Bernie Madhoff’s Fraud – Back Story On Why It’s Called “Ponzi Scheme”

PonziSM.jpgWe keep hearing the term “Ponzi Scheme” on the news as they refer to Bernard Madoff who ripped off $50 Billion from trusting people who were expecting high dollar results. What is a Ponzi Scheme, and why is it called a “Ponzi Scheme”?

Basically, it’s a pyramid scheme: rob Peter to pay Paul. It is named after a man named Charles Ponzi who was born March 3, 1882 and died January 18, 1949.

Ponzi was an Italian immigrant to the United States who became one of the greatest swindlers in American history. His aliases include Charles Ponei, Charles P. Bianchi, Carl and Carlo. The term “Ponzi scheme” is a widely known description of any scam that relies on a “pyramid” of “investors” who contribute money to a fraudulent program. He promised clients a 50% profit within 45 days, or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeem them at a higher face value in the United States as a form of arbitrage.

>[The simultaneous purchase and sale of the same securities or commodities in different markets to profit from unequal prices.] >

Ponzi was probably inspired by the scheme of William Miller, a Brooklyn bookkeeper who in 1899 used the same pyramid scheme to take in $1 million.

On November 15, 1903 Ponzi arrived aboard the S.S. Vancouver in Boston. By his own account, Ponzi arrived in the United States in 1903 with two dollars and fifty cents in his pocket, having gambled away the rest of his life savings during the voyage. “I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me,” he later told the New York Times.

He quickly learned English and spent the next few years doing odd jobs along the East Coast, eventually taking a job as a dishwasher in a restaurant, where he slept on the floor. He managed to work his way up to the position of waiter, but was fired for shortchanging the customers and theft.

His next scheme was in Quebec where he worked as an assistant teller in a new bank. He found out they were in financial trouble, so he used money deposited in newly opened accounts to flee to Mexico.

Next, Ponzi engaged in checkbook forgery and spent three years in a Quebec prison. Of course, he wrote a letter to his mom telling her he had found a job as a “special assistant” to a prison warden.

After his release in 1911 he decided to return to the United States, but got involved in a scheme to smuggle Italian illegal immigrants across the border. He spent two years in an Atlanta prison for this one.

He received a letter in the mail from a company in Spain asking about his catalog he had designed. Inside the envelope was an “International reply coup” (IRC) which he had never seen before. He asked about it and found a weakness in the system which would allow him to make money.

The purpose of the postal reply coupon was to allow someone in one country (let’s say Italy) to send it to someone in another country (let’s say America) who could use it to pay the postage of a reply. Since IRCs were priced at the cost of postage in the country of purchase (Italy), but could be exchanged for stamps to cover the cost of postage in the country where redeemed (America); if these values were different, there was a potential profit. All they had to do was sell the stamps in America. Aha! A mind that is looking for an illegal scheme will surely find one, right?

Ponzi canvassed friends and associates to back his scheme, offering a 50% return on investment in 45

days. The great returns available from postal reply coupons, he explained to them, mad such incredible profits easy! They bought it, and Ponzi started his own company, the “Securities Exchange Company”, to promote the scheme.

Some people invested, and were paid off as promised. The word spread, and investment came in at an

ever-increasing rate. Ponzi hired agents and paid them generous commissions for every dollar they brought in. By 1920 his total take was US $5,000 (approximately $54,000 in 2008 dollars).

A month later he had made $30,000 ($328,000 in 2008 dollars). Two months later he had made $420,000 ($4.59 Million in 2008 dollars). Two months later (July 1920) he had made millions. People were mortgaging their homes and investing their life savings. Most did not take their profits, but reinvested.

Even though Ponzi was raking in the dough, the operation was running at a large loss. As long as money kept flowing in, existing investors could be paid with the NEW money. In fact, NEW money was the only source Ponzi had to pay off those investors, as he made no effort to generate legitimate profits.

People kept asking how Ponzi could have gone from being penniless to a multi-millionaire in such a short time. And it was a furniture deal-gone-bad that did him in.

In August of that same year, Ponzi was arrested and he plead guilty to mail fraud. He was sentenced to five years in federal prison. Afterwards, as the authorities were trying to deport him, he escaped and fled to Florida where he opened up another dishonest business.

Five years later when he was working as a non-licensed realtor, he was arrested and sentenced to another year in the Florida State Prison. His life was lived out with several escapes from prisons, more businesses, and finally death in 1949 in a charity hospital in Rio de Janeiro.

Before he died, he granted one last interview to an American reporter, and commented about the wild ride he had given Bostonians.

“Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over.” Ponzi also had the audacity to write his autobiography.

(c) 2008 April Lorier