Foreign Exchange Company, where he took in the money and paid principal and interest without fuss or bother. The newspapers in Boston picked up the story and soon Ponzi was not only famous, but he was also taking in about $1 million a week. He had grand expansion plans and he talked of establishing a string of banks and brokerage houses. Soon he was purchasing a controlling interest in the Hanover Trust Co., and made himself its president.

Sobel writes of these times that wherever Ponzi went, crowds followed. "You're the greatest Italian of them all!" Ponzi protested, "No, no. Columbus and Marconi. Columbus discovered America. Marconi discovered the wireless." "Yes," came the response, "but you discovered money."

The Boston district attorney began an investigation. Edward Dunn of the Boston Post also began an inquiry. Dunn discovered that less than $75,000 worth of reply coupons were printed in most years, and in 1919 there were only $58,560 worth issued. Ponzi said he took in millions and invested them in the coupons. Clearly, Dunn reasoned, money had been used for other purposes.

Dunn was to find out during his investigation that Ponzi - using the name Charles Bianchi - had been involved in a remittance racket in Montreal back in 1907. Confronted with the evidence, Ponzi denied all. The story was printed and Charles had to act fast to avoid a panic. He countered by promising to pay his investors 50 percent interest on money left with him for 45 days, rather than the initial 90 days previously required. But Ponzi's operations were closed down on July 26, pending the district attorney's investigation. Charles proclaimed his innocence and lenders besieged his office. Somehow he managed to pay them all off, though, without a single default.

Forced to go public more than he desired, he warned investors not to dispose of their holdings and told them they had nothing to fear. He also asserted at this point that he was worth at least $12 million. For a time, confidence returned and money began to flow back in.

On August 2 the Boston Post had claimed that Ponzi was insolvent, but even this did not prevent the positive flows. Finally, the end came on August 11 when all of his companies and offices were closed, never to reopen. Sobel writes:

"In the days that followed it was learned that the dapper financier had purchased a few reply coupons, but used most of the money he received to pay those who presented 90-day notes. In effect, he was taking in money with one hand and paying out more with the other. Such a scheme could not last for long, unless increasing amounts continued to arrive. Ponzi was bound to collapse when the money ran out."

On August 16, Boston and the nation learned the Old Colony Foreign Exchange Company had no assets and liabilities of $2,121,895. The search for Ponzi's money extended into October and little was ever found. Ponzi himself was declared insolvent on October 15. The presiding judge, James Olmstead, commented:

"While Mr. Ponzi is not to be classed in the same category with robbers and burglars, he was undoubtedly a clever manipulator who took advantage of the credulity of the investing public, which in this instance is the usurer. The investors who loaned their money for a return of the principal and 50% interest would seem themselves guilty of usury if such existed."

It was finally resolved that Charles Ponzi had taken in some $15 million in 8 months, and that his books showed a deficit of $5 million; less than $200,000 was eventually recovered from his holdings.

While out on bail pending appeal, Ponzi decided he had to scam some other innocent fools so he sold underwater lots in Florida to the unsuspecting, thereby making another small fortune. [Ponzi was one of many crooked real estate agents selling useless land in Florida's mosquito-ridden interior during the 1920s.] Nonetheless, his appeal denied, Ponzi went to prison until 1934. Upon his release he was deported to Italy where he immediately joined the fascists and gained positions in the government. Later, he was sent to Rio de Janeiro by his employer, LATI Airlines, where he became a fixture in the social set. He died of natural causes in 1949.

*In doing the research for this piece, I came across a quote from Robert Sobel, the applicability of which to today's environment is scary. While Ponzi was well known, there were countless other schemes which didn't catch the nation's attention. But this was 1920 and Sobel writes of what followed:

"Wall Street happenings would be followed assiduously by millions who in 1920 cared little about the stock markets. Many who had never before purchased securities would 'take a flyer' on one stock or another. The Ponzi scheme affected less than 50,000 unsophisticated people. Millions were involved - some directly but most indirectly - in the stock market by the end of the decade. Among their number were highly shrewd, knowledgeable speculators who brought years of experience to the market. At first it seemed as though the market rise was a once-in-a-lifetime chance to make money with little or no risk. But as stock market prices continued to rise, many began to believe that the rise would be permanent, that the growth curve would be unending. In prospect, this conclusion was reasonable, for the nation was engaged in a great expansion, profits were rising, and conditions seemed sound. In retrospect, we can see the flaws in the argument, the contradictions in the economy which eventually were reflected on Wall Street. The cult of the stock market was, in the end, the greatest fantasy in an age filled with illusion."

Sources:
"The Great Bull Market: Wall Street in the 1920s," Robert Sobel
"Manias, Panics, and Crashes," Charles Kindleberger
"Wall Street: A History," Charles Geisst

Brian Trumbore