In 1919, Charles Ponzi had a brilliant idea. He figured out that he could theoretically make a 400% profit through trading postal reply coupons (essentially a gift certificate for postage that immigrants would include in their letters back home). To run this operation, he set up the ironically-named Securities Exchange Company and wooed investors with the promise of doubling their money in 90 days. At first, things worked great and he was able to deliver the profits to his modest number of investors, but as the news of Ponzi’s sure thing spread, pretty soon everyone wanted a piece of the action. Before long, he went from making $5000 to raking in a quarter million dollars per day. Needless to say, with everyone’s hands in the cookie jar, nobody took a step back to ask the basic question “who’s buying all of these coupons?” When financial analyst Charles Barron looked into the company, he made two startling revelations : Ponzi wasn’t even investing in his own company and the SEC’s investments would require 16,000,000 coupons, but the postal service had only printed about 27,000. Investors lost everything and the “Ponzi scheme” was born.
The snowballing effect is explained at the Wikipedia thusly :
There was something clueless in Ponzi’s cleverness. He had set a scheme in motion that was sure to collapse sooner or later. He was pulling in a pile of cash, but only at the expense of going into even greater debt. At some point, the sensible thing to do would be to take the money and run to someplace where the law couldn’t get at him.Instead, he stayed with it. The only reason that makes any sense is that he thought he could use the fortune he was accumulating to come up with a new scheme that would save him. He could figure out some way of diverting the fortune and the debt into a legitimate line of business, or maybe he could just hire lawyers and judges and buy his way out of trouble.
I just gone done watching a screener for the extraordinary documentary Enron : The Smartest Guys In The Room and the parallels to Ponzi’s scheme are stunning. From Roger Ebert‘s review of the film :
To keep its stock price climbing, Enron created good quarterly returns out of thin air. One accounting tactic was called “mark to market,” which meant if Enron began a venture that might make $50 million 10 years from now, it could claim the $50 million as current income. In an astonishing in-house video made for employees, Skilling stars in a skit that satirizes “HFV” accounting, which he explains stands for “Hypothetical Future Value.” Little did employees suspect that was more or less what the company was counting on.
. . .
One Enron tactic was to create phony offshore corporate shells and move their losses to those companies, which were off the books. We’re shown a schematic diagram tracing the movement of debt to such Enron entities. Two of the companies are named “M. Smart” and “M. Yass.” These “companies” were named with a reckless hubris: One stood for “Maxwell Smart” and the other one … well, take out the period and put a space between “y” and “a.”What did Enron buy and sell, actually? Electricity? Natural gas? It was hard to say. The corporation basically created a market in energy, gambled in it and manipulated it. It moved on into other futures markets, even seriously considering “trading weather.” At one point, we learn, its gambling traders lost the entire company in bad trades, and covered their losses by hiding the news and producing phony profit reports that drove the share price even higher. In hindsight, Enron was a corporation devoted to maintaining a high share price at any cost. That was its real product.
And like Ponzi, once executives like Lay and Skilling saw the writing on the wall and realized how bogus their business model was, they got the hell out of there and left their investors to fend for themselves. Then again, Ponzi didn’t also cause a power crisis and steal billions of taxpayer dollars.
After suffering through countless documentaries by Michael Moore-clones who have a lot to say, but can’t be bothered to make a good movie, The Smartest Guys in the Room was like a breath of fresh air. For one, the filmmakers took a wonky accounting scandal and used it to tell the story of a bunch of arrogant bastards whose dedication to economic Darwinism caused their eventual downfall. It would have been easy to tell a dry, by-the-numbers tale of Enron’s fall by drowning the viewer economic rhetoric, which leads me to my second reason to recommend the film. It’s a good looking and well made documentary. While most documentaries these days are shot on video and look like they were edited with a pair of scissors and a roll of scotch tape, the filmmakers here didn’t let their dedication to the material serve as blinders to their ultimate goal of entertaining and informing the audience. They tell the story of the rise and fall of Enron without falling into the trap of featuring nothing but talking heads and close-ups of faxes. And while Roger Ebert is right when he opened his review saying “This is not a political documentary. It is a crime story.”, rest assured that the Bushes and Arnold Schwarzenegger get their due.
When it comes out on Tuesday, I strongly recommend checking it out.
