The many layers of Scott Rothstein’s Ponzi scheme continue to be peeled back, revealing a tangled web of Madoff-like feeder funds, alleged co-conspirators, and vast sums of money being transferred throughout the world.
The Miami Herald reports, here, that Rothstein moved money to Venezuela, Switzerland and Morocco, and used dummy Delaware corporations to disguise his ownership stakes in real estate holdings and other assets. The Miami Herald also reports, here, that a feeder fund may have contributed close to $2 billion to Rothstein over a 2 year period.
Unfortunately, the media’s focus has been on Rothstein’s opulent living arrangements, including fancy cars, boats, condominiums, watches and mansions. These assets, as dramatic and sensationalistic as they are, represent but a miniscule portion of total contributions by investors. Even assuming that Rothstein accumulated $100 million in trinkets, baubles and cars, that still leaves the vast portion of the money unaccounted for. For those of us unaccustomed to wealth, it is incomprehensible to understand how difficult it is to spend vast sums of money on tangible goods and assets. No, most of the investors’ funds were not spent on Rothstein’s junkets, but were likely dissipated throughout the world in a flurry of wire transfers, and are quite likely parked in exotic locales that have poor regulatory structures or banking laws.
Investigators will first determine the amount of gross receipts into Rothstein’s funds. This will be accomplished through interviews with investors or bank statements and records, assuming, of course, that suitcases packed with cash were not the primary mode of receipt by Rothstein.  Investigators will also marshall the remaining tangible assets and attempt to reconcile Rothstein’s expenditures and cash outlays. Even assuming a wide margin for error and unknown expenditures, investigators should know with some degree of accuracy the amount of missing funds. As difficult as it is to spend hundreds of millions of dollars on tangible assets, it is even more difficult to legally move these funds throughout the world without leaving telltale signatures and audit trails. Following the dissipated money throughout the world will be time-consuming but not terribly difficult or challenging. The challenge will be in recovering the funds, which have likely been withdrawn or divided into much smaller “packets” within the recipient countries.  Pursuing these funds into jurisdictions unfriendly or hostile to the United States may become the Achille’s heel of the investigation.
As the lawsuit in the Herald article indicates, it is impossible to conceive of a fraud of this magnitude that did not involve co-conspirators or at least “fraud-friendly” acquaintances. The mere act of recordkeeping, reconciling, transferring, and manipulating vast amounts of money requires a team of personnel, each of which understood that a fraud was occurring or likely. At a minimum, Rothstein’s garish lifestyle must have triggered alarm-bells in his colleagues, partners, associates, and bankers. Lawyers, even top-litigators, simply cannot earn “stupid-money”. Even if Rothstein’s role as  money manager was factored into his lifestyle, potential investors must have questioned the size and scope of the legal settlements that served as the basis for their investments. Did no one, colleagues or potential investors, deign to ask, “Where and from whom is Scott obtaining legal settlements sufficient to generate these returns”? Did lawyers in the firm compare notes and determine which partner or associate was performing work or billing on these cases, even if not filed in court yet? Again, this was a spectacular failure to perform due-diligence and demonstrates that crowds of purportedly intelligent professionals and entrepreneurs can be easily duped and misled.
Further, even assuming the legitimacy of these structured settlements, Rothstein’s commissions could not have generated the funds required to fuel his extravagant lifestyle, which reportedly cost Rothstein at least $10 million per month. Finally, lawyers at the firm must have understood or could easily have performed back-of-the-napkin calculations regarding the firm’s expected gross revenues and expenditures. The discrepancy between these two numbers should have alarmed these folks, who may now become defendants in dozens or hundreds of civil, if not criminal actions. Complicit stupidity or active fraud?

As Wall Street became the destination of choice for MIT and Harvard mathematicians and physicists throughout the last decade, alarm bells should have sounded at our regulatory and policy-making institutions.
An interesting op-ed piece by Calvin Trillin appeared in the New York Times recently, here, that caps a recent trend exposing the so-called genius of Wall Street as a fraud. Other Times writers, including Joe Nocera, here, Dennis Overbye, here, and Steve Lohr, here, have tackled the subject of Wall Street’s smarts, but none as succinctly as Mr. Trillin. In the op-ed, Mr. Trillin claims to have met a man in a Manhattan bar who summarized the cause of the financial system’s near-collapse: “Because smart guys had started working on Wall Street.” This overly simplistic analysis became profoundly interesting as I continued reading, and developed into the following rubric:

Fortune and academic standing on Wall Street are historically inversely correlated, with Wall Street’s millionaires graduating in the lower third of their class;
The lower third, who usually made generous livings on Wall Street, became enamored of potentially huge fortunes, and began leveraging their businesses;
Top graduates, who typically became physicists or judges (tip money on Wall Street), instead began calculating arbitrage risks for hedge funds and other investors;
The top graduates, who were very smart, invented credit default swaps and other derivatives, enabling the lower third to become obscenely wealthy;
Wall Street nearly collapsed largely due to derivatives and credit default swaps developed by these very-smart people.

This theory, while enticingly simple, truly exemplifies what occurred on Wall Street as a result of the oversimplification of risk into quantifiable and discrete components. Although I have written about this before, here, this discussion has largely been ignored by both the regulatory structure and policy making institutions in the United States. We continue to be highly exposed to complex financial instruments that few understand or even acknowledge. The potential domino effect of interrelated industries and institutions is just now beginning to be understood.
Smart-thinking has enabled Wall Street to develop complex and leveraged financial products that have never been tested or vetted in less than optimal conditions and whose potential downstream impacts are unknown, while leverage has magnified the institutional risks of these products ten-fold. We literally outsmarted ourselves into believing that we had created structured products that could withstand severe economic headwinds, but without any understanding of how these products behaved or how they would impact the financial institutions they serviced.
We’re no better off than we were 10 years ago, when top graduates began migrating in large numbers to Wall Street, we’ve simply transferred most of their failures to the taxpayer. Where does it stop?

It bears worth repeating that the most interesting aspect of many of the recent Ponzi schemes that have surfaced, among them Bernie Madoff’s and Scott Rothstein’s, is not the motivation that propelled these individuals to commit these frauds, but the rationale of seemingly sophisticated investors and wealthy individuals to dispense with the due-diligence that would typically accompany investments in these funds.
This unexplored angle to these stories deserves significant scrutiny, not because it will prevent future fraudulent activity or greatly assist in the forensic examination of these crimes, but because it will shed light on the dynamics of human behavior and psychology, which are far more interesting and compelling. Most reporting of these stories attributes investor behavior to greed or the desire to earn outsize returns in a market largely devoid of enhanced earning vehicles.
This easy answer is convenient and may even be partially correct, but only strikes the surface of the dynamics and drivers that precipitated these frauds. Indeed, if greed was really the motivating factor for these investors, then it would be very easy in the future to trigger warning flags and alarms throughout the investment community once tell-tale characteristics or badges of fraud are detected, and prevent yet another scheme from hatching.
Unfortunately, human behavior is not nearly so linear, predictable or well-defined. Something much deeper, more profound, yet subtle was at play in at least these two frauds: our constant desire to receive attention from or align ourselves with elite membership in exclusive social organizations or clubs that are not otherwise available to “everyone else”. It’s really that simple.
While it’s a fact that Madoff mined his ethnic and religious ties within the Jewish community, and these ties greatly aided him in building false trust in that community, Madoff principally grew his scheme by cultivating the notion of exclusivity within his investors and feeder funds. This exclusivity propelled the Ponzi scheme to dizzying heights and constantly rewarded him with new investments.
Madoff understood that his “club” would not remain sufficiently enticing or compelling through simple appeals to his ethnic circle, or by repeatedly highlighting the steady and predictable returns generated by his fund. Madoff also understood that restricted membership in his investor club would be the carrot that would entice large numbers of wealthy individuals to his flock.
Potential investors were duped into assuming that if other, similarly spectacular and wealthy investors chose to participate in the Madoff fund, that alone would suffice as the acid test of Madoff’s credibilty. How others felt about Madoff would ultimately define these investors’ subjective feelings regarding their investments. The exclusivity of Madoff’s investor pool was the underlying driver that defined these feelings, and created the “Madoff Mystique”.
Similarly, Scott Rothstein’s Ponzi scheme appears to have blossomed once his association with “elite” financial and political groups within Florida became widely known and publicized. Although it does not appear that Rothstein sold investors on the notion of exclusive access to his investor pool directly, his high-level relationships and connections ultimately created the same emotional intoxication that surrounded Madoff.
Once established in investors’ minds, these notions became re-defined and confused as trust by these investors. Two pieces of excellent journalism, one about Madoff in Vanity Fair, here, and another about Rothstein in the Miami Herald, here, highlight the trust bestowed on these individuals by the wealthy and powerful. Investors granted Madoff and Rothstein their trust based not on any objective standard, but on subjective exhortations by other similarly misinformed investors.
These Ponzi schemes were created in much the same fashion as simple rumors, once they had established sufficient critical mass, they were nearly impossible to dispel and became firmly entrenched in the minds of most prospective fund investors. Madoff sold exclusivity and membership in an elite club, Rothstein sold his connectivity to Florida’s elite financial and political establishment. These intoxicants proved irresistible to thousands of very wealthy individuals, many of which deposited their life savings and earnings into the funds.
A core lesson here, though, is that investor behavior is increasingly driven by herd mentality tied to notions of exclusivity, uniqueness and intellectual superiority. These investors wanted to be different, to belong to exclusive groups that few others would have access to and achieve uncommon returns that would define them as intellectually superior. In the end, they too succumbed to herd behavior and the foolishness of crowds, although their herd was a club to which the rest of us are rarely granted access.

Is there any doubt that the federal government is now propping up nearly the entire housing market?
The New York Times reported here that the Federal Housing Administration, FHA, the government agency whose loan-insurance programs have essentially prevented the entire housing market from collapsing, is in severe trouble and has dwindling cash reserves. The agency has admitted that its cash reserves had dwindled to 0.53 of the total portfolio of loans held, far below the mandated 2 percent minimum. The FHA has acted as a backstop for the nation’s housing markets, ensuring that marginal buyers are approved for loans with minimal down payments.
The politicization of the goals and loan policies at FHA was nearly guaranteed following the collapse of the conventional housing market in 2007 and the federal takeover and subsequent bailout of Fannie Mae and Freddie Mac. Freddie and Fannie have been propped-up by the Federal Reserve for the last two years, which has purchased a significant percentage of the securitized mortgage products issued by the two agencies in the absence of conventional buyers. Now, FHA may require federal intervention to prevent its own collapse. With no plan for the eventual re-capitalization of Fannie or Freddie on the horizon, it is now virtually guaranteed that the federal government will continue to play the most important role in the nation’s housing markets for years to come.
What’s truly alarming, though, is FHA’s rather transparent efforts to conceal the extent of its problems. By lowering its loan underwriting criteria and extending loans to larger pools of risky credit borrowers, the FHA is hoping to reduce the overall percentage of currently delinquent loans relative to its total loans outstanding.
In effect, the FHA is extending more loans to marginally poorer credit risks, inflating the size of its overall loan portfolio, and then claiming victory, as the overall percentage of its delinquent loans declines relative to total loans. This may, though, ultimately become a pyrrhic victory of sorts if the housing market continues to deteriorate and foreclosures continue to accelerate. FHA is essentially betting that it can outrun its problems by increasing the size of its balance sheet.
These are the same bets made by speculators and other investors at the height of the national euphoria that engulfed this nation, and it was painfully obvious how this dynamic played out. Politicizing FHA and forcing it to play an even greater role in the housing markets is a recipe for disaster.
The nations leaders and housing “experts” continue to ignore the fact that the only remedy for the ills of the housing market is to ensure that greater numbers of people legitimately qualify to own homes, and only two methods will ensure this: either personal income increases or asset deflation in the housing stock must sufficiently reduce home values. In this time of severe recession, personal income is likely to remain relatively stagnant for years.
Lower home values, while accelerating the pain of those that viewed their homes as retirement portfolios, will ensure that greater numbers of families will ultimately qualify for loans. Attempting to re-inflate the housing bubble by lowering credit standards will simply ensure that another massive federal bailout will soon occur, this time at FHA. By sustaining the unsustainable, the federal government will prevent any real recovery in overall asset valuations and ensure that future economic growth will be tepid at best. Short term housing stimulus will prevent real growth and recovery in the long-term.
Asset valuations, especially the housing sector, should be allowed to fall to levels commensurate with income and sustainability. Absent this, it will be a painful decade, at best.

Another week, another Ponzi scheme emerges: Scott Rothstein, a prominent Broward County, Florida lawyer, has been accused of orchestrating a scheme to bilk investors of hundreds of millions of dollars.
The ruse involved the sale of legal settlements finalized by Rothstein, acting as plaintiffs’ lawyer, to wealthy investors, who would pocket the difference between the present value amount paid to plaintiffs in legal cases and the future value of the installment amounts negotiated with defendants. The spread between the present value of the settlements and their future, installment value represented profit, and was marketed aggressively to high net-worth investors seeking high yields and returns. Broward County’s Sun Sentinel, which has closely tracked the story, reported yesterday that a local bank, TD Bank, apparently maintained the bank accounts for the investment business.
What is remarkable about this purported fraud are the similarities it shares with other, recently discovered financial schemes: Bernard Madoff (fake investment accounts), Allen Stanford (fake certificates of deposit), Marc Dreier (fake securities and notes), Scott Rothstein (fake legal settlements) and a host of other, lesser known individuals, including recent allegations of missing funds leveled at Lewis Freeman, the Miami court receiver and forensic expert.
The substantive similarities between these schemes is remarkable: 1) The schemes themselves were all fairly unsophisticated and noteworthy for their relative simplicity; 2) they were perpetrated over many years and had long “shelf-lives”; 3) most involved industries that were either highly regulated (Madoff and Stanford) or faced Bar review of their activities (Dreier and Rothstein); 4) all involved highly sophisticated investors with the wherewithal and means to conduct extensive due diligence; 5) all involved schemes that should have been easily uncovered by even cursory due diligence or review, and 6) all involved “feeder funds” or hedge funds, which funneled other people’s money into the fraudulent schemes.
Marc Dreier’s scheme is remarkably similar to Mr. Rothstein’s, in that both Mr. Rothstein and Mr. Dreier were prominent attorneys, and both attempted to sell bogus securities, notes or settlements to unsuspecting hedge funds or investors. Mr. Dreier’s story is eloquently discussed by Vanity Fair’s Bryan Burrough, and attempts to discern the motivation that propelled Mr. Dreier to steal hundred’s of millions of dollars from unsuspecting hedge funds.
While understanding what motivated these individuals to misappropriate huge sums of money certainly appeals to our very basic human need to dissect and understand behavior, the truly interesting angle is why sophisticated hedge funds and rich individuals keep getting duped into forking over hundreds of millions of dollars into very unsophisticated financial schemes. Although I will review each fraud in more detail in later articles, a trend begins to emerge that ties these frauds together: either because of greed or ignorance, most investors are not performing adequate due diligence in the United States.
The motivation or rationale that prevented these investors from conducting even minimal due diligence can be discussed ad nauseam, yet no single unifying theme will probably emerge or suffice to explain these lapses. None of these theories will adequately explain why highly sophisticated individuals, feeder funds and hedge funds purposely failed to perform the due diligence required prior to investing hundreds of millions of dollars into third-party financial schemes, with most of these investments being other people’s money, not their own.
After all, most of these schemes could have been detected with even minimal due diligence: 1) Bernard Madoff never actually made any trades on behalf of his clients, yet trade ticket confirmation would have been relatively easy; 2) Marc Dreier never actually had the authority to sell notes or securities to investors, yet the notes were never independently confirmed with the underlying issuer; 3) Scott Rothstein never actually had plaintiffs that settled cases, which a search of the Broward County court cases (or other jurisdictions) might have revealed (or independent verification for un-filed claims), and 4) Allen Stanford never actually invested his clients’ funds into CD’s at third party institutions or other easily confirmable depositories, providing a huge red-flag to investors.
Although discerning the reasons why these investors failed to conduct due diligence is interesting and perhaps compelling, whether it was greed or simple ignorance, it becomes clear that these investors trusted the fraudsters with their money, oftentimes their life savings. How trust can be so easily granted and dispensed is really a defining characteristic of these crimes, how we have allowed fraudsters to so easily seduce us is an important unresolved issue.
More importantly though, has anyone really learned anything from these massive frauds, or are we trapped by our own greed and ignorance to forever repeat the mistakes of the past?