April 09, 2009
Financial frauds-2: The original Ponzi model
(For previous posts in this series, see here.)
Following up on yesterday's post, Charles Ponzi's scheme used the fact that a person could legally buy postal coupons in one country using the currency of that country, but in the denomination of the currency of another country. If you mailed the coupons to the other country, the recipient could then exchange the coupons in their post office for stamps.
In 1920, after World War I, the British and German currencies lost value compared to the US dollar. But since postal coupons were based on fixed exchange rates set in 1907 by the International Postal Union and were thus based on a higher value for those currencies, Charles Ponzi saw the chance for a scheme that would work by sending money overseas to buy coupons for American stamps that had greater value than the amount he had sent, and having the coupons shipped back to him. As economist Michael Hudson says, "An American penny could buy foreign stamp orders that could be converted into six cents in U.S. stamps, for a 500 per cent profit."
But there was a catch.
The problem was that it would take a truckload of such postal orders to make serious money. A million-dollar investment would involve a hundred million penny coupons – which then would have to be converted into stamps and sold in competition with the U.S. Post Office, presumably at a discount, mainly in immigrant neighborhoods.
This shipping of such huge numbers of coupons from one country to another, and then trying to sell the stamps on the street to get back cash, would have involved hard work and been tedious. So what Ponzi did was simply tell investors that this was his business model for making money, but not actually carry it out.
Focusing on the principle of arbitrage rather than such laborious implementation, Ponzi explained that he could make a 400 per cent gain after expenses. He promised that investors could double their money in 90 days, pretending to take due account of the costs and shipping time from Europe to America.
Ponzi, like every other perpetrator of such schemes since, took advantage of that aspect of human psychology, especially common among greedy investors, that as long as they are getting the interest rate on their money that they were promised, they would not inquire too closely into the details of the business, being satisfied with vague generalities that gave them something plausible to believe in.
Ponzi had noticed this trait much earlier when he had worked at as a teller at a bank that attracted investors by paying higher interest rates than their competitors and used that money to invest in real estate, expecting those prices to rise. When the real estate market took a downturn and their investments went bad, the bank went bankrupt. But while they were making money, the bank's depositors were quite happy, a scenario that should sound depressingly familiar to people today.
Ponzi promised to double his investors' money every three months and he delivered, at least at the start. What he did was to pay on schedule to the early investors, who spread the word that this was a good investment. More investors gave money, which Ponzi used to pay the promised interest to the earlier investors. As long as increasing numbers of new investors (or to use a technical term, "suckers") were coming in with new money, he could pay off the earlier ones, thus creating a pyramid of investors, the ever-growing large base supporting payoffs to the smaller group closer to the top.
When his Securities Exchange Company paid early investors the high returns he had described, they spread the word to others. Ponzi’s inflow of funds rose from $5,000 in February 1920 to $30,000 in March, and $420,000 by May. By July an estimated $250,000 a day was flowing into his firm, mainly from small investors who let their book credits build up rather than taking out their money. Some people put their life savings into the plan, and even borrowed against their homes.
Like other frauds, Ponzi spent money lavishly on himself, living well, buying a mansion, and even bringing his mother over from Italy. And Hudson points out that like the Ponzi schemes of today, there were enough clues that he was running a racket if only financial reporters and investigators took the trouble to look for them. In each case, there were a few people who had stumbled upon the fact that the sheer volume of transactions that would have to be involved to generate such returns did not, and could not, match the reality, and that hence there must be some racket going on.
The financial reporter Clarence Barron (publisher of Barron’s) noted that if he really had invested the money as he told his investors he had done, Ponzi would have had to purchase 160 million postal reply coupons. Yet the post office reported that few were being bought at home or abroad, and only 27,000 were circulating in the United States.
There were similar clues that shady dealings were going on in the Escala/Afinsa stamp fraud of 2006, if only people were willing to look into the actual workings of the business.
The denouement came shortly after Lloyd’s of London withdrew from a 1.2 billion euros policy to insure Afinsa’s stamps. One of its experts noticed that if $6 billion really had been invested, it would have bought up all the investment-grade stamps in the world many times over. The fact that stamp prices did not reflect any such extraordinary buying implied that few bona fide stamp transactions occurred at all, and there had been a massive over-billing.
The same is true for the fraud perpetrated by Allen Stanford, which began to unravel when a Venezualan financial analyst looked into Stanford International Bank (SIB) as a favor to a friend who was thinking of investing in it. "No matter how hard he tried, he could see no way in which SIB’s business model could produce the returns that it claimed to or fund the dividends that it was continuing to pay its investors."
Bernard Madoff's scheme was similar, as we will see tomorrow.
POST SCRIPT: Quote
"There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs." (From Kung Fu Monkey.)