Friday, January 29, 2010

Ponzi’s foray into foreign exchange

Charles Ponzi’s “untrodden path to fabulous wealth” took him into the world of foreign exchange via international reply coupons. These coupons, issued by the post offices of most countries, were prepaid postage. For instance, a coupon from Spain read: “This coupon [purchased for 30 centavos] may be exchanged at any post-office of any country in the Universal Postal Union for a postal stamp of the value of 25 centimes, or its equivalent.” (p. 104) Thirty centavos were nominally equivalent to 6 cents; 25 centimes, 5 cents.

Ponzi calculated that he could make a modest profit on Spanish coupons. “The peseta . . . was then quoted at 15 cents . . . instead of 20 cents, its par value. A little figuring disclosed that, at that rate, six and two-thirds pesetas could be bought for one dollar. Since a peseta was made up of 100 centavos, six and two-thirds pesetas were equal to 666 centavos. It didn’t take much to find out that with 666 centavos, I could have bought at any Spanish post-office 22 . . . coupons which I could exchange in the United States for a 5 cent stamp each. Or, $1.10.” (p. 105)

Admittedly, a 10% margin wasn’t spectacular. But other currencies were more debased. The Italian lira was quoted at 5 cents instead of 20 cents. “A dollar would have brought 20 lire, or 2,000 centesimi. With 2,000 centesimi,” Ponzi wrote, “I could have obtained 66 coupons at 30 centesimi each. Or enough coupons to obtain in exchange for them at the Boston post-office $3.30 of 5 cent stamps. A gross profit of 230%.” (p. 105)

This scheme was not illegal, but it obviously had to be carried out on a grand scale to bring in substantial profits. The Boston postal inspector was skeptical, so Ponzi explained his business plan in more detail. “Assume . . . that France needs fifteen million dollars of francs. I borrow in this country one million dollars at 50% interest.... The million dollars, at the current rate of exchange, is equal to fifteen millions of francs. I send a draft of it to the French government with the understanding that France will issue to me 50,000,000 of international reply coupons. France can obtain the coupons from the Universal Postal Union on open account. As soon as I receive the coupons, I exchange them here for stamps. Then I sell the stamps at a 10% discount. Let us assume that I pay also a 10% commission to the agents who have been instrumental in obtaining for me one million dollars from the public.” (p. 127) So, Ponzi explained, he would get $2,250,000 from the sale of the discounted stamps, pay $1 million in principal and $500,000 in interest to his noteholders and $100,000 to agents, with a gross profit for himself of $650,000.

And, as Ponzi continued to explain, the Universal Postal Union ledger would show the U.S. with a $2.5 million credit and France with a $3 million debit. “Why three million dollars? Because the coupons cost the French government 15,000,000 francs payable in gold, at their gold parity of 5 francs to the dollar. While they didn’t cost me but one million dollars, at the current exchange rate of 15 francs to the dollar. The difference between what France must pay and what the United States can collect, represents the charges of the Universal Postal Union for the service.” (pp. 127-28)

Although France is facing a $2 million shortfall as a result of this transaction, it can finance it through a bond issue. Ponzi calculated that France would actually realize a profit of $1.2 million on a twenty-year bond and France’s bondholders would earn $1.8 million. In brief, everybody makes money—Ponzi’s noteholders with their 50% return in 45 days, the United States post office that presumably turns a profit on the sale of $2.5 million worth of stamps, the Universal Postal Union ($500,000 in fees), those who buy stamps from Ponzi at a discount, the French government, and holders of the French bonds. All participants in Ponzi’s business deal get a free lunch.

Unfortunately there was no free lunch for Ponzi’s investors. He had counted on a limitless supply of international reply coupons but in fact was able to buy very few. As he wrote, “If [people] gave a thought at all to the coupons, they must have got dizzy figuring how many of them I needed to justify what I was doing. In fact, my visible resources then were in excess of $5,000,000. Assuming I earned two cents on each coupon, I should have had to handle over 250,000,000 of them! It was absurd. There were not that many in the world. There had never been that many. It would have taken months to print them.” (p. 153)

And so an extravagant but legal business plan quickly morphed into what the world now knows as a Ponzi scheme.

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Postscript: Charles Ponzi entered the banking business after the creation of the Federal Reserve (1913) and before the FDIC (1933). He believed that bank depositors were not getting a fair deal. “They were at the mercy of the board of directors who might and might not be honest men. . . . The depositors . . . were not receiving adequate returns for the risks they were incurring.” (p. 197) He came up with an idea for bank reform. Addressing the executive committee of Hanover Trust Company, he outlined his idea. Let me quote him in full.

“It occurs to me that this committee has supreme control over the millions which our depositors have intrusted to this bank. We may or may not exercise control judiciously. If we do, we earn some extra stock dividends. If we don’t, we might lose not over twice the amount of our buildings, or $800,000 while our depositors may lose several millions. The greater risk is theirs. Theirs is the greater loss. Yet, when all goes well, we only pay them about 4% a year. The situation seems unfair. I would be in favor of extending to depositors greater privileges and larger returns. For instance, I suggest that the depositors be permitted to elect a certain number of directors. They have a right to know what is being done at these meetings. In addition, I suggest that stockholders be paid a definite dividend of 7%, the same as the depositors are being paid 4%. All net earnings in excess of that should be equally prorated between stockholders and depositors. In other words, I advocate profit sharing banking.” (pp. 197-98)

The committee endorsed Ponzi’s plan. They subsequently invited all the financial editors of Boston papers to a meeting to explain this plan. But the newspapermen were beholden to the “Boston banking machinery”; they “knew only too well which side of their bread was buttered. In fact, the next day they reported that, after consulting with their managing editors, they couldn’t publicly endorse my plan.” (p. 198) Although Ponzi was prepared to publicize the plan with “his own” money, the law was closing in; his idea for banking reform remains but a footnote in off-beat financial history.

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