He is an Italian tennis champion known for his consistency, balance, and sportsmanship on and off the court. But, as the Italian newspapers reported recently, Andreas Seppi, a 35-year old top Italian tennis player, became a victim in a fraudulent financial scheme that even in Italy is called a Ponzi scheme, in which investors are paid not by profits from an underlying asset but from the funds of more recent investors. How did this scheme get its name?
Charles Ponzi (1882-1949) was born in Lugo, Italy. His ancestors had been well-to-do, but the family had fallen onto hard times. At the age of 21, he emigrated to America. He later told The New York Times,“I landed in this country with $2.50 in cash and $1 million in hopes.” He quickly learned English and took a number of odd jobs. It was several years later that he moved from Boston to Montreal; his charming and cheerful personality enabled him to find work in a bank, first as a teller, then as a bank manager, where he first learned the scheme of “Robbing Peter to pay Paul.” The bank was paying 6% interest on bank deposits—double the going rate at the time. Because of bad real estate loans, the bank was in serious financial trouble; it was funding the interest payments not through profits on investments but by using the money deposited in newly opened accounts. The bank eventually failed.
After a series of scams, Ponzi returned to Boston where he came up with the idea of selling postal reply coupons. It involved a form of arbitrage, in which one could buy postage at a lower price in one country and then sell it in another country at a higher price. He needed to raise money to implement this plan and promised investors that he would double their investments in 90 days (he later shortened this to 45 days at 50% interest). At the time, banks were paying a 5% annual interest rate.
Ponzi set up his company in January 1920. Within a month he had 18 investors. As word spread, the frenzy began building. By May he had received $420,000 (about $5 million in 2017 dollars) and by the next month people had invested $2.5 million (about $30 in 2017 dollars). People were mortgaging their homes and investing their life savings. Newspaper boys to rich Boston Brahmins were eager to get on board. At this rate, Ponzi was able to pay back his investors as promised but most wanted to reinvest. But Ponzi was never able to figure out how to convert postal coupons into cash.
By the summer of that year, suspicions arose over Ponzi’s rapid rise, and the Boston newspaper began a series of investigative reporting. It claimed that it was all a scheme and that Ponzi was hopelessly insolvent. This touched off panic and a massive run on the company, and by August it all came crashing down not only for Ponzi but also for 6 banks. Investors lost $20 million in 1920 dollars ($225 million in 2011 dollars). By comparison, Bernard Madoff’s similar scheme that collapsed with the recession in 2008 cost his investors about $18 billion, 53 times the losses of Ponzi’s scheme.
Ponzi certainly wasn’t the first to try to pull off this fraud. In the 1880s in Boston Sarah Howe set up the “Ladies Deposit” in which she offered clientele an 80% monthly interest rate; she eventually stole the money. Charles Dickens’ novels, Martin Chuzzlewit and Little Dorrit, feature this scheme. But because Charles Ponzi became so notorious throughout the U.S., his name is attached to the fraud.
What about Andreas Seppi? He lost his investment of 500,000 euros plus the promised interest. It was like throwing away the prize money from the most important tournaments of his career in Moscow, Eastbourne and Belgrade. Fortunately, it is not ruinous for him.
Even very smart people can fall victim to these schemes. Bernie Madoff took a slightly different approach from Charles Ponzi. Rather than offer high returns to all comers, he offered modest but steady returns to an exclusive clientele. His investment methodology was “too complicated for outsiders to understand.” He marketed to the well-heeled Jewish circuit he met at country clubs on Long Island and in Palm Beach. But he refused to meet with investors, which gave him an “Oz” aura and increased the allure of his “fund.” Among his victims was the baseball sports team, The New York Mets. Because the 2008 fraud is the largest in history, perhaps it deserves a fresh moniker, the “Made-Off” Scheme.