Market Related Articles » Ponzi Scheme » Problems with a Ponzi Deal
What Goes Up - Must Come Down!
The problem with Ponzi's investment scheme is that it is difficult to sustain this game very long because to continue paying the promised profits to early investors you need an ever larger pool of later investors. The idea behind this type of swindle is that the con-man collects his money from his second or third round of investors and then beats it out of town before anyone else comes around to collect. These schemes typically are short term scams, but some have lasted years. In fact, the US Social Security system is considered by many who study Ponzi schemes to be the biggest one of all.
There is of course always the temptation to stay around just a little longer to collect another round of investments - especially since each new round has to be bigger than the ones before. But Ponzi made another, equally fatal, error. He became a member of high society and once he had gotten the taste of this life, he couldn't give it up.
The Decline & Fall of the First Ponzi Scheme
Although he started his business as a penniless coupon clipper, by the end of May 1920 Ponzi was able to purchase a palatial home in the banker's colony of historic Lexington. He also acquired a 38% interest in Boston's Hanover Trust Bank and became an instant pillar of the community.
Ponzi started his scheme on December 26th. Precisely seven months later, on July 26th, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10,000,000 from about 10,000 investors. As word got out about his legal troubles, worried investors swarmed his office. Ponzi confidently greeted them and assured them all was well. He announced he would continue to pay matured notes at face value. Unmatured notes would be refunded in the amount of the original investment for those not willing to wait. He assured investors and law enforcement personnel that he had millions in banks here and abroad, far in excess of his liabilities.
From July 26th until he was jailed on August 13th, Ponzi kept up this practice, appearing at the office each day and redeeming bonds from worried investors. During this time he actually redeemed $5,000,000 of his bonds in a futile attempt to convince the authorities that he was on the up and up. At his bankruptcy trial, it was discovered that Ponzi still had bonds outstanding in the amount of $7,000,000 and total assets of about $2,000,000. Indeed, the seemingly lucky investors who redeemed their bonds after July 26th had to return their windfalls to the bankruptcy court to be distributed among Ponzi's larger circle of creditors. Ultimately, after about seven years of litigation, Ponzi's disillusioned investors got back 37 cents on the dollar of their principal, with, of course, no whiff of any profits from the nation's first and most notorious Ponzi scheme.
During his trial Ponzi's attorneys considered a defense of "financial dementia." Ponzi's acquaintances testified that for more than twenty years he was obsessed with devising various grand plans for amassing immense wealth. Perhaps, after all, Charles Ponzi believed in his own scheme.
The Logic of Ponzi Schemes, Chain Letters & Pyramid Schemes
The essence of the Ponzi scheme was that Ponzi used the money he received from later investors to pay extravagant rates of return to early investors, thereby inducing more investors to place their money with him in the false hope of realizing this same extravagant rate of return themselves. This works only so long as there is an ever-increasing number of new investors coming into the scheme. To pay a 100% profit to the first 1,000 investors you need the money from 2,000 new investors. To pay the same return to these first 3,000 investors in the next round, you need the money from 6,000 new investors. If all the investors stay in the scheme, then you will need 18,000 new investors to pay off the first 9,000 investors. In fact, if all the investors stay in the scheme, the number of investors participating has to triple with every round of investments. In Ponzi's scheme, starting with only 1,000 investors, after the 15th round the number of investors would exceed the population of the earth.
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In the classic chain-letter scheme 1 person gets, say, 10 people to make an investment and each in turn get 10 additional people to invest, who then in their turn must each get 10, and so on. The money for the first 10 "investors" comes from the 10 they enroll, and the money for the second group of 10 comes from the 10 investors that each of them enrolls, and so on. Diagrammatically, such a scheme looks like a pyramid - hence its alternative name.
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The reason that this is a scheme and not an investment strategy, is that the progression it depends on is unsustainable. You must continually get more and more new people into the system to pay-off the promises to the earlier members. So if I promise to double your money, the only way I can do that is to get two new people to give me the same amount you "invested," which I then pay to you as your "profit." But now I have two new people, each of whom expects the same pay-off. And to pay them, I need to get four new people. And to pay those four, I will need eight more, and son on. After a few rounds of this kind of increase, the number of new participants in the next round would be larger than the number of persons on the earth. That's why all pyramid schemes must inevitably come crashing down.