Ponzi Schemes

Ponzi schemes have been in the news a lot lately - thanks to one Richard Madoff who bilked a large number of people out of their hard earned money. Richard Madoff, at 70, has had to move out of his posh luxury penthouse in Manhattan and move into a 7x10 jail cell after pleading guilty to a multitude of charges of "Ponzi scheming" brought against him.

So what exactly is a Ponzi scheme ? Its easy to guess from the context in which the phrase is used that it involves the taking of money from one group of individuals with a promise of incredible returns - often numbers that seem too good to be true.

The label was coined after a fellow named Charles Ponzi who spun his web around 1920 when he scammed about $15 million - Richard Madoff is estimated to have scammed upwards of $50billion 90 years later.

Charles Ponzi's scheme used International Reply Coupons or IRCs - the very same things I remember using as a kid to get pen pals. These coupons were used in the receiving country to buy postage stamps equal to the value of the IRC Coupons. Ponzi claimed that the difference between the amount paid to acquire these in one country, and the amount of postage stamps they could buy in the country where they were being redeemed, represented profit. The difference was enough to yield a 50% return in 45 days and 100% return in 90 days. There are many articles that chronicle Charles Ponzi's scam - http://en.wikipedia.org/wiki/Ponzi_scheme .

Apart from the fact that the real cost of purchase, redemption and distribution would have wiped out the huge margins, because the per unit cost of these coupons was very small, Ponzi did not actually buy the IRCs , he merely said he would. He used new money that was flowing in to pay off the older creditors. With no real value being created, or real profit being generated, he quickly ran out of new investors to pay off the rabidly growing group of older investors.

20 years ago, I had the opportunity to witness the evolution of a Ponzi scheme as my employer tried one "cash flow" based scheme after another to run a business while maintaining a flamboyat lifestyle.

The first venture was recruitment that received "Retainer Deposits" from corporate clients with the promise to find them people to fill jobs in their company. In theory the deposit was fully refundable. The deposits put cash in the bank to allow the comany to pay the salaries and incur the expenses of running a recruitment or placement firm.

The second big phase was "leasing" of office space and furniture. A private investor purchased the fine furnishings for our fancy Nariman Point office, and charged the business a monthly rental fee. This allowed the company to have a very nice office, without the cash outlay. However, it did drive up monthly expenses, and with it the need to pump more cash through the system. The recruiting business never did generate the cash flow required to sustain the fancy office digs.

This saw the introduction of a "Auto Card", where private individuals placed a deposit with the company, who issued them a "card" that they could swipe at gas stations around the city. Funds would be deducted from their deposits and settled with the gas stations on a daily basis. Gas stations and individuals could get out of the business of handling cash.

Funds for the daily settlements with the gas stations ran out almost within the first two weeks. And thus was invented Cash Card - a similar deposit based debit card scheme - which got you a card that you could use at subsequent retailers.

The lights went out on this business, figuratively and literally, about 3 years after the first recruitment retainer was collected. The schemes originated from the rich, US educated imagination of the Gujarati business man who founded the company. There was an indictment, there was a trial or the start of one. And then the scheming business man died - leaving thousands of unpaid bills in his wake.

The sad part in that particularly Ponzi scheme was that no wealth was actually accumulated. Mr. Shah, the founder of the company went back to living in his mother's apartment, as penniless as the day he was born. While the fact that he had frittered away the precious savings of hundreds of middle class families, it was sadder still that he had nothing left to show for it.

Maddox's $70M penthouse atleast gives people something to figuratively hold onto.