The Ponzi Scheme

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Ever heard someone say that a given scheme or deal is a Ponzi scheme? This week, I will discuss the historical context of the term ‘Ponzi Scheme’.


Charles Ponzi, on whose name the term was coined, was born in Italy in 1882, where he led a life that involved doing minor crimes and frauds adjacent to his primary job. During early stages of his life as a banker, Ponzi was caught forging a signature on a check and was sentenced to serve prison time for 4 years at Quebec. Despite of being caught initially, Ponzi was again involved in a criminal activity wherein he was caught smuggling few Italian immigrants into the United States. After serving prison time again, Ponzi decided to come back to the United States, where he tried multiple minor jobs until he performed his mastermind scandal.

While in the United States, Ponzi could not find a proper job and hence, he was forced to work in his father-in-law’s grocery store. While checking his father-in-law’s mailbox, he found his criminal inspiration on a mail that he received from a European company that offered its shares and bonds and promised a rate of interest of 5%. Ponzi’s criminal mind got an idea that he was later able to use to amass massive sums of money.

While it may seem to a common man that Ponzi’s excitement for this plan could be related to the excitement upheld by the commoner for his stool ideas, Ponzi was, however, not willing to give up on his plan.

Ponzi had had a history of being a failed criminal. He had performed criminal activities, but he was never able to capitalize on them. This time, however, he knew that his plan had some basis – ‘Human Greed’. The first part of his fraud revolved around Ponzi asking his men to buy share certificates in countries abroad and then converting them for air-post stamps in the US, eventually selling them at a premium as high as 200%. To earn more money, Ponzi mass-released a scheme where he offered a 50% gain to people who invested for a span of 45 days and 100% gain to people who invested for a span of 90 days. The scheme spread like forest fire. People started giving money to Ponzi, to an extent that he was able to circulate the money he earned as revenue and the money he gave as interests. Even after doing so, Ponzi was able to amass huge sums of wealth.

However, Ponzi’s dream run did not last long. When Boston Post began investing the source of the returns that he promised, investors began to fear for their money and demanded their money to be return. However, Ponzi was in no situation to return the money. Eventually, on 12th August 1920, Ponzi was charged with 86 counts of mail fraud and for beholding bad debts of US$ 7 million.

Favorite question time! Why did this happen?

Ponzi was smart. People were greedy. The system was blind.

To explain this, one of my general education courses – criminology – helped. During this course I have understood that people with criminal tendencies exist because of their socio-economic conditions. Similarly, Ponzi was a poor and an under employed person. He knew that if he did not pull-off any such financial trick, he would live a life in solace and poverty.

 Let’s talk about the people who got fooled by this trick.

The offer put forth by Ponzi was too good to be true. If people would’ve compared it with other companies offering investment deals, they should have understood that the deal put forth by Ponzi was bound to have loopholes. However, the greed for money overpowered all their eccentric value systems and further, their ability to analyze situations.

Have we seen any such major Ponzi scheme in the recent history?

Yes, certain cryptocurrencies. In 2017, there was a sudden buzz around cryptocurrencies and the block-chain technology. In fact, in the month of August of 2017, 50 new cryptocurrencies arrived in the market. During an after-math analysis it was realized that many of these 50 cryptocurrencies were self-manipulated. While these currencies offered massive rates of return, they were hollow rises. When these cryptocurrencies were scrutinized, their prices fell dramatically and many people, across the globe, lost a lot of money, including me.

The Satyam Computers scandal

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This week we will talk about Satyam Scandal – the largest corporate scam of India and the 10th largest in the world

Satyam Computers, the organization that was involved in the scam, was the brain child of two brothers – Ramalingam Raju and Rama Raju. The company was started in 1987 in a city called Hyderabad in India as an IT and computing consultancy agency. During it’s entire life, Satyam computers rose as the largest IT firm in India, followed by accreditation by World Bank organization, followed by its eventual downfall in 2009 when it saw its share prices fall from Rs. 410(approximately US$7) to Rs. 25(approximately US$0.3) within 3 days.

On 7th of January 2009, Satyam Computers’ owners – Ramalingam and Rama – wrote a letter to the board of directors, explaining the manipulations they had done with the company’s balance sheets. In this letter they explained the degree to which this scam was done and the entire process that led up to their confession.

Former Chairman, Satyam Computer Services (India)

What could have caused Satyam computers, a US $2.1 billion company to perish is a very interesting story

                The two brothers established the pillars of the company in 1987 to explore the newfound field of technology – computers. Satyam computers was amongst the first few IT related companies that were established in the east and hence, it had business partners across India, Japan, China, and several south east Asian countries. It was also amongst the few successful IT companies that were able to provide dynamic and customer friendly services and hence, by 2003, its business operations expanded to the United States, Germany, France and several prominent economies across the globe. In 2004, Satyam computers was handling IT operations for World Bank and multiple multinational organizations.

THEN THE SCAM BEGAN…

                Ramalingam Raju along with his brother tried to reap personal benefits by taking advantage of the company’s esteemed reputation. In the process of doing so, he would show non-existent profits in his company’s balance sheets, eventually causing the stock prices to rise. Between 2003 and 2008, the company’s average operating profit was shown as 21% and the average compounding profit was shown as 35%. To explain the ever-rising profit margin, Satyam computers would divert the ‘fake profit’ to an asset that never existed. This would lead to an increased share-holder trust, causing them to invest more. This would drive stock prices up. At the end, Mastermind Raju and his brother in crime would realize the profits that they gained from the rise in stock prices.

                While I found certain things too complicated to understand and explain, I was able to understand that their act of financial manipulation had the potential to lead the company to an irrevocable disaster. And so, it did. In his letter to the board of directors, Mastermind Raju claimed that the assets had been overstated by US$ 150 million; interest that was being paid factiously on an annual basis was US$ 77.46 million, for a credit that never existed; the companies liabilities were understated by US$ 300 million; and the revenue which was shown as US$36.60 million was actually US$28 million.

                Raju, however, realized by late 2007 that his attempt to inflate share prices was about to counter react and hence he proposed to his shareholders to invest in a company called ‘MYTAS’. MYTAS was partly (35%) owned by Raju’s family members and thus, he wanted to merge Satyam Computers and MYTAS’s assets to fill up the financial gaps. While the board of directors accepted the proposal, the shareholders rejected the proposal, fearing diversion of money from Satyam computers to MYTAS.

Have you ever had this feeling of being successful in un-screwing up a problem that you created and later realizing that in the due course you may have aggravated the problem? The remorse is real. This is how Raju was feeling after realizing that the deal had been turned down. But things were about to get messier for Raju and Satyam computers and he had no idea about it.

On 28th December 2008 a lawsuit was filed in the United States against Satyam Computers for manipulating financial documents. When reports of the lawsuit reached the Indian stock market, their stock crashed. In retaliation and maybe, in fear of being harshly prosecuted, Raju came out clear to his board of directors with his ‘confession letter’ on 7th of January 2009 stating that a fraud worth Rs. 7,800 crore(approximately US$ 100 million) had been done.

The stock prices fell by 40% in a day, eventually causing Satyam computers to appeal for a bailout. The company was then taken over by Mahindra.

Let’s talk about my favorite question… why did this happen?

It was later found out that Mastermind Raju, his brother, the managing director of the company, external auditors – Pricewater house coopers – and government auditors were the main culprits. All the five parties were motivated by the idea of ‘greed’. We can also say that they were motivated by materialistic outsets as they faltered on their morals and ethics for self-gain.

Here, we can also describe the Indian Income Tax department and the investors of Satyam Computers as naïve and ignorant. Both the parties that were directly affected by the performance of Satyam computers continued to ignore the exceptional gains that Satyam Computers was having (possibly because they too, were beneficiaries of the exceptional rise in revenues and stock prices).

All being said and done, this incident tells us one thing about human behavior – Humans will report atrocities and misconducts only and only when they are staged as the disadvantaged party. This is possibly the reason why societal divisions continue to exist in our modern societies.

 

Think: Do you see any similarity in the names of the two companies discussed – MYTAS and SATYAM? If you did, let me know in the comments.

The Mississippi Company case

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The case of the Mississippi company and John Law is considered to be the largest financial fraud of the 18th and the 19th century. The intriguing fact of the entire fraud was that it was based on manipulative and constructive practices of a lone man – John Law. Another reason why this financial fraud is regarded as one of the biggest scam is because this scam was able to shake an entire economy and its fundamentals.

The fraud was the result of subsequent and multiple steps that worked counter-intuitively for the entire economy of France. The basis of the entire situation was the debt crisis that rose after the death of Louis XIV. Louis XIV took loans from the public in order to raise funds for fulfilling his lavish expenses – building a new palace, maintaining his lavish lifestyle, rebuilding the ecology of France, and beautifying the city of Paris. After his death, the new king – Louis XV – was only five years old. Thus, an alternative power took over. In order to fulfill the debt crisis, he issued of IOUs, yet, people were not satisfied. John Law, an economist, came to France while touring western Europe, making people aware of the concept of ‘paper currency’. He realized that France’s financial system was poorly structured and thus, proposed the usage of paper currency and an institution called ‘bank’. Initially, it was difficult for him to explain that to the ministers at the king’s court, however, in the backdrop of the debt crisis, his solutions appeared to be the most feasible solutions.

John Law had the power and the ability to make sure that things went according to his plan and that, people won’t look at his activities suspiciously. For this, he became a bug in the ears of the ruler. He encouraged the ruler to ask its people to exchange their gold coins for currency notes. The ruler then outlawed gold coins and established the currency distributed by John Law as the ‘currency of France’.  In the said process, John started sending gold coins abroad to fill his own chests.

In spite of knowing the fact that by printing more cash, an economy tends to devalue its currency, John asked the printing agency to continue printing currency notes. When a prince went to the bank to exchange his currency notes for solid gold, it was realized that an economic disruption was on its way. John and his associates realized that he had only a fifth of gold reserves against the cash driven out. The news got out, and people became speculative of their deposits.

Things got worse when there was hyperinflation. When the ruler asked John to resolve the problem, John suggested the ruler to devalue gold and abolish exchange of gold. John then issued shares and promised a buyback at par if the shares were to fall. He glorified the state of Louisiana as a state with immense developmental growth potential and his willingness to invest in assets in Louisiana through the money he receives through share contributions. The demand for shares was immense and he purposely kept the supply low to inflate share prices. Though promised, he never purchased any assets in the state of Louisiana and instead purchased gold offshore.

Eventually, even the ruler got suspicious of his activities and further forced him to declare his bank’s financial status. Instead, he secretly fled the country with all the gold reserves. This caused a major financial crisis in France, hereby causing people to lose all their money, businesses to crash and gold to devalue.

 

Let’s think global!

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Thanks for taking a look at my blog.

I will be writing about major financial frauds that have taken place across the world.
Financial Frauds are amongst the most impactful crimes. While they have the potential to impact thousands of people at once, they also have the potential to disrupt an entire country’s financial system.

Feel free to critique my blogs
I look forward to seeing you every Thursday, 10 PM