I wrote a post on Ponzi schemes back in the early days of Rolling Alpha – and I think it’s worth a re-fresh and re-post.

You know the old adage: “If it seems too good to be true, it probably isn’t?”

The gentleman that said it first was probably the victim of a Ponzi scheme.

It’s a name that most people associate with those product fliers that you find attached to your windscreen. The type with glossy photographs of well-manicured housewives and large-fonted promises of earning “up to R50,000 a month – it’s in your hands!!” On the back, there are always testimonials of how the product/retirement vehicle/stream of income changed lives and influenced people. And there’s usually a smiling model that abandoned “a successful career in <obscure field>” to pursue his lifelong dream of owning a Jamaican small-holding with an infinity pool and a personal chef.

The first Ponzi Scheme to be called a Ponzi Scheme

Ponzi schemes are named after Charles Ponzi, the famous con artist of the 1920s. And he began with a really good idea.

In the 1920s, post was king – and postage stamps were the crown jewels. At the time, there was a coupon available (the “International Reply Coupon”, or IRC) that you could attach to the letter that you were sending, and the recipient would then be able to go into a post office wherever he was (provided that he was in a country that belonged to the Universal Postal Union – and almost all countries were/are) and exchange it for a stamp that equalled the price of sending the letter back. That, or redeem the cash (so I’ve read).

And this was quite useful, because most countries in the 1920s had strict capital controls: and the IRC allowed you to circumvent them*.
*instead of wiring money, you just sent IRCs and the recipient could cash them in.

But the exciting part (from Mr Ponzi’s perspective) was that he realised that while these IRCs could be redeemed anywhere, they had different prices in different countries. For example, high inflation in the mediterranean countries made return postage much cheaper in US dollar terms than return postage from the States. This created an arbitrage opportunity.

Postage arbitrage

Hypothetical example: the USA and Mexico. Let’s say that an IRC was worth $1.50 in the USA, but cost an effective $1.00 in Mexico. Now let’s assume that I lived in Texas, within close proximity of the Mexican border. I could have done the following:

  1. Borrowed $1,000 from my bank.
  2. Jumped the border.
  3. Purchased 1,000 IRCs with it.
  4. Jumped the border again.
  5. Redeemed the IRCs for $1,500 at a US Post Office.
  6. Paid the bank back $1,000.
  7. Kept the $500 profit.

And that, in a nutshell, is arbitrage. “Risk-less” profit – although there were a few risks in the above example, if I’m honest. But that’s the general idea.

So Charlie spotted this, and decided to get other people in on the game.

At some point, I’m sure people must have asked some questions:

  • What if you can’t redeem all the stamps?
  • Surely it costs money to move from one country to another – how are you covering that cost?
  • Ummm – how is it that the total value of your investment exceeds the value of the world’s supply of IRCs? (my personal favourite – this question was asked when people realised that his total amount invested implied that there were around 160 million IRCs in issue. In reality, there were about 27,000).
Postage arbitrage ponzi

As it happened, those were good questions to ask. Because not a lot of arbitraging was taking place. Instead, the process went something like:

  1. Charles told his closest buddies about the opportunity. He promised a 50% return in 45 days (genuinely what he claimed). They gave him $100 to start with.
  2. He paid them $50, and was left with $50.
  3. They thought he still had the $100, and they told him to keep it so that he could do it again.
  4. They also told their closest buddies about it. The second group of investors gave Charles $200.
  5. 45 days later, Charles paid everyone back $150 (50% of $300). The investors thought that he still had the original capital of $300 (in reality, he had $300 – $50 – $150 = $100). The second group of investors told their closest buddies about it. The third group of investors gave Charles $400. Note: as the investors tell people, there is exponential growth occurring. one person tells two people (now three know). Those two people each tell two more people (now five people know), and so on.
  6. Charles paid everyone back $350 (50% of $700). The investors still thought that he had the original capital of $700 (in reality, he had $700 – $50 – $150 – $350 = $150).
  7. And so on – an expanding investor base, with new capital being used to pay these artificial returns.
  8. But these investor bases could not grow indefinitely. Eventually, the scheme grew too big, and not enough new investors were around to finance the expanding return requirement.
  9. But to illustrate the collapse,, let’s just assume that there were no new investors after the third group. In the next round of payments, Charles needed to pay out another $350. He couldn’t, because he only had $150 left.
  10. So, he announced a loss.
  11. As investors started to withdraw their money, they realised that there was no capital left. Charlie had been robbing Peter to pay Paul, as the saying goes.

And that, more or less, is a Ponzi scheme. Someone comes out with a crazy investment idea that seems to make sense. People invest. Those people get the returns promised. More investors flock to the “opportunity”, generating more returns. And so on, until the con artist disappears with the cash, or some external factor makes the investors attempt to withdraw their money.

The second situation is what happened with the Bernie Madoff Ponzi scheme. When the subprime crisis began, investors were trying to pull their investments out, and then everyone had the crushing realisation that the cash was gone.

The take-home message

So the next time you receive a flyer, chuck it.

And if your mate comes to you with this great investment idea – remember that high returns can very easily be a myth.

In fact, they probably are.

Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha. Also, check out the RA podcast on iTunes: The Story of Money.