What Was the Original Ponzi Scheme?

Five cents. That's what a Boston post office would give you in stamps for the paper coupon at the heart of the original Ponzi scheme. Not five dollars, five cents. And buying them cheap in Europe and trading them in here was perfectly legal. By the summer of 1920, the line outside Charles Ponzi's office on School Street on Boston By his own account, four people abreast, down the stairs, out the door, around the corner. Every one of them had come to hand over real money for a business built on postage vouchers, a business Ponzi had already disclosed to the newspapers in fairly precise detail. The beginning of the end came from a man who never met him, never walked into the office, never opened a ledger, never subpoenaed a thing. He asked a different question. Not whether Ponzi was honest, whether there was enough paper in the world for the story to be true. The easy answer is that Ponzi made the business up. Charming immigrant, good suit, invents a fake trade, promises impossible returns, pays the old investment brokers with money from the new ones, runs until the music stops. That last part is exactly right. It's also a description of what happened, not an explanation of why so many people believed it. And the first part is wrong. The trade wasn't fake. In 1906, the Universal Postal Union invented something called an international reply coupon. The idea was simple and rather kind. If you wrote to your mother in Italy and wanted her to be able to write back, you couldn't send her an Italian stamp because you didn't have one. So you bought a coupon at your own post office, folded it into the envelope, and she took it to her post office and traded it for the stamps she needed. The rate at which those coupons turned into stamps was set by treaty. Then the First World War happened and the currencies of Europe fell apart. The treaty rate didn't move with them. So a coupon that cost a few small coins in Rome or Madrid could be carried into an American post office and traded for noticeably more American postage than the buyer had paid for it. That's not a con. That's an arbitrage sitting in plain sight. The Smithsonian's own postal museum says as much plainly, coupons bought in weak currency countries were genuinely worth more on this side of the Atlantic. And Ponzi didn't dream it up. By his own account, he found it in his mail, a letter from a business contact in Spain with one of the coupons folded inside. Money arrived as a loan. You handed Ponzi cash. He handed you a note promising to pay it back with half again on top in 90 days. Then he beat his own deadline and paid early, which sent everyone who got paid out into the neighborhood to talk. He also paid a commission to whoever had signed you up out of the same pot. Here's the arithmetic the Supreme Court laid out in 924, going through the wreckage. Put the agent's commission together with the interest promised and every loan Ponzi paid back in full cost, 60% more than it brought in. Sixty cents of loss on every dollar that walked through the door. Not eventually. Not after a bad stretch. On the day the note was signed. Which means the better the business did, the more insolvent he became. Success and collapse were the same event, moving at some speed. Every new dollar had to cover the last dollar plus its promise and then find another dollar standing behind it. There's no version of that arrangement that improves with volume. The court's summary of what he actually did with all that money runs to seven words. He made no investments of any kind. That's the entire audit. By the first of July, 1920, cash was arriving at about a million dollars a week in a business whose basic unit was worth five cents. The man with the question was Clarence Barron. He owned the Wall Street Journal. He had done more than anyone alive to invent American financial journalism. And in late July of 1920, the Boston Post asked him what he made of the Wizard Wars and School Street. Ponzi by then was being written up as a genius on two continents. Barron didn't say the coupon trade was impossible. He said the opposite. You could make money at it. He granted that immediately. What you could not do was make much. And then he went and asked the Universal Postal Union how many of these coupons were actually out there, a few hundred thousand dollars worth in the entire world. Ponzi's was describing a trade running to 10 or 15 million. The postal inspectors had already arrived at the same place on their own. Their investigation had shown that worldwide coupon sales came nowhere near what Ponzi's story required. They couldn't arrest him for it. At that stage, nobody had complained of being cheated. So there was nothing to charge him with. They knew, and they had to stand there and watch the line get longer. And that's before the physical part. Somebody has to stand at a post office window in Europe and buy those coupons from a clerk one transaction at a time. Somebody has to ship them across the Atlantic in a decade when that meant a boat. Somebody has to carry them into American post offices, which had already begun, refusing to cash them in large batches. Then somebody has to turn a heap of postage stamps into actual money by selling them at a discount to people who happen to need stamps. You're probably imagining warehouses. There were no warehouses. There was a man in a queue. The trade was real. It had a ceiling, and the ceiling was built out of paper and clerks and boats, and it sat roughly where a decent side income sits. Which puts the interesting part of this story where people don't usually look. Ponzi's problem was never inventing a business. It was finding one true enough to survive the first question and vague enough to survive the second. The coupon did both. It was checkable at the level of one coupon and unimaginable at the level of a million of them. And the gap between those two facts is where he lived for eight months. Here's my opinion, and it runs against the moral this story usually gets. The dangerous part of a Ponzi scheme isn't the lie. It's the true thing sitting in front of the lie. A completely invented business dies fast because the first person who asks a question gets a bad answer. A business with a real idea at the bottom of it survives. Because every careful person who checks the first step finds that the first step is fine. Diligence stops at the wrong depth. That isn't a failure of intelligence. It's just how checking works. Which is why the shape keeps coming back. Wearing better clothes. In October of 2005, an analyst Harry Markoplos sent the Securities and Exchange Commission a complaint titled, The World's Largest Hedge Fund is a Fraud. He'd been asked years before to reproduce that fund's returns, and he hadn't been able to. The strategies the fund described was a real one, a standard options hedge. The sort of thing taught in a classroom. Markoplos didn't argue with the strategy. He listed the warning signs, and one of them was simply the volume of options the fund claimed to be trading, held up against the volume that existed. The Commission's own Inspector General later set that complaint out in a report about how the agency failed to catch Bernie Madoff. Same argument. Same question. Different paper. The next one won't look like a lie either. It'll look like homework. And the homework will check out all the way down to the last step, which is always the one where somebody asks how much of the stuff actually exists in the world.