Robbing Peter to Pay Paul: Ponzi Schemes Throughout History

Robbing Peter to Pay PaulPonzi Schemes Throughout HistoryBy Becky LaughnerPonzi artists (left to right): Ivar Kreuger,Bernie Madoff and Charles Ponzi.Ponzi schemes have captured thepublic’s attention recently with thefall of Bernard Madoff’s investmentfund, which, at approximately $36billion, is the biggest financial fraudin history. The principle behind aPonzi scheme is simple. The SecuritiesExchange Commission definesit as investment fraud involving thepayment of returns to existing investorsfrom funds contributed by newinvestors, with the organizer usuallyfocusing on soliciting new investorsin order to provide promised payoutsto earlier investors instead of engagingin legitimate investment activity.Since no legitimate profits are generated,Ponzi schemes are not sustainableand inevitably collapse becausethey require more and more depositorsto support the fictitious returns.The Museum’s new exhibition, “Scandal!Financial Crime, Chicanery andCorruption that Rocked America,”focuses on the most infamous Ponziartists: Charles Ponzi, Ivar Kreugerand Bernie Madoff.The Original Ponzi ArtistThe eponymous Charles Ponzi gainedhis notoriety when he coaxed approximately$7 million from investors in1920. Ponzi began making a namefor himself in Boston, promising a50% return in 45 days with the purchaseof his “Ponzi notes.” An Italianimmigrant and self-made businessman,Ponzi set up a firm with a seeminglyofficious and legitimate name,the Securities Exchange Company, andsold fake securities to investors. Hismany investors did not realize thathis company made no actual profit.Instead, Ponzi paid dividends on hisnotes with money collected from subsequentinvestors, which in turn requiredhim to find yet more investors to coverhis increasing liabilities. Ponzi realizedthat such a plan is not an easy undertaking,but he had confidence andcunning in spades. He also concocteda plausible investment strategy.To attract his initial investors, Ponziadvertised his high returns, explainingthat investment money was beingused for the “lucrative” arbitrage ofInternational Reply Coupons (IRCs).The Universal Postal Union introducedIRCs in 1906 as a way for peopleto purchase postage for someone inanother country, particularly necessaryin that era due to the explosionof immigration across Europe and inAmerica. IRCs could be purchasedin one country and then redeemed inanother for standard letter postageFinancial History ~ Spring 201016www.moaf.org

to a foreign country. Although therate of exchange was set by regulations,the devaluation of currenciesacross Europe following World WarI wreaked havoc with rates, creatinga potential arbitrage opportunity.In theory, the trade of InternationalReply Coupons could produce a profit,but there have never been enough couponsin circulation to support the scaleof Ponzi’s scheme. Most investigatorsnever probed deeply enough to realizethat his IRC plan was a hoax, and ifthey attempted to do so he claimedhe could not reveal his source for thecoupons for fear that a competitorwould steal his methods. Most of all,his impressive knowledge of the intricaciesof the postal system was enoughto convince anyone who questionedhis tactics.Ponzi’s scheme was eventuallyexposed. The editors and reportersof the Boston Post (now defunct, butwhich won a Pulitzer in 1921 for itscoverage of Ponzi and his crimes)became suspicious and brought thescheme to the attention of financialreporter Clarence Barron (founderof Barron’s) to look into Ponzi’soperations. Barron determined thatPonzi was most likely a fraud butthe final straw came after the BostonPost revealed Ponzi’s dubious historyand criminal past in its pages.The news triggered runs by investorsto exchange their notes, causing thescheme to unravel. When an audit wasconducted to determine how muchmoney had been lost, the final tallywas almost $4 million. Six Bostonbanks were also ruined, and Ponzi’sinvestors received only about 30 centson the dollar for their investments.For his crimes, Ponzi served almost10 years in federal and state prisonand was eventually deported backto Italy. He lived there briefly untilhe got a job through a cousin in theairline industry and moved to Brazil.He worked there quite successfullyuntil World War II disrupted the airline’sservice between Italy and Brazil.Despite his innate genius and charismaticpersonality, he spent his life tryingto get rich quickly and ultimatelydied penniless in Rio de Janeiro in1949 at the age of 67.The Match KingIvar Krueger was known as the “MatchKing” because his factories producedmore than two- thirds of the world’smatchsticks at the height of his reignin the 1920s. Although famous for hismatchstick making, Kreuger was actuallya financial genius who masteredseveral industries. Using his experiencein finance, he was able to utilizeMuseum of American FinanceStock certificate for shares in Ivar Kreuger’s company, Kreuger & Toll, dated October 22, 1931.www.moaf.org 17 Financial History ~ Spring 2010

Museum of American FinanceInternational reply coupons like this formed the basis for Charles Ponzi’s money-making scheme.creative accounting practices withoutgetting caught, and move moneyaround via off balance sheet liabilitiesand inter-company holdings and raisemassive capital by introducing complexhybrid securities.Kreuger’s life reads like a moviescript. Born in Sweden to a familywith a small match factory, Kreugeractually got his start in business in theengineering and construction industry.After finishing school in Sweden, heleft for the US to make a name forhimself and spent several years floundering,attempting to set himself up indifferent regions of the country. EventuallyKreuger got a lucky break thatenabled him to pursue engineering. Hespent much of his life as a young adulttraveling the world assisting in majorconstruction projects including thestadium for the 1912 Olympics, theStockholm city hall, the MetropolitanLife Tower, the Flatiron building, TheMacy’s building, Syracuse University’sstadium and many beautiful hotelsaround the world including the Plazaand St. Regis hotels.After stumbling across “KahnIron,” an innovative new reinforcedconcrete building material used primarilyin America, Kreuger came upwith the idea of introducing it toEurope. Partnering with Paul Toll, afellow Swede and Kahn’s representativein Europe, the two pioneered newconstruction methods and formed theextremely successful Swedish engineeringfirm Kreuger & Toll. WithKreuger’s business savvy, the companyquickly developed a near-monopoly inconstruction in Europe and Scandinavia.Soon, though, Kreuger set hissights on bigger things and partedways with Toll. Leaving him to runthe construction company, Kreugerestablished and ran a spin-off holdingfirm bearing the same name as hisconstruction company.Kreuger began pursuing a differentindustry: matches. Due to its abundanceof natural resources, especiallytimber, Sweden had long been a majorplayer in the matchstick market. Beginningwith the takeover of his family’smatch factory and then with other factoriesin the region, Kreuger quicklycame to dominate the Swedish matchstickindustry. Unlike Ponzi, Kreugerproduced actual profits and was quitea successful entrepreneur and financialmanager. It would not be until laterthat Kreuger would begin his scheme.In 1922 Kreuger made a triumphantreturn to America to court the prominentinvestment bank Lee, Higginson& Co. With his extensive knowledgeand ability to recite facts and statisticson even the most arcane financialtopics, Kreuger impressed the Lee,Higginson & Company board, anda partnership was formed. Togetherthey introduced numerous securitiesto the American public over the next10 years until Kreuger’s death in 1932.Securities were issued for Kreuger &Toll, International Match and SwedishMatch Company, the largest ofKreuger’s companies, though it isbelieved that Kreuger supervised over400 different corporations worldwide,some of which were legitimate andothers that only existed on paper.Because Kreuger was incrediblysecretive and he alone controlled hisbusinesses, he treated his companiesas one giant corporation and freelymoved funds between them, oftento the confusion of his accountants.This provided him liquidity and theability to pay consistently high dividends,usually 20–25%, even on hisfailed ventures. (One of Kreuger’sunsuccessful endeavors included a tryat the film industry, which he loved.He is credited with discovering GretaGarbo, a fellow Swede and longtimefriend.) Kreuger realized that hecould use the capital raised from InternationalMatch securities to negotiateloans to foreign governments inexchange for match monopolies. Hethen turned around and used profitsof his monopolies to pay returns onhis securities and negotiate the issuanceof new securities. Playing on theincredible confidence US investors hadin him, Kreuger would occasionallyissue securities before the negotiationswith national governments for matchmonopolies that funded the securitieswere finalized.Kreuger was remarkable in that heFinancial History ~ Spring 201018www.moaf.org

existed as a sort of private financier tothe world, negotiating complex loanswith governments. He essentiallyachieved what the Dawes Plan didby himself; in a little over a decade,Krueger negotiated loans with matchdeals to Peru, Poland, Ecuador, Estonia,France, Greece, Hungary, Latvia,Portugal, Romania, Yugoslavia, Germany,Bolivia, Bulgaria, Guatemala,Lithuania, Turkey and after extensivenegotiations without a resolution, hefabricated a deal with Italy, even forgingthe Minister of Finance’s signatureon fake bonds. He was able to coverhis liabilities and support new businessendeavors by collecting fundsfrom new security issues by Kreuger& Toll and its subsidiaries in a giant,complex Ponzi scheme.After the Crash of 1929, Kreuger’scompanies appeared to weather thestormy economic climate better thanmost. Not believing that the crashwould continue, Kreuger continuedpaying out false dividends and evenextended his liabilities by negotiatinga $125 million loan to Germany.It was impossible to raise sufficientfunds in the aftermath of the crash tokeep up with his obligations. Eventually,Kreuger began to falter on hispayments. Realizing he would soonbe discovered, he committed suicide inMarch 1932. A financial crisis ensuedalmost immediately after Kreuger’sdeath, but it would not be for anothercouple of years that the full extent ofhis deception would be known.Bernard MadoffIn 2008, the largest Ponzi schemein history was revealed by the mastermindbehind it: Bernard Madoff.Unlike Ponzi and Kreuger’s pasts,Madoff’s background provided noindication of his capacity to commitfraud. A co-founder and former chairmanof NASDAQ, he served on theboard of the National Associationof Securities Dealers, was active inphilanthropic circles, and his firm wasat one time the largest market-makerin NASDAQ securities. Founded in1960, Bernard L. Madoff InvestmentSecurities LLC was mostly known formarket making and acting as the middleman in the transaction of buyingand selling stocks. He was a pillar inthe securities industry, providing solidadvice for almost 50 years. Whenhe turned himself in, he caught theworld off-guard, including the SecuritiesExchange Commission.It is estimated that Madoff’s fraudbegan sometime in the 1980s or early1990s, meaning he collected between$10–17 billion in bogus investmentsin only 20 years. Estimated losseswith fabricated gains are thought tobe approximately $65 billion. Thereare many similarities between Ponzi,Kreuger and Madoff’s schemes. LikeKreuger, Madoff’s legitimate activitiesacted as a cover for his fraudulentdealings. Madoff oversaw a secretive,guarded arm of his renowned firmthat provided wealth management services.Keeping it separate from the restof his business, even physically segregatingit on another building floorfrom the rest of his operations, it wasunder this secret division that Madoffran a Ponzi scheme with money fromhis wealthier clients. Madoff did notopenly advertise his special privatewealth management services, creatingthe illusion of exclusivity. The fundconsistently paid out a steady returnof 12% (less ostentatious than Ponzi’s50% or Kreuger’s 20–25%). Oncegranted the privileges of investingwith Madoff’s fund, depositors werereluctant to question the details of hismethods or strategy.As a well-respected financial manager,a man who had testified beforeCongress and who had also workedalongside the SEC in the regulation ofNASDAQ in its early days, the SECfound it unnecessary to interrogate hisoperations as well. His swindle wasnot actually discovered until he turnedhimself in, revealing everything andtaking sole credit for the entire scheme.It is curious that a serious investigationwas never made. In hindsight, thesigns are all there and we know thata handful of people had picked upon the suspicious nature of Madoff’sprofits. In May 2001, both Barron’sand a trade publication called Mar/Hedge published investigative reportson his hedge fund, both citing theimpossible annual returns, Madoff’sdecision to charge a paltry commissioninstead of collecting management fees,and Mar/Hedge additionally noted theunlikelihood of Madoff’s hedge fundbeing one of the largest in the worldwhile remaining virtually unknown.Harry Markopolos also vociferouslyproclaimed Madoff to be a fraud,picking up on suspicious behavior asearly as 1999 and even reported hismisgivings to the SEC on more thanone occasion.At age 71, Madoff went to trial andpled guilty to 11 federal offenses, possiblysparing his family and those aroundhim from admitting responsibility. Hewas sentenced to 150 years in prison,the maximum allowable sentence withno possibility for parole.None of these three stories havehappy endings. Between severe prisonsentences and death, each financierpaid duly for their crimes. Even if theybelieved their schemes were only atemporary means to an end, they allultimately proved that fraud does notpay (for very long) and that a Rob-Peter-to-Pay-Paul scheme is never sustainable.Despite these three examples,which vividly illustrate this importantlesson, Ponzi artists continue to practicetheir art. Just as Kreuger ignoredPonzi’s fate and Madoff disregardedthem both, small scale Ponzi schemesare still amazingly still being revealedeven with Madoff’s name still in newspaperheadlines. FHBecky Laughner is the Museum’sAssistant Director of Exhibits andArchives.www.moaf.org 19 Financial History ~ Spring 2010