The Hindu Business Line : Dynamics of the Ponzi scheme

The Ponzi scheme is a popular economic hoax whose appeal comes for its paradoxical simplicity and extravagant results. As Charles Ponzi put it “To the crowd there assembled, I was the realisation of their dreams....the ‘wizard’ who could turn a pauper into a millionaire overnight!”

A Ponzi scheme involves raising money from investors with the promise of quick gains. The schemer usually cites a ‘proprietary’ method for attaining those high returns, usually through a complicated arbitrage scheme that is unsustainable. To pay those high returns, the schemer pays off older investors with money he has raised from new investors.

Inherent design flaw

To keep the ruse going, the schemer has to continually raise larger sums from new investors. Obviously, he also skims off funds for personal gains. But the scheme, due to its inherent design flaw, most certainly can’t end well. As Ramalinga Raju of the Satyam infamy so elegantly put it, “It was like riding a tiger, not knowing how to get off without being eaten.”

Charles Ponzi, an Italian immigrant, raised $15 million from the residents of Boston in the summer of 1920 over a period of eight months. His promise — a 50 per cent return in 45 days by trading in international reply coupons (IRCs).

Forex arbitrage

His basic premise was to purchase standardised IRCs in international currency, exchange them for US stamps, then resell the local stamps for a value higher than what the IRCs had cost him abroad. It was essentially foreign exchange arbitrage.

But the catch here was that only $56,000 worth of IRCs had been printed in 1919 though Ponzi had $15 million of investment money! Armed with stacks of cash, Ponzi proceeded to juggle old and new investors, first raising money, cajoling people into leaving their deposits with him for a little longer, paying off old investors with the new investors’ money. Ultimately, the ruse caught up with him; the Boston Post newspaper investigated his scheme and declared him as being ‘insolvent’ which prompted a ‘run’ on his scheme. His grand scheme was in debt of over $2 million when it folded. Only $200,000 was recovered from him. Investors ultimately recovered a third of the money they had invested.

‘Business model’

Ponzi’s scheme and others like it revolve around a simple premise: That money will keep rolling at an increasingly fast clip. Donald Rumsfeld’s line on the Iraq war, “We have no exit strategy…”, applies quite well to Ponzi schemers. Most Ponzi schemes in history are constructs of very persuasive promoters managing to lead along dazzled and gullible investors.

In many respects, the original Ponzi scheme set up the “business model” for all future financial scams. While schemes have acquired new names and claim to profit through different instruments, they largely remain true in principle to Ponzi.

Moral and a warning

Several chit funds which went bust in the late nineties loosely adhered to the Ponzi principle. The US 64’s attempt to sustain dividend payouts, even as its portfolio value plunged in response to falling stock prices, led to a Ponziesque situation where dividends were paid out of capital. The recent Madoff scam, a fund supposedly based on “put-call option arbitrage” turned out to be a $65-billion Ponzi scheme with its investors including some respectable banks and hedge funds.

The sub-prime crisis, whose underlying bad loans spawned a large number of derivative instruments on them, can be likened to a Ponzi-like payoff. Ponzi schemes and their various avatars over the years hold both a moral and a warning to investors. The moral tale is of the oft-quoted pitfalls of greed — there is no return without equivalent risk.

The warning is: Don’t be lured into esoteric schemes which don’t explain how they generate their returns. And if something sounds too good to be true, it is often neither good nor true!