Ponzi Scheme

views updated Jun 11 2018

Ponzi Scheme

Ponzi scheme is the name given to any business or economic entity promising to pay a higher return to its investors than can be generated by this business’s net operating income. Operations of this type are sustainable only as long as funds from new investors or lenders are available to meet outstanding payout requirements.

This phrase originated in a get-rich-quick operation devised in the early twentieth century by Charles Ponzi (Zuckoff 2005). After immigrating to the United States from Italy in 1903 and serving time in prison, Ponzi launched his scheme in Boston in mid-1919. Ponzi’s operation was based on the arbitrage possibilities of the cross-border system of postal-reply coupons. In this system, people mailing documents internationally could send along coupons that enabled recipients to mail back the documents using stamps bought in the recipient’s country. The system used rates fixed in 1907 that had not been adjusted for subsequent currency realignments. Ponzi and his agents took advantage of this system by converting funds into devalued currencies, using those monies to purchase postal-reply coupons, trading them (at 1907 par values) for postal coupons in countries with stronger currencies, then converting these stronger countries’ coupons back into currency.

Ponzi obtained funds for his plan by offering a 100-percent return in ninety days. By July 1920 he had attracted millions of dollars to his Security Exchange Company. His scheme triggered an investment mania, and he began living luxuriously. Most of the returns paid to investors in Ponzi’s schemes came from new investors’ funds, not from postal-coupon investment earnings. Ponzi’s scheme was exposed by the U.S. Postal Service, and federal agents raided the Securities Exchange Company in August 1920, rendering worthless the stakes of his 17,000 investors. After serving more time in prison, Ponzi was deported to Italy; he died at a charity hospital in Rio de Janeiro in 1949.

Ponzi schemes have arisen frequently, both in the past (Kindleberger 1978) and in the present. Many Ponzi schemes now operate on the Internet. Such schemes can be sustained as long as existing investors do not liquidate their positions, and as long as new investors opt in and regulators do not intervene. When a bailout is expected, it can be rational to participate in a Ponzi scheme (Bhattacharya 2003). These schemes resemble asset bubbles in that investors in both cases suspend belief and are often driven by greed; but asset bubbles arise in open markets with changing sets of investors, whereas Ponzi schemes arise via closed contracts made to well-defined sets of investors. Pyramid schemes are one variant of the Ponzi scheme in which the earlier in the scheme a participant signs on, the greater that person’s share of excess returns.

Economists increasingly describe any situation as “Ponzi” when it involves payout obligations that can be met only through borrowing against future income. For example, in his theory of financial fragility, Hyman Minsky (1975) used the term Ponzi finance to denote the borrowing requirement of firms whose cash flow from current operations is insufficient to meet current liability obligations. Thomas Sowell (2003), among others, has argued that social security systems have Ponzi characteristics, in that old-age benefits liabilities are transferred across generations instead of being self-financed. Other economists, such as Stephen O’Connell and Stephen Zeldes (1988), have modeled the behavior of governments with growing fiscal deficits as Ponzi games.

SEE ALSO Bubbles; Discounted Present Value; Discounting; Financial Instability Hypothesis; Financial Markets; Future Prices; Hedging; Leverage; Liquidity Premium; Overlending

BIBLIOGRAPHY

Bhattacharya, Utpal. 2003. The Optimal Design of Ponzi Schemes in Finite Economies. Journal of Financial Intermediation 12: 2–24.

Kindleberger, Charles P. 1978. Manias, Panics, and Crashes: A History of Financial Crises. New York: Basic Books.

Minsky, Hyman. 1975. John Maynard Keynes. New York:Columbia University Press.

O’Connell, Stephen A., and Stephen P. Zeldes. 1988. Rational Ponzi Games. International Economic Review 29 (3): 431–451.

Sowell, Thomas. 2003. Applied Economics: Thinking Beyond Stage One. New York: Basic Books.

Zuckoff, Mitchell. 2005. Ponzi’s Scheme: The True Story of a Financial Legend. New York: Random House.

Gary Dymski

International Encyclopedia of the Social Sciences

Ponzi Scheme

views updated May 21 2018

PONZI SCHEME

A fraudulent investment plan in which the investments of later investors are used to pay earlier investors, giving the appearance that the investments of the initial participants dramatically increase in value in a short amount of time.

A Ponzi scheme is a type of investment fraud that promises investors exorbitant interest if they loan their money. As more investors participate, the money contributed by later investors is paid to the initial investors, purportedly as the promised interest on their loans. A Ponzi scheme works in its initial stages but inevitably collapses as more investors participate.

A Ponzi scheme is a variation of illegal pyramid sales schemes. In a pyramid sales plan, a person pays a fee to become a distributor. Once the person becomes a distributor, he receives commissions not only for the products he sells but also for products sold by individuals that he

brings into the business. These new distributors are beneath the person who brought them into the pyramid scheme, so they are "under the pyramid." In illegal pyramid schemes, only the people at the top of the pyramid make substantial money because they get a commission from the products sold by everyone below them. As more people become distributors, the persons lower in the pyramid have less chance to make money.

A Ponzi scheme was once was called a "bubble," but it was renamed in 1920 after Charles Ponzi and his Boston-based company had collected almost $10 million from ten thousand investors by selling promissory notes that claimed to pay 50 percent profit in forty-five days. When the scheme was exposed, a Boston bank collapsed, and investors lost most of their money.

Ponzi, an Italian immigrant, thought of profiting from the widely varying currency exchange rates for International Postal Reply Coupons (IPRCs), which were redeemed for stamps. IPRCs were intended to facilitate the sending of international mail. The sender put an IPRC, rather than a stamp, on a piece of mail going to another country, and the recipient exchanged the IPRC for the appropriate stamp in her country.

Ponzi contended that he could pay a small amount for IPRCs in weak-currency countries and then redeem them at a substantial profit in the United States. He correctly noted that a stamp transaction might yield a 400 percent profit, but the amount of profit in real terms was very small. Nevertheless, he promoted his idea through his Boston-based securities Exchange Company. In March 1920 he began soliciting funds for purchasing the IPRCs with a promised 40 percent return in ninety days. Bank interest rates at the time were just five percent. Investors started loaning Ponzi their money, and within a short time he increased the promised return on forty-five-day notes to 50 percent. He also promised a 100 percent return on funds loaned to him for ninety days. He pledged to refund money on demand to any investor before the loan period was up.

Money soon flooded Ponzi's offices. By July 1920 he was taking in $1 million a week. Ponzi made an arrangement with the Hanover Trust Company of Boston to deposit his funds. Hanover officials soon realized that Ponzi was not paying his initial investors with interest income but with the deposits of the new investors. Nevertheless, the bank eagerly sold Ponzi a large amount of its stock.

On August 2, 1920, a Boston newspaper revealed the fraud and reported that Ponzi was hopelessly insolvent. Thousands of victims immediately demanded refunds. Ponzi paid as many as he could but exhausted his funds in a week. He then declared bankruptcy. In bankruptcy, the court ordered all of the persons who had been paid by Ponzi during the life of the scheme to return the proceeds to the bankruptcy trustee, who distributed the money on a pro rata basis to all of the other victims. Ponzi was eventually convicted of fraud in both state and federal court and imprisoned for several years.

The Ponzi scheme did not end with Charles Ponzi. It has proved to be a reliable scam in which persons are lured into giving their money to con artists who promise enormous financial returns. The early cycle of a Ponzi scheme appears to confirm the reliability of the investment, as some investors are paid the promised returns. The scheme is doomed to collapse when not enough new money exists to pay old obligations.

Gullible individuals are not the only victims of Ponzi schemes. In the early 1990s, John G. Bennett, Jr., and his Foundation for New Era Philanthropy lured many U.S. universities and nonprofit groups into investing millions of dollars in the foundation. Bennett promised these organizations that they would double their money in six months with the help of anonymous philanthropists. In May 1995 Prudential Securities, Inc., where most of the funds were deposited, discovered that New Era was under federal investigation and froze its accounts.

The action triggered New Era's bankruptcy. Bennett was later charged with eighty-two counts of fraud, money laundering, and income tax evasion. As with the original Ponzi scheme, defrauded investors agreed to be reimbursed for up to 65 percent of their losses, with the money coming from groups that had deposited money with New Era early in the scheme and made a profit.

Internationally, the nation of Albania was plunged into civil unrest in 1997 when a multimillion-dollar Ponzi scheme collapsed. Many Albanians had invested large amounts of their savings in the scheme, which allegedly had the backing of Albanian government officials. Faced with economic ruin, citizens rioted against the government.