“Masters of the Universe.”
Author Tom Wolfe gave that name to Wall Street’s financial wizards in his 1987 bestseller, The Bonfire of the Vanities.
These “Masters of the Universe” made millions of dollars a year and lived posh lives on New York City’s Upper East Side.
Many tried to buy immortality by putting their names on opera halls, museums and university buildings.
Yet none of them would ever achieve the enduring infamy of a financial antihero named Charles Ponzi.
This compact, dapper and loquacious Italian immigrant even earned his name a place in the Oxford English Dictionary.
Today, over a century after Ponzi’s arrest, the term “Ponzi scheme” remains synonymous with financial swindle.
A Ponzi scheme is a type of investment fraud that promises large profits at little to no risk.
The pitch for a Ponzi scheme is always the same…
A promoter tells investors he can earn astonishing profits by employing some arcane – often secret – investment strategy.
Of course, the promoter’s primary focus is on luring in new investors and using their funds to pay “profits” to earlier investors.
A Ponzi scheme is sustainable as long as new investors contribute new funds and do not demand full repayment.
When the money flow runs out, the scheme falls apart.
Charles Ponzi’s Colorful Life
Born in Italy, Ponzi was as far from a Yale-educated Wall Street blue blood as one could get.
Ponzi worked as a laborer, clerk, fruit peddler, smuggler and waiter until the age of 42.
Those who knew him described a smug little man just over 5 feet tall.
He was slim, self-assured and quick-witted. Above all, he had a silver tongue.
Ponzi began his infamous scam in early 1920. His timing was impeccable. It was the start of the Roaring ’20s, and money flowed easily.
Ponzi started by setting up the Securities Exchange Company as an investment vehicle.
The company invested in obscure coupons that made money in an exchange transaction conducted with the U.S. Postal Service.
Ponzi offered to pay investors 50% interest in 45 days and 100% in 90 days.
He made the scheme sound risk-free.
Investors cared little – and understood even less – about the details.
They cared only about the promise of quick riches.
Ponzi talked up a storm…
Stockbrokers, widows and businessmen all clamored to send Ponzi money.
Ken Fisher profiled Ponzi in 100 Minds That Made the Market and described his success this way…
The money flowed in, first in drops, then in buckets… At first the money was stuffed into desk drawers in Ponzi’s little Boston office, but then it started coming in at a rate of over $1 million per week! Bills flowed from the tops of wastepaper baskets, then covered the floor ankle-deep! There was an endless flow of cash – plenty with which to pay off eager investors.
This “endless flow of cash” is precisely what Ponzi needed to pull off his scheme.
As long as the money kept coming, he kept paying what he’d promised.
Ponzi was robbing Peter to pay Paul.
Then Ponzi started planning for branch offices. He spoke of creating a string of banks and brokerage houses.
He even bought a controlling interest in Hanover Trust Company and made himself president.
Ponzi moved into a large house with servants. Crowds followed him in the streets, chanting, “You are the greatest Italian of them all.”
But it was all too good to be true.
All Good Things Come to an End
The Boston district attorney’s office began to investigate Ponzi. The Boston Post then revealed that Ponzi had been involved in a remittance racket in Montreal 13 years earlier.
All this could have sparked panic among his investors.
But like all good promoters, Ponzi upped the ante.
He promised to double investors’ interest payments.
Money continued to flow in. Finally, Ponzi was arrested by federal authorities on August 12, 1920, and was charged with 86 counts of mail fraud.
Even when out on bail, Ponzi sold underwater lots in Florida, making another small fortune.
In only eight months, Ponzi had taken in $10 million and issued notes for more than $14 million.
That’s the equivalent of $180 million today.
Authorities recovered less than $200,000 from his accounts.
Ponzi eventually pleaded guilty to charges of larceny and mail fraud. He spent over 12 years in jail. When he was released in 1934, he was deported to Italy.
He joined the fascist government and later became the business manager of an airline in Rio de Janeiro.
Ponzi ended up making a meager living teaching English. He died in 1949 with just $75 to his name.
The Red Flags of a Ponzi Scheme
Ponzi’s life story is a striking reminder of the dangers of Ponzi schemes – and how to avoid them.
To identify a Ponzi scheme, here’s what you should look out for:
- Guaranteed promises of high returns with little risk
- Consistent returns regardless of market conditions
- Investments that have not been registered with the Securities and Exchange Commission
- Investment strategies that are secret or too complex to explain
- Lack of paperwork for clients’ investments
- Difficulties withdrawing clients’ money.
Of course, Ponzi schemes did not end with Ponzi’s arrest.
As finance has evolved, so has the nature of the Ponzi scheme.
In 2009, Bernie Madoff was convicted of running a Ponzi scheme in the form of a hedge fund.
His firm falsified trading reports to show profits from investments that didn’t exist.
Madoff kept going for decades, despite several outside analysts like Edward O. Thorp and Harry Markopolos warning as far back as 1991 that his hedge fund was a Ponzi scheme.
The lesson is this…
Motivated by greed, some investors will always fall for the latest incarnation of a Ponzi scheme.
These schemes can take many forms.
Today’s version is a charismatic CEO with a cult following who touts his stock, fund or cryptocurrency with fantastic but unfulfilled promises.
The particulars of each new Ponzi scheme will differ.
But its eventual demise is always inevitable.
Consider yourself warned.