Charles Ponzi - Origin of The Term "Ponzi Scheme"

Origin of The Term "Ponzi Scheme"

After Ponzi's release from prison, he made his way back to Boston. There he met Rose Maria Gnecco, a stenographer, to whom he proposed marriage. Though Ponzi did not tell Gnecco about his years in jail, his mother sent Gnecco a letter telling her of Ponzi's past. Nonetheless, she married him in 1918. For the next few months, he worked at a number of businesses, including his father-in-law's grocery, before hitting upon an idea to sell advertising in a large business listing to be sent to various businesses. Ponzi was unable to sell this idea to businesses, and his company failed soon after.

A few weeks later, Ponzi received a letter from a company in Spain asking about the catalog. Inside the envelope was an international reply coupon (IRC), something which he had never seen before. He asked about it and found a weakness in the system which would, in theory, allow him to make money.

The purpose of the postal reply coupon was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. IRCs were priced at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed; if these values were different, there was a potential profit. Inflation after World War I had greatly decreased the cost of postage in Italy expressed in U.S. dollars, so that an IRC could be bought cheaply in Italy and exchanged for U.S. stamps of higher value, which could then be sold. Ponzi claimed that the net profit on these transactions, after expenses and exchange rates, was in excess of 400%. This was a form of arbitrage, or profiting by buying an asset at a lower price in one market and immediately selling it in a market where the price is higher, which is not illegal.

Seeing an opportunity, Ponzi quit his translator's job to set his scheme in motion. He borrowed money and sent it back to relatives in Italy with instructions to buy postal coupons and send them to him. However, when he tried to redeem them, he ran into an avalanche of red tape.

Undaunted, Ponzi went to several of his friends in Boston and promised that he would double their investment in 90 days. The great returns available from postal reply coupons, he explained to them, made such incredible profits easy. Some people invested and were paid off as promised, receiving $750 interest on initial investments of $1,250.

Soon afterward, Ponzi started his own company, the "Securities Exchange Company," to promote the scheme. He set up shop in a building on School Street. Word spread, and investments came in at an ever-increasing rate. Ponzi hired agents and paid them generous commissions for every dollar they brought in. By February 1920, Ponzi's total take was US$5,000, (approximately US$54,000 in 2010 dollars). By March, he had made $30,000 ($324,000 in 2010 terms). A frenzy was building, and Ponzi began to hire agents to take in money from all over New England and New Jersey. At that time, investors were being paid impressive rates, encouraging others to invest. By May 1920, he had made $420,000 ($4.53 million in 2010 terms).

He began depositing the money in the Hanover Trust Bank of Boston (a small bank on Hanover Street in the mostly Italian North End), in the hope that once his account was large enough he could impose his will on the bank or even be made its president; he bought a controlling interest in the bank through himself and several friends after depositing $3 million. By July 1920, he had made millions. People were mortgaging their homes and investing their life savings. Most did not take their profits, but reinvested.

Ponzi was bringing in cash at a fantastic rate, but the simplest financial analysis would have shown that the operation was running at a large loss. As long as money kept flowing in, existing investors could be paid with the new money. This was the only way Ponzi had to pay off those investors, as he made no effort to generate legitimate profits.

Ponzi lived luxuriously: he bought a mansion in Lexington, Massachusetts, with air conditioning and a heated swimming pool, and he maintained accounts in several banks across New England besides Hanover Trust. He also brought his mother from Italy in a first-class stateroom on an ocean liner. She died soon afterward.