GUIDE TO THE STOCK MARKET

The Ponzi Scheme

The only difference between this raving lunatic and the typical investor is dress.  Ponzi scheme fraudsters use this fact to their advantage.

The only difference between this raving lunatic and the typical investor is dress. Ponzi scheme fraudsters use this fact to their advantage.

Nobel economist Bob Shiller of Yale University explains the bizarre behavior of inexperienced public investors using the Ponzi scheme as illustration. The Ponzi scheme was a con job perpetrated on the public in 1920 that created the exact same kind of public dog pile behavior in rising bull markets and the desperate rush to sell we see in crashing bear markets.

Carlo “Charles” Ponzi was born in Parma, Italy, in 1882. He immigrated to the United States in November of 1903. Over the next 14 years, Ponzi wandered from city to city and from job to job. He worked as a dishwasher, waiter, store clerk and even worked as an Italian interpreter. In 1917, he settled in Boston, where he took a job typing and answering foreign mail. He also had a dark past he was hiding, and it was in Boston on the fateful day of August of 1919 that Ponzi invented a mechanism to make himself vastly wealthy at the expense of his investors. At the same time, he made his name synonymous with the high-yield investment program con job.

At the time, Ponzi was considering publishing an export magazine. He had written a letter about the proposed publication to a gentleman in Spain. When Ponzi received the reply, the man had included an international postal reply coupon. The idea behind this enclosure was very simple. All Ponzi had to do was take the coupon to his local post office and exchange it for American postage stamps. He could then use the American stamps to send the magazine to Spain.

Ponzi noticed…

that the postal coupon had been purchased in Spain for about one cent in American funds. Yet, when he cashed it in, he was able to get six American one-cent stamps. Thoughts of riches whirled about his mind. He could buy $100 worth of stamps in Spain and then cash them in for $600 worth of stamps in the United States. He also knew that he could not get this kind of inter- est return at a bank.

Ponzi’s mind quickly went into overdrive as he devised a clever scheme to capitalize on his idea. He was determined to be a rich man. His first step was to convert his American money into Italian money (or any other currency where the exchange rate was profit- able). Charles Ponzi then claimed that he had found foreign agents who were using the money to purchase international postal coupons in countries with weak currencies. The stamp coupons were supposedly exchanged back into a strong foreign currency and finally back into American funds. He claimed that his net profit on all these transactions was in excess of 400%. It sounded reasonable enough, but nobody knew it was a scam from the start.

He really couldn’t do what he was claiming.

The red tape of dealing with a bunch of different country postal organizations and the long delays in transferring currency would have destroyed all of Ponzi’s promised profits. Yet Mr. Ponzi knew exactly what he was doing and began bragging to everyone he knew about his high-yield investment program. Friends and family members easily understood what he was saying and they wanted in. They understood exactly the same way investors in London understood and bought stock in the company that claimed to be able to turn chickens into sheep I described to you at the beginning of this book.

On December 26, 1919, Ponzi filed an application with the Boston city clerk establishing his new business as The Security Exchange Company — remember that this was before the SEC existed.

He promised a 50% interest payment in 90 days, and the world wanted in on it. Word spread very quickly about Ponzi’s great idea and, within a few short months, the lines outside the door of his office began to grow. Thousands of people purchased Ponzi’s promissory notes, paying $10 to $50,000. The average investment people made with Ponzi was $300 (which is over $3,000 today).

Why would so many people pay into a scheme that didn’t really work?  The reason was that the early investors did get great returns on their money. Ponzi used the money from later investors to pay off his earlier obligations.

It was a new twist on the age-old pyramid scheme.

With an estimated income of $1,000,000 per week — $10 million a week in today’s money — at the height of his scheme, his newly-hired staff couldn’t take the money in fast enough. They were literally filling all of the desk drawers, wastepaper baskets and closets in the office with investors’ cash. He opened branch offices. Copycat schemes popped up quickly across New England as other fraudsters caught wind of Ponzi’s success.

By the summer of 1920, Ponzi had taken in millions and began to live the life of a very rich man. Ponzi dressed in the finest of suits, had dozens of gold-handled canes, showered his wife in fine jewels and purchased a 20-room mansion.

From the start, regulators were suspicious; federal, state, and local authorities investigated him. Yet no one could pin Ponzi with a single charge of wrongdoing. Ponzi had managed to pay off all of his notes in the 45 days he had promised. Since everyone was happy to get their profits, not a single complaint had ever been filed.

On July 26, 1920, Ponzi’s house of cards began to collapse. The Boston Post headlined a story on the front page questioning the legitimacy of Ponzi’s scheme. Later that day, the District Justice was mysteriously convinced to suspend him from taking in new investments until an auditor had examined his books.

Within hours, crowds of people lined up outside Ponzi’s door demanding that they get their investment back. Ponzi obliged, assuring the public that his organization was financially stable and that he could meet all obligations. He returned the money to those that requested it. By the end of the first day, he had settled nearly 1,000 claims with the panicked crowd.

By continuing to meet all of his obligations, the angry masses began to dwindle and public support swelled. Crowds followed Ponzi’s every move. He was urged by many to enter politics and was hailed as a hero. Loud cheers and applause assured him of public confidence and people were eager to just touch his hand.

Ponzi continued to dream and scheme.

He had planned to establish a new type of bank where the profits would be split equally between the shareholders and the depositors. He also planned to reopen his company under a new name, the Charles Ponzi Company, whose main purpose was to invest in major industries around the world. Ponzi wasn’t as bright as inside corporate executives are today who know that the key to any successful swindle is to take the money and run.

The public continued to support him until August 10, 1920. On that day, the auditors, banks, and newspapers declared that Ponzi was definitely bankrupt. Two days later, Ponzi confessed that he had a criminal record, which only worsened his situation. In 1908, he had served 20 months in a Canadian prison on forgery charges related to a similar high-yield investment scheme he was part of. This was followed in 1910 by an additional two-year sentence in Atlanta for smuggling five Italians over the Canadian border into the United States.

On August 13, Ponzi was finally arrested by federal authorities and released on $25,000 bond. Just moments later, he was re-arrested by Massachusetts authorities and re-released on an additional $25,000 bond.

The whole thing turned into a gigantic mess for the public. There were federal legal suits, state civil suits, criminal trials, bankruptcy hearings, individual law suits against Ponzi and countersuits filed back by Ponzi. Five different banks collapsed in the aftermath! At least 40,000 people had paid $15 million (about $151 million in inflation-adjusted U.S. money today) into Ponzi’s scheme. A final audit of his books concluded that he had taken in enough money to buy approximately 180 million postal coupons, but auditors could only confirm the purchase of two.

Ponzi’s only legitimate source of income over the period of the scam was $45 that he received as a dividend of five shares of telephone stock. His total assets came to $1,593,834.12, which didn’t come close to paying off the outstanding debt. It took about eight years, but inexperienced public investors who were note holders were able to recover a meager 37% of their investment in installments over time. They got their money back just in time to lose it again in the 1929 stock market crash!

– Doc Brown

Dr. Scott Brown

Dr. Scott Brown

BIO: Doc Brown is a national expert on the stock market. His courses “How to Make a Million Dollar Portfolio from Scratch” at the Oxford Club is a national bestseller. Dr. Brown’s research appears in some of the most prestigious academic journals in the field of finance. See Journal of Financial Research and Financial Management. Scott is an associate professor of finance in the Graduate School of Business at the University of Puerto Rico.


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CHAPTER CONTENTS

Chapter 7: Hysteria and Manipulation

Topic 1: Mass Hysteria

Topic 2: Beta Death

Topic 3: Tulip Mania

Topic 4: Ponzi Schemes

Topic 5: Irrational & Happy

Topic 6: Savvy Investors

Topic 7: Insider Executives

Topic 8: Market Corners

Topic 9: Hudson (1851)

Topic 10: Harlem (1863)

Topic 11: Harlem (1864)

Topic 12: Prairie (1965)

Topic 13: Michigan (1866)

Topic 14: Erie (Mar 1868)

Topic 15: Erie (Nov 1868)

Topic 16: Gold (1869)

Topic 17:  Erie (1872)

Topic 18: NW (1872)

Topic 19: NP (1901)

Topic 20: Stutz (1920)

Topic 21: Piggly (1932)

Topic 22: RCA (1928)

Topic 23: Recent Corners

Topic 24: Anti-Corner Laws

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