Bernard Madoff meet Charles Ponzi

Earning enough for retirement requires a long term commitment and regular saving. As an alternative, America has a variety of get rich quick schemes, the most famous of which belongs to Charles Ponzi. His scheme dates from 1920 and even though his was not the first, and definitely not the last, he continues to be an American icon for get rich schemes.

Ponzi’s modus operandi called for three separate transactionsin two countries to buy stamps at a low price to resell at a higher price. By international agreement a foreign national could send a letter to an American using their foreign stamp and for the price of a foreign stamp also buy a Postal Reply Coupon to enclose with their mailing. The American receiving the letter could exchange the postal reply coupon for an American stamp to make a return mailing.

Ponzi noticed that he could have a foreign national send him letters with postal reply coupons: the first transaction. Then he could exchange the coupon for an American stamp: the second transaction. Then he could re-sell the American stamp to an American: the third transaction.

He claimed he could earn a 400 percent return, which was technically correct. American stamps were two cents. If you buy a foreign stamp for a half cent and resell it for two cents you have a 400 percent return. However, it is lots of work to earn 1.5 cents. Earning just a dollar requires 66 of the above mentioned three transaction cycles.

Never mind though, Mr. Ponzi formed the Securities Exchange Company and began luring “investors” by selling vouchers for $1,000, which had a written promise to pay investors $1,500 in 90 days.

Beginning in February 1920 investors started buying the vouchers. At first only a few, but the pace picked up in just a few months. As the early vouchers came due Mr. Ponzi made payoffs with the money from new investors.

It was the early payoffs that brought in more investors until by July 1920 reports indicate he had sold hundreds of thousands of dollars in vouchers. The scheme collapsed after 6 or 7 months because continued payoffs require ever increasing investors to keep up.

Money paid was described as income, but payoffs were actually a distribution of other people’s money. In popular lore, any investment that pays early investors from the capital of latter investors is a Ponzi scheme.

This fall’s bad news in the sub-prime mortgage market was a failure of people who were reckless and irresponsible. The current news about Bernard Madoff is worse because his Ponzi scheme, like all Ponzi schemes, requires fraud.

Charles Ponzi’s investors look foolish expecting a 400 percent return from postal coupons. Mr. Madoff had better disguise, but the Securities Exchange Commission was notified of irregularities, which they did investigate. A serious investigation will detect the payout of capital funds. We will hope their failed detection was just incompetence, but Mr. Madoff, gives the strongest message yet this fall that America needs better regulation of financial markets.