What Is a Ponzi Scheme?

A Ponzi scheme is a type of investment scam in which money coming into the scheme from new investors is used to pay out returns to existing investors. On the surface, these schemes appear legitimate, but it is all an illusion: statements to the investors are phoney and there are no productive underlying investments, or, if there are, they are not producing the declared returns.

Such a scheme is sustainable for only as long as new investors are drawn into the Peter-pays-Paul model and the majority of investors stay invested.

Often, Ponzi schemes begin as genuine investments in real businesses but turn to using new inflows to keep existing investors happy when the businesses do not deliver on returns or fail entirely. They are typically controlled by a single mastermind.

Mr Ponzi’s 1920 scheme

The operation that gives this type of scam a name was far from being first of its kind. In fact, Ponzi schemes are probably as old as history – Charles Dickens describes them in his novels Martin Chuzzlewit and Little Dorrit, and there are reports of them swindling investors long before Dickens. Ponzi himself took his inspiration from other schemes operating at the time.

Charles (Carlo) Ponzi, was born in Italy in 1882 and arrived in the United States in 1903 with US$2.50 in his pocket. His scheme involved postal coupons that people in the US could buy to pay for postage coming from Italy. The plan was to exploit a difference between the coupon’s price and the currency exchange rate. But this was little more than a ruse to attract investors – he promised to double their money in 90 days. Launched in January 1920 as the Securities Exchange Company, it caught on so quickly that in a few months Ponzi had agents all over America. By June 1920, people had invested $2.5 million and by July he was bringing in about $250 000 dollars per day. His investors were initially from the middle class, but within a short time the wealthy were scrambling to join the action.

It took a wily financial journalist, Clarence Barron, working for The Boston Post, to conclude that this was all a gigantic hoax. Not only would the number of postal coupons need to be thousands of times those in actual circulation, but Ponzi wasn’t investing any of his own money in the scheme!

More investigations followed, and eventually the game was up for Ponzi. Six banks failed as panicked investors tried to withdraw their money. On average, they received less than 30 cents to the dollar, and lost about $20 million in total (about $315 million at today’s values).

Ponzi spent about 12 years in US jails before being deported to Italy in 1934. He later moved to Rio de Janeiro, Brazil, where he died in poverty in 1949.

Recent large Ponzi schemes

Two recent schemes that make for fascinating, if sobering, reading are Bernie Madoff’s elaborate hedge-fund hoax in the US and Barry Tannenbaum’s Aids drug investment scheme in Sandton.

Bernie Madoff was one of the most highly respected investment professionals in New York. His hedge fund operated for more than 30 years and his investors were a who’s who of the rich and famous. The interesting thing about Madoff’s scheme, and which is not typical of a Ponzi scheme, is that the returns were relatively mundane. What kept people invested – and what led to Madoff’s eventual downfall in 2008 – was that the returns were too consistent. Madoff’s clients’ accounts totalled about $65 billion, of which two-thirds was fake profits, bringing the amount lost to about $18 billion, the biggest known Ponzi scheme in history.

Barry Tannenbaum operated what appeared to be a lucrative business importing Aids drugs in the mid-2000s. When the multi-billion-rand scheme, which also involved overseas investors, was blown open in June 2009, Tannenbaum was already far out of reach in Australia. People were astounded at how some of South Africa’s most astute and successful businessmen had been taken in by what, in hindsight, had “too good to be true” written all over it. In this case, if people “rolled over” their short-term loans, they could achieve – on paper, at least – returns of up to 219% a year. The scandal is the subject of Rob Rose’s well-researched book “The Grand Scam”.

• A follow-up article deals with recognising the hallmarks of a Ponzi scheme and how to avoid investing in one.

References

“The Grand Scam: How Barry Tannenbaum Conned South Africa’s Business Elite” by Rob Rose (Penguin Random House 2013)

https://en.wikipedia.org/wiki/Charles_Ponzi

https://en.wikipedia.org/wiki/Ponzi_scheme

https://www.investopedia.com/terms/p/ponzischeme.asp

https://www.investopedia.com/terms/b/bernard-madoff.asp