How Ponzi Schemes Work

Charles Ponzi's Scheme

In the 1920s, whenever a generous person wanted to send a piece of mail overseas, he or she would probably also buy an international reply coupon. This was handy for the recipient because it was a voucher that paid for the postage required to reply back to the sender. Because this was a relatively common system at the time, no one questioned Charles Ponzi (an Italian immigrant to the United States) when he found an intriguing investment opportunity in the process.

Ponzi's investment idea was plausible: He could buy reply coupons in a different country where they were cheaper, and then sell them in the United States where they were worth more [source: Trex]. The difference was profit that he could share with his investors. He sucked his investors in by promising 50 percent returns in 45 to 90 days [source: Valentine].

The hitch? When he tried to carry through on his business idea, it didn't work out as well in practice as it did in theory. The mechanics of conducting business overseas, transporting the coupons and exchanging them for cash caused delays and extra costs that prevented him from paying investors as quickly as he'd promised. Nevertheless, he kept the bad news to himself. Every day, new, excited investors who heard about the idea wanted in and handed over their savings. Ponzi decided to take the money, but not run. He kept up the ruse by paying off his initial investors with some of the new money that was pouring in and pocketed some for himself. Because his early investors were making money, no one was complaining.

He wasn't clever enough, though. The whole thing fell apart after a few months of Ponzi living lavishly on the millions he had made. People starting wondering how he was buying and selling what must've been 160 million reply coupons out of the 27,000 that existed in the world [source: Trex]. Eventually, authorities busted him.

Charles Ponzi wasn't the first to implement such a scam. However, he stood out from the rest of the petty crooks because of the amount of money he raked in -- which totaled millions of dollars -- and number of people he swindled.