Financial Shenanigans : Ponzi Scheme

What is a Ponzi Scheme and how did it get this name?

A scheme where we lure customers for high and quick returns without any actual underlying business, but paying the returns to the first investors from money invested by the following customers.  The oldest term referred to this scheme is robbing  Peter to pay Paul.  Charles Ponzi was the first to do this kind of financial swindling at large scale in the US later on became a de facto name for any  rob Peter to pay Paul kind of financial scheme.

How Ponzi scheme different from Pyramid Scheme?

Pyramid scheme’s is a business model that involves promising participants payment primarily for enrolling other people into the scheme. Here the participants are asked to sell some high priced useless product, and at the same time asked to recruit additional people under them to form a ladder. So the folks who are top in the ladder get commissions for addition of new members or sale of products in the lower levers of the pyramid. Remember the power of Geometric Progression, if each person in the ladder has to recruit 5 other people under them, within just 14 levels you would need more than 6 billion people to be part of the pyramid to sustain the scheme. At level 15, you would not have that many people across the world. There are many multi level marketing schemes which are camouflaged versions of pyramid scheme. I remember my relatives selling some high priced very ordinary products like paste, soap buy joining the scheme with some high initial deposit amount. They are assured of making money buy selling that product, as well as adding few people below in their ladder. So they get commissions for  adding, as well as trail commission for the sale made in the lower levels. Though in the beginning you may get some initial peanut amount as returns from this, but eventually this is bound to go bust and you are going to lose the capital as this is completely not sustainable as you can see. We work within a city and within our own circle and event at just say 5-6 levels, you are almost reaching a maximum and if you had joined at that level into the scheme you bound to lose even immediately.  So as said earlier, Ponzi Schemes are not pyramid scheme and no sale of products etc. It is just assuring high return on your invested money and buy paying from the next set of investments received without any actual investments happened to the inflowing money. There was a very nice Tamil short film (Ooruku 4 Peru) on MLM and Pyramid schemes , it is a good watch.

What was the Business model Charles Ponzi had and what were the problems?

Charles Ponzi started his financial company that would help customer invest and double their money. He did this in the 1920s at Boston under a company named Security Exchange Company (not the regulatory body SEC which was established later). Under this scheme Ponzi assured people that he has a legitimate business model similar to currency arbitrage. He assured the investors he could double their money in 90 days, or 50% returns in 45 days. It is too good to survive right, as Ponzi kept paying the principal and interest for the early investors from the principal he received from later investors. And also using some of the money from this incoming pool for his own personal purposes. It has to get bust, and later investors lost a lot of money. Of the 20,000 people who held Ponzi notes at the time of collapse of his scheme, received refunds to 37.5% of their investment. That is a huge capital loss resulted from this get-rich quick scheme.

To begin with Ponzi had a business model in mind, it was not to started to simply swindle the money. His idea was to generate profit that could be made by taking advantage of differing postal rates in different countries ( this happens because of different exchange rates) to buy postal department international reply coupons cheaply in one country and exchange them for stamps of a higher value in another country. So later he could sell the stamps to the business at a discount and still make a profit in the range of 200 to 300% for each dollar invested.  But the only problem was that, the model existed only in paper. Because to do this in large scale there is a lot of logistical problems – for even an amount of 1000 USD he would need to buy a huge number of IRCs and would need to ship them back to US to convert as stamps. With even more money, he would need a ship full of IRCs and there are not that many printed and you cannot covert them to such large number of stamps.  But he wanted to start the company before even figuring out these logistical hurdles, and half way he realized, he was already in deep shit, and the business model he had in mind is not feasible. Since he started collecting a lot of money already from new investors he had to continue that process in order to honor the commitment made to the previous investors,  and got everyone into this huge trap. He tried to get into various business half way so that he can come out of this scheme, but it is so hard to do that once you start this cycle. 

I really enjoyed reading Mitchell Zuckoff’s book Ponzi Scheme  over the last weekend. Zuckoff is well known for investigative journalism, he has done a very good job of bringing vivid images of the real story for a non fiction book like this. He spent a lot of time collecting data across 400+ secondary sources about Ponzi’s life and his scheme, and also the photos from various news paper clipping. He also covers a bit about Ponzi’s past personal life and life after the scheme got bust. The narration about the Boston Post daily that played a key role in busting Ponzi’s scheme covers some details about the tactics played in news paper industry to increase circulation in the 1920s and also covers how there was a delay in passing information across borders which was filled by these news papers those days.  The most interesting parts of the store were - how Ponzi continued to be confident for quite sometime that he would be out of this mess and also how he kept on always dreaming he would become a millionaire someday.

What to learn from Ponzi’s story?

Only in death bed Ponzi accepted his business was fraudulent, till that time he always tried his best having Poker face that his business was legit. His statement before his death to a reporter ,

Those were confused, Money mad days. Everybody wanted to make a killing, I was in it Plenty deep. Rolling in other people money. My Business was simple- it was old game of rob Peter to pay Paul. You would give me one hundred dollars and I would give you a note to pay you one hundred and fifty dollars in three months. Usually I would redeem my note in forty five days. My notes became more valuable than American Money

When you read those vivid moments of how people reacted when they saw the opportunity to make quick money they all flocked and rushed just by hearing from others. This is completely a mob behavior, similar to lemmings following one after the other for a suicide into this without really doing any research. They just madly believed in this person without really thinking how he really made money out of this scheme. The even more interesting part was , did such incident teach us something and did we learn not repeat, no this came back in even bigger form in the same old Ponzi scheme model under Bernie Madoff. 

Something from my own life. This only makes me wonder at our own behavior, this includes me as well. I have not got into such a scheme that I had to write. I did remember investing a small amount of money in Reliance Power of IPO, which was over subscribe by many times, and this was in 2007 when I was still learning to invest in stock market. Though the amount I invested was 6800 INR, and expected to make listing gains. Reliance power had made projections till 2016 for their valuations, and it never took off. I was just plainly lucky that I sold the stocks at 6983 with a <2% gain after the brokerage charges over 6 months. Though it was not a Ponzi scheme, that was a similar investment mistake many other people did before, trading of a small amount with the expectation of a huge payoff.  This behavior is what that makes us to gamble as well, and hence Warren buffet rightly said,

Las Vegas has been built upon the wealth transfer that occur when people engage in seemingly small disadvantageous capital transactions -WB, 1982 Berkshire Hathaway Letter.

So Greed & Hope followed by fear have created enough financial mess - millions of dollars in the 1920s and Billions of dollars with Madoff schemes in the 21st century.