What are Ponzi Schemes
In a Ponzi scheme, potential investors are wooed with promises of unusually large returns, usually attributed to the investment manager’s savvy, skill or some other secret sauce.
The returns are repaid, at least for a time, out of new investors’ principal, not from profits. This can continue as long as new investors line up with cash, and old investors don’t try to withdraw too much of their money at once.
Ponzi schemes are also known as pyramid schemes, from the shape of any chart that reflects their basic premise -- that ever-growing layers of new recruits are needed to provide gains to the smaller, earlier cohorts. A gigantic pyramid scheme virtually bankrupted Albania after the fall of Communism.
Ponzi schemes are named after Charles Ponzi, the flamboyant con man whose scam followed a particularly spectacular course. Mr. Ponzi began telling New York investors in December 1919 that investments in foreign postage coupons could yield 50 percent returns in 45 days. By redeeming coupons bought cheaply overseas for much higher amounts in the United States, he could double their money in three months, he claimed.
Mr. Ponzi was a fast-talking immigrant and college dropout, and his scheme — according to Mitchell Zuckoff, Mr. Ponzi’s biographer — rested on the eagerness of ordinary working people to benefit from the wealth they saw being generated around them as the economy recovered from World War I.
As the fever spread, millions of dollars were coming in every week, most of it from ordinary working-class people investing as little as $10 at a time. It's estimated that nearly three-quarters of the Boston Police Department invested in "Ponzi notes," as they became known.
With successive waves of people entrusting him with their cash, Ponzi needed only enough money to pay off those people redeeming their coupons. Of course, with the prospect of increasing their savings exponentially every couple of months, few ever redeemed anything.
A born overreacher, Mr. Ponzi sketched out ever more grandiose financial schemes and, always smiling, talked as fast as he could. It was not enough. The Boston Post, the financial journalist Clarence W. Barron and state banking officials began digging, and the more they dug, the more they found. In the end, the prison gates swung open once again, investors were left holding the bag and the brief, brilliant reign of Charles Ponzi came to an end.
Mr. Ponzi was convicted of mail fraud in 1920 and served time in federal and state prisons before he was deported to Italy in 1934, never having become a citizen. He died penniless in Rio de Janeiro in 1949 and was buried in a pauper’s cemetery there.
The $50 billion fraud that federal authorities say Bernard L. Madoff perpetrated has been called the largest Ponzi scheme in history. Though the magnitude, scale and details are different, Mr. Ponzi’s scheme and the fraud that Mr. Madoff has been charged with each reflect their respective, super-heated financial eras.