The Most
Dangerous Trade
How Short Sellers Uncover
Fraud, Keep Markets
Honest, and Make
and Lose Billions
Richard Teitelbaum
Copyright © 2015 by Richard Teitelbaum. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Teitelbaum, Richard, 1961–
The most dangerous trade : how short sellers uncover fraud, keep markets honest, and make and lose
billions / Richard Teitelbaum.
pages cm
Includes index.
ISBN 978-1-118-50521-2 (cloth) – ISBN 978-1-118-77424-3 (epdf) – ISBN 978-1-118-61614-7 (epub)
1. Short selling (Securities) 2. Fraud. 3. Investments. 4. Speculation. I. Title.
HG6041.T43 2015
332.64
′
5–dc23
2015017857
Cover Design: Wiley
Cover Images: businessman walking ©iStock.com/4 × 6;
background ©iStock.com/delirium
Printed in the United States of America
10987654321
Dedicated to former mayor of New York City, Mic hael Bloomberg,
without whom this book would not have been possible.
Contents
Preface vii
Chapter 1 Ackman: The Activist Grandstander 1
Chapter 2 Asensio: Exile on Third Avenue 27
Chapter 3 Chanos: Connoisseur of Chaos 51
Chapter 4 Einhorn: Contrarian at the Gates 87
Chapter 5 Block: Playing the China Hand 125
Chapter 6 Fleckenstein: Strategies and Tactics 153
Chapter 7 Kass: Nader’s Raider Hits the Street 177
Chapter 8 Tice: Truth Squad Leader 203
Chapter 9 Pellegrini: Behind the Great Subprime Bet 227
Chapter 10 Cohodes: Force of Nature, Market Casualty 257
About the Author 297
Index 299
v
Preface
A
t its crux, short selling is about failure. Things break down.
Whereas most of mankind basks in a natural optimism, there are
those who navigate the darker side of events—the miscalcula-
tions, fraud, and follies that spur us onward toward disaster. Catastrophe’s
natural handmaidens are greed and, yes, plain evil.
The natural state of a collapsing universe is the breaking down of
order. Short sellers understand this and seek to prot from it.
I knew these dynamics before starting this project in 2012. After
all, I quoted the pessimist philosopher Arthur Schopenhauer in college
and still enthuse over Samuel Beckett plays. In hindsight, I’m embar-
rassed to say, my eort was more about careerism than anything else.
Colleagues and rivals were churning out acclaimed books in the wake
of the 2008–2009 nancial crisis. I was toiling for Bloomberg News,ata
sparsely read monthly magazine under the yoke of a petulant editor. Yes,
I was proud of a good portion of my work—racking up a record 23 cover
stories. Some of it explored the underside of the nancial crisis. But my
peers were on Charlie Rose or, worse, had even penned movie deals.
John Wiley & Sons approached me, suggesting I write a book pro-
ling short sellers—something I suspect they soon came to regret. Short
sellers, a mist breed of investor tilting against the relentless onslaught of
vii
viii PREFACE
hype emanating from Wall Street’s powerful marketing machinary, make
a colorful cast of characters—an assortment of loners, rebrands, cynics,
liars, and losers. What could go wrong?
My paranoid suspicion—evidence for which is utterly
circumstantial—is that the wheels began to fall o the project
before it began, with an investigative story I wrote for the January
2012 issue of the magazine. In July 2008, U.S. Treasury Secretary
Henry Paulson met at the oces of Eton Park Capital Management
with a group of hedge fund managers and other Wall Street types,
many of them alumni of Goldman Sachs, where he was CEO from
1999 to 2006. According to a source at the meeting, the secretary
disclosed material nonpublic information—that the government was
planning to put mortgage guarantors Fannie Mae and Freddie Mac into
conservatorship—wiping out equity holders in those state-sponsored
companies. Disclosing this was not illegal, as I reported, citing legal
experts. Yet Paulson had recently said such a move was unlikely.
Nothing much came of that story until September 2012, when the
Wall Street Journal reported that the U.S. Securities & Exchange Com-
mission (SEC) had launched an investigation into the matter. I was on
book leave, and Bloomberg News did not, according to standard prac-
tice, match the story. Nothing much seems to have come of the SEC
investigation.
Except perhaps this: A month or so after the Journal story, while
still on book leave, I was summoned to Bloomberg headquarters and
informed that I was being demoted to essentially a data entry position.
They somehow neglected to change my senior writer title. Of course
plenty of people are demoted all the time. Later, Bloomberg LP revealed
that then-mayor Michael Bloomberg had a business relationship with
Paulson. Indeed, they are co-chairs of an environmental organization
called the Risky Business Project, along with ex-hedge fund manager
and Goldman Sachs alumnus Thomas Steyer.
But if this book was to chronicle breakdowns—nancial, regulatory,
ethical, structural—my star-crossed eorts to bring the project together
seemed to eerily reect that. Subjects declined to be interviewed. Others
did so only o the record. I was given bogus information, including a
false address by one subject, and others claimed to have no record of past
returns. A retired woman short seller relayed to me that she had become
Preface ix
so averse to the short-selling profession that she no longer dated men
under six feet tall.
One source, after an Italian dinner in a rough part of town, asked
to talk to me on “deep background” in a dark and deserted parking lot
behind the restaurant, away from prying eyes and ears. I thought, briey,
I was about to get whacked.
Bad news mounted. The façade of my Greenwich Village apart-
ment building required immediate replacement, costing $30 million in
total. The jackhammers were merciless. On the eve of a key investment
conference in Dallas, Superstorm Sandy swamped New York. My ight
was canceled, scuttling interviews, and the resulting oodwaters knocked
out electricity and forced battalions of mice into my co-op, necessitating
bouts of successive eorts to eradicate them. Fortunately, we already had
a good exterminator, because my crisscrossing of the country staying at
cheap hotels had ushered in a virulent infestation of bed bugs. Interest-
ingly, they seemed to prefer my voluminous cartons of interview notes
and books to our beds.
The last of my roster of short sellers agreed, after initial refusals, to
cooperate in the rst half of 2013. I was on course to blow my deadline
not by weeks but months. Like so much else, in this project, it was hum-
bling, embarrassing—but nothing like what I was about to experience.
On July 5, the lion’s share of reporting and writing was complete.
My book leave had ended and the new job in data entry was going
surprisingly well, in its own fashion.
The phone rang. It was from the hospital. My special-needs daughter
Nina was in septic shock. “It’s bad,” the doctor intoned, when my wife
passed the phone to him, panic in his voice. “It’s really bad.”
Toxins were lling her body. The window of opportunity to arrest
it is vanishingly small—every hour from its inception increases the mor-
tality rate by 20 percent, I’ve been told.
A series of operations on Nina proved successful—she would
spend months in and out of intensive care. I returned to data entry at
Bloomberg, but struggled to complete my remaining chapters with my
daughter in the hospital. She is recovering.
Next came a series of unrelated deaths in a staccato procession:
A brother-in-law (of a heart attack), my 90-year-old mother-in-law, and
my rst editor at Fortune magazine, John Curran, 59 (of amyotrophic
x PREFACE
lateral sclerosis). Sources and characters in my narrative were dying,
too—Barron’s Alan Abelson, 87, died of a heart attack, and Doug Millett,
49, formerly of Kynikos Associates and largely responsible for exposing
the Enron fraud, succumbed to a cancer of the salivary glands. Already
suspicious, I was fast becoming superstitious.
In November 2013, Bloomberg LP, in company argot, red
me—along with a raft of vastly more talented journalists. Another
phenomenally expensive operation for Nina lay ahead, but of course
I had no idea whether her medical care had inuenced the decision
(Nina’s hospital tab for her rst night was $330,637.54). Short sellers
had taught me that paranoia is often well-founded. “What you see,”
one short seller told me, “is not what really is.”
Fictions and delusions collapse as a consequence of their internal
dynamics. Bad things happen. That’s the most important thing that short
sellers—damaged, battered, often nearly broke—can remind us. If they
make a buck or two in the process, who am I to judge?
Chapter 1
Ackman: The Activist
Grandstander
I
t had taken William Ackman more than 18 months to get this far—
with zero to show for it. Over that time, the founder of Pershing
Square Capital Management, with more than $15 billion in assets
under management, had been hammering away at Herbalife, what can
only be called a marketing machine that used so-called independent dis-
tributors to peddle nutrition and weight-loss products through a vast
pyramid scheme. There was an enormous amount of money at stake—
Ackman, who goes by Bill, had at one point borrowed some 20 percent
of Herbalife’s stock, worth more than $1 billion, through his brokers and
then sold it. His goal: Expose the company as a fraud and repay those
borrowed shares for pennies on the dollar—or nothing at all.
That’s how short-selling works—and Pershing Square had by now
spent more than $50 million in research and fees alone on the eort.
Now, in July 2014, the six-foot-three-inch-tall Ackman was
wrapping up an impassioned, polished presentation for the media
1
2 THE MOST DANGEROUS TRADE
and investors that laid out the details of how Herbalife entrapped its
distributors through a system of so-called “nutrition clubs” that were
meant to lure people into the base of the pyramid scheme and goose
sales by foisting products on them. In the U.S., the lion’s share of
distributors were low-income people, typically Hispanic-Americans,
but Herbalife was pushing its weight-loss products in countries from
India to Zambia.
Ackman singled out the Herbalife CEO. “Michael Johnson will go
down in history as the best CEO of a pyramid scheme in the world,”
he said, pointing out that the former Walt Disney and Univision
Communications executive had extensive experience in marketing
to Hispanic-Americans. He alluded to another famed notorious
pyramid scheme, that of nancier Bernard Mado, who duped investors
of some $20 billion. He compared Herbalife’s marketing to that of
the Nazis.
Then things got personal. His voice trembling with emotion, Ack-
man detailed his immigrant forbears’ history in the United States, his
great-grandfather apprenticing as an assistant tailor, the family’s coat busi-
ness, and his father’s own formidable achievements as a mortgage broker.
“I am a huge beneciary of this country, okay?” he said, choking up
with emotion. “Michael Johnson is a predator. Okay? This is a criminal
enterprise. Okay? I hope you’re listening, Michael. It’s time to shut the
company down!”
“This is an ingenious fraud,” Ackman said and, wrapping himself in
the Stars and Stripes, added that Pershing Square preferred to invest in
companies that help America. “I said I’m going to take this to the end
of the earth. We’re going to do whatever makes sense.”
Before taking a break, he red o: “This company is a tragedy and
it’s also a travesty.”
Whew! Pass the water.
Beyond the Ackman histrionics, his argument had merit.
The accusation was that Herbalife virtually forced its distributors to
commit to buying more product than they could sell to earn a living
wage, and Ackman, with the help of a contract research rm, had just
furnished the evidence for his claim that Herbalife was a sophisticated
pyramid scheme, illegal under U.S. Securities & Exchange Commission
(SEC) and Federal Trade Commission rules.
Ackman: The Activist Grandstander 3
The son of a successful commercial real estate broker, Ackman was
born with a proverbial silver spoon in his mouth—and a highly polished
one at that. He grew up in lush Chappaqua, New York—these days
home to former President Bill Clinton and his wife, former Secretary
of State Hillary—graduating from one of the nation’s foremost public
secondary educational institutions, Horace Greeley High School.
Ackman picked up both a B.A., magna cum laude, and an M.B.A.
from Harvard. Immediately after graduation in 1992, with no formal
training, Ackman launched his own hedge fund, Gotham Partners,
which he eventually shuttered in the face of investor withdrawals—but
not before making a high-prole, unsuccessful bid to gain control of
New York’s Rockefeller Center. Even friends say the hyperambitious
Ackman comes o as overcondent and a know-it-all—but one
whose big bets and relentless drive have generated 20 percent–plus
returns for investors in his current agship fund, called Pershing Square
Capital Management.
Ackman began his Herbalife campaign at a December 2012 event
sponsored by the Sohn Conference Foundation—a charity that nances
pediatric cancer research and care. Dubbing the presentation “Who
Wants to Be a Millionaire?” after the television game show, he and col-
leagues spent an astonishing three-plus hours detailing a convincing case
that Herbalife, which peddles nutrition bars, vitamins, and powdered
smoothie mixes of soy, sugar, and protein, was a giant pyramid scheme
with sales that year that would amount to $4.1 billion.
The business model required that independent Herbalife distribu-
tors pull in more and more distributors into their network to make real
money, pushing those newbies in turn to recruit other hapless friends,
acquaintances, and relatives to do the same. The takeaway: Products went
in large part to distributors themselves instead of end customers, with
the lion’s share of the money paid to distributors for bringing in fresh
candidates to the sales force, not selling the products.
That’s basically the denition of a pyramid scheme—in which an
ever-growing number of recruits is duped into paying o the previous
set. “Basically, the large numbers are such that if you go back to that
pyramid, you need a bigger and bigger base at the bottom to support
it,” Ackman explained. “Problem is, the money at the top is made from
losses of the people at the bottom, and there are a very few people at the
4 THE MOST DANGEROUS TRADE
top and a huge number at the bottom.” The arrangement works until it
runs out of recruits.
By late 2012, Pershing Square was shorting Herbalife’s stock,
borrowing millions of shares and then selling them, hoping that
exposing the alleged fraud would prompt regulators—the SEC, the
Federal Trade Commission, the Justice Department or perhaps states’
attorneys general—to step in and bring the stock crashing down,
proting Pershing Square investors. In the perfect scenario, the price
would go to zero and the hedge fund wouldn’t need to repurchase stock
at all.
Failing that, the accompanying publicity, much of it based on
third-party analysis by a boutique research rm called Indago Group,
might cause investors to dump shares, scare the company’s auditors who
sign o on nancial statements, or even rattle prospective Herbalife
distributors who might have otherwise been attracted to the business
scheme, eectively deating what to Ackman was a blatant if fairly
sophisticated scam.
For Ackman this was not just another investment gambit—it was
acrusade.
Herbalife was also an extraordinarily risky bet, with Ackman
borrowing and selling about one fth of Herbalife’s total stock out-
standing. The shares could be called back by their owners for any
reason—meaning Pershing Square was on the hook if those he had
eectively borrowed the shares from wanted them back. Yet, the shares
dropped 8 percent in the days leading up to the initial December 19,
2012, presentation as rumors of Ackman’s upcoming speech began to
swirl. He didn’t disappoint.
Ackman’s rst rousing speech, which he made without pre-
pared notes, hammered away at Herbalife products’ stratospheric
pricing—three times as much as competing goods. He pointed out the
lack of research and development (R&D) and marketing. And Ackman
railed against Herbalife’s use of Nobel laureate advisory board member
Lou Ignarro—not for research, but for touting Herbalife’s products
at conferences. Former Secretary of State Madeleine Albright was a
consultant too. Ackman showed a Herbalife video that the company
played for its distributors, with one of the higher paid ones driving a
Ferrari and living in a lavish Southern California mansion.
Ackman: The Activist Grandstander 5
But it all came down to one simple accusation. “Participants in
the Herbalife scheme, the distributors, obtain their monetary benets
primarily from recruitment rather than the sale of goods and services
to distributors, not consumers,” Ackman told attendees back in 2012.
That was, almost verbatim, the Federal Trade Commission’s denition
of a pyramid scheme. In a perfect world, it would have been an
open-and-shut case.
Initially Ackman’s bet looked like a winner. The day of the presen-
tation, Herbalife shares tumbled a further 12 percent, hitting $33.34,
and they continued to fall thereafter. The day before Christmas 2012,
Herbalife shares bottomed at $26.06. It looked as if in Herbalife, Ackman
had picked an enormous loser, or in the case of Pershing Square investors,
a gigantic winner to the tune of more than $1 billion.
Then, as is often the case in short-selling campaigns, the market
began to turn. Somebody was buying, and Herbalife stock began to
climb. As shares rose, a coterie of hedge fund managers and other
investors jumped on the chance to initiate a short squeeze—buying
Herbalife shares to drive up the price in hopes of forcing Ackman to
cover, or buy back shares, at a big loss. A keenly watched metric in the
short-selling game is called days to cover. That refers to the number of
days, given average daily volume as a benchmark, it would take a short
seller to cover a short position. And Herbalife’s days to cover metric was
o the charts.
So while Pershing Square’s bet was huge, the size of his position left
Ackman open to upward pressure on the share price if anyone wanted
to buy shares and cause trouble by running up the price—a so-called
“short squeeze” in Wall Street argot. And the prematurely silver-haired
hedge fund manager—one acquaintance dubbed him the Yeti, after the
abominable snowman—had plenty of enemies.
It’s easy to see why. In an industry known for its titanic egos, even
Ackman’s stood out. According to those who have dealt with him, he
constantly proered unasked-for advice to friends and rivals and com-
pared his record to that of Berkshire Hathaway CEO Warren Buett.
Ackman was also bluntly direct, passing on the name of his nutritionist
to an acquaintance who had added a couple of pounds or setting up single
colleagues on blind dates. A Pershing Square board member once inad-
vertently smeared a dab of cream cheese on his own jacket lapel during a
6 THE MOST DANGEROUS TRADE
morning meeting and failed to notice it. While someone else might have
taken the board member aside or whispered to him, Ackman bellowed
across the conference table: “You’ve got cheese on your jacket there!”
It did not escape notice that when Pershing Square oated shares
of a closed-end fund it manages on the Amsterdam Stock Exchange,
in October 2014, that he joked about the fact that they sold o, end-
ing down 12 percent that day. “The stock is down, which is good,” he
quipped. “If it had gone up, we’d have sold too low.” Holders included
Qatar Holdings LLC, Blackstone Group, and Rothschild Bank AG.
Still, some look at Ackman’s forthrightness and straight-shooting
advice as just boldfaced honesty—commendable—while others do not.
Even before the closed-end fund oering, Ackman managed Pershing
Square like a disciplined governance-centric corporation with a board
that includes former New Republic owner and editor-in-chief Martin
Peretz; an ex-chief nancial ocer of McDonald’s Corp., Matthew
Paull; and Harvard Business School management professor Michael
Porter, who is both a mentor and colleague. That compares to other
funds, which can often seem like alpha male–dominated frat houses.
Employees meet with the board without Ackman present so they can
express their opinions about him forthrightly and deliver complaints
about how the rm is run.
He maintains some high standards: Ackman, after consulting with
the board, red an employee for expensing a dinner that hadn’t been
on company time. (Of course, that was money out of his own pocket).
More than anything else, though, what drove rivals of the 49-year-old
hedge fund manager crazy was his knack for generating stellar returns,
which, though volatile, were more than 20 percent annualized for his
agship fund—and with little leverage. That doesn’t, ahem, include his
closed Gotham Partners fund or his side pocket investments.
Full disclosure: Ackman, who is widely known for assiduously court-
ing the media to an unusual, sometimes unseemly extent, declined to be
interviewed for this book. It may have had to do with an unattering
article in the monthly Vanity Fair by the author William Cohan that
appeared shortly before I made my request.
One investor harboring particular vitriol for Ackman at the time
was Carl Icahn, chairman of Icahn Enterprises LP—the onetime 1980s
corporate raider and greenmailer; that is, someone who would buy up
Ackman: The Activist Grandstander 7
shares in a company, threaten a takeover, and then sell them back to the
target at above-market prices in exchange for simply going away. It was
deemed a louche manner in which to earn a paycheck.
But Icahn had successfully refashioned himself into the more
honorable profession of activist investor—shaking up corporate boards
and enriching all shareholders, not just himself. And Icahn, a native
of the rougher parts of the New York City borough of Queens, was
pretty good at it—agitating for the sales, breakups, or restructurings of
companies like Kerr-McGee, Time Warner, eBay, and Yahoo! Returns
for his public investment rm were more than 20 percent annualized
since 2000.
Ackman and Icahn shared a litigious history. Faced with investor
withdrawals and illiquid holdings, Ackman in 2001 was winding down
his rst hedge fund, Gotham Partners, which itself had made some public
short bets. He cold-called Icahn about buying the fund’s 15 percent stake
in Hallwood Realty Partners, a real estate investment trust.
The wily Icahn was amenable. Ackman had another, higher oer of
$85 to $90 a unit on the table, yet he agreed instead to sell Gotham’s
Hallwood stake to Icahn for less, just $80 a unit plus what Icahn termed
“schmuck insurance,” incorporating a Yiddish term for a part of the male
anatomy. Under the contract, according to Ackman, Icahn would pay
50 percent of his prots, above a 10 percent gain, if he sold or otherwise
transferred the REIT units within three years. Ackman’s view was that
Icahn might bid for the whole company himself, because he was in fact
unloading his shares on Icahn at what he deemed a re-sale price, barely
more than half their true value.
Well, Ackman was half right. Hallwood cashed out a year or so later
for $136.70 per unit in cash, selling itself not to Icahn but to HRPT
Properties Trust. Ackman called to congratulate Icahn and collect his
“schmuck insurance.” Icahn blew him o—refusing to pay—and the
two investors ended up in court, where Ackman ultimately prevailed.
The bitterness, however, had only festered over the years.
On January 25, 2013, in the kind of broadcasting melodrama
that TV producers can usually only dream of, they both were call-in
phone guests on CNBC’s Fast Money Half Time Report TV program,
hosted by Scott Wapner, by which time Herbalife shares were surging
past $43.
8 THE MOST DANGEROUS TRADE
Ackman would soon be losing money on his short sale. And the
televised exchange quickly became personal.
“I’ve really sort of had it with this guy Ackman,” groused Icahn, in
his rough, outer borough accent. “He’s like the crybaby in the school
yard.”
Icahn continued in a stream of consciousness-style rant of insults.
“He’s the quintessential example on Wall Street of if you want a friend,
get a dog,” he said. “Ackman is a liar.”
Ackman returned the compliments—his diction crisp and Harvard
perfect. “This is not an honest guy, and this is not a guy who keeps his
word,” he said, enunciating every syllable to perfection. “This is a guy
who takes advantage of little people.”
They spent a lot of time going over the Hallwood deal.
Icahn recalled having dinner with Ackman. “I couldn’t gure out
whether if he was the most sanctimonious guy in the world or the most
arrogant,” he said. “I was dizzy after having dinner with him.”
The CNBC host struggled to bring the conversation back to Herba-
life, but the two antagonists kept returning to the Hallwood deal a decade
earlier. “I was concerned about dealing with Carl Icahn because Carl
unfortunately does not have a good reputation,” Ackman said. “Carl
Icahn thought, ‘this guy is roadkill on the hedge fund highway,’” refer-
ring to himself.
Icahn disputed the whole notion of the “schmuck” insurance. “I will
swear to it on any bible you want,” Icahn said. “I had a verbal agreement
that he wasn’t going to have any piece of the money on this.”
Then Icahn launched into an attack on Ackman’s strategies and
tactics—lambasting them.
“Herbalife is a classic example of what he does,” Icahn said. “He
probably woke up in the morning and decided, ‘What company can we
do a bear raid on?’”
Icahn piled onto the dangerous nature of Pershing Square’s Herbalife
short and even suggested that the upstart hedge fund manager was intent
on robbing retirees, that is, investors in the vitamin company, of their
savings. Traders on the oor of the New York Stock Exchange stopped
and stared at the televised duel, gaping at TV screens as the barrage of
insults continued.
Ackman: The Activist Grandstander 9
“I wouldn’t have an investment with Ackman if you paid me to,”
Icahn declared. “Even if Ackman paid me.” He even hinted at a possible
buyout. “I will tell you, that I think HLF could be the mother of all
short squeezes,” he said.
Icahn declined to say whether he was buying Herbalife shares as part of
a short squeeze strategy. He virtually invited investors to do so. “In a com-
pany like Herbalife, you can ask almost any pro, you don’t go 20 percent
short,” Icahn said. “You go in and you get 20 percent, if there’s ever a
tender oer, which there well might be in Herbalife, what does he do?
I’d like to get to ask, where does he get the stock? Let’s say there’s a ten-
der oer for Herbalife and they call back the stock and if you know Wall
Street, when there’s a tender oer, everybody calls back the stock.”
The consequences, with the stock trading at a bit over $40 a share,
would undoubtedly be dire for Pershing Square. “That stock could rush
to a $100, what the hell does Ackman do?” Icahn demanded.
Ackman was unappable. “Number one, Carl’s free to make a tender
for the company,” he responded succinctly. “Carl, you want to bid for
the company? Go ahead and bid for the company.”
Icahn sputtered with rage. “Hey, hey you don’t have to tell me what
I’m free to do,” he responded. Ackman clearly had a way of getting
under the septuagenarian’s skin.
“Number two: We don’t think there’s going to be a tender for the
company. We don’t think this company is viable,” Ackman said. “We
don’t think anybody’s going to write a check for 4 or 5 billion dollars
for a company that is fraudulent.”
It was an astonishing airing of animosity and dirty linen—the kind
of thing that generally isn’t done on Wall Street, at least without the
careful vetting of lawyers. After the on air-spat, Herbalife shares began
to climb, actually piercing $80 by year-end 2013. Ackman’s paper
losses—mark-to-market, in industry speak—were likely expanding.
Icahn disclosed a 13 percent stake in Herbalife in February 2013 and
soon took three Herbalife board seats. Third Point LLC’s Daniel Loeb,
a former friend of Ackman’s who had been burned by investing in a
Pershing Square side fund that made a disastrous, all-in bet on discount
retailer Target Corp. using call options, also piled in to drive up the
Herbalife share price. It was payback time.
10 THE MOST DANGEROUS TRADE
In October 2013, Ackman, with Herbalife shares trading at $70,
told investors in a letter that he had swapped 40 percent of his short
position in Herbalife with what amounted to an equivalent exposure
selling put options. Such options, give the seller to right to sell shares in
the company at a set price, in this case likely roughly the price at the time
the letter became public. If Herbalife tumbled Pershing Square would
score, if not the rm would lose the premium it paid. “The restructuring
of the position preserves our opportunity for prot—if the Company
fails within a reasonable time frame we will make a similar prot as if
we had maintained the entire initial short position—while mitigating
the risk for further mark-to-market losses—because our exposure on
the put options is limited to the total premium paid,” the letter said, as
reported in the New York Post. “In restructuring the position, we have
also reduced the amount of capital consumed by the investment from 16
percent to 12 percent of our funds.”
Ackman would make money if shares fell enough to hit the strike
price and cover the cost of the options, usually a couple of bucks.
It looked, almost, like he was heeding Icahn’s advice.
In July 2014, Ackman was back on a publicity campaign to trumpet
his latest research—and to rescue his souring bet. He was losing money
on Herbalife, yet doggedly hell-bent on bringing the company down.
“I will follow this trade to the end of the earth,” he had said, taking
care to say he would use his own money and not his investors’, if that
was the more prudent course of action. For the record, in another tele-
vised spectacle, Icahn and Ackman eventually made up, at least publicly,
at the CNBC Institutional Investor Delivering Alpha Conference that
same month. There was an awkward hug, which brought applause from
the audience.
Ackman certainly primed the publicity pumps the day before his
speech. “This will be the most important presentation I have made in
my career,” he boasted on CNBC as he made the rounds. “We are going
to expose an incredible fraud tomorrow . . . . Come early. There is lim-
ited seating.” Ackman promised new evidence, suggesting that a “death
blow” to Herbalife was in the ong.
The plush, 487-seat wood-paneled auditorium at the AXA Equi-
table Center in Midtown Manhattan was full, as media, investors, and
assorted hangers-on piled in. Next, a sultry-voiced female announcer
Ackman: The Activist Grandstander 11
introduced Ackman as if he were a talk-show host. “Ladies and gen-
tlemen, please welcome founder and CEO of Pershing Square Capital
Management, Mr. Bill Ackman,” she enthused. The billionaire hedge
fund manger bounded onstage decked out in a dapper dark blue suit and
began his re and brimstone sermon.
The new, groundbreaking information concerned so-called nutri-
tion clubs, details of which were provided by Christine Richards, a
former Dow Jones and Bloomberg News reporter who had penned Con-
dence Game (Bloomberg Press, 2010) an exhaustive book on an earlier
Ackman short, insurer MBIA, which eventually netted him millions in
prots after a three-year battle that included suits and investigations into
Ackman and his fund by the New York State Attorney General at the
time, Eliot Spitzer, the SEC, and the Justice Department. MBIA even-
tually lost its AAA S&P rating.
The upshot was this: Herbalife, he had discovered, was using a vast,
secretive network of so-called “nutrition clubs”—informal meetings run
by distributors—to ooad company products on its distributors and lure
in customers. They had to buy products, oer samples to potential buyers
in shady, anonymous locations, and pay for this themselves. Desperate
mothers, Richards reported, were feeding the nutrition mixes to their
newborns, probably to help make ends meet.
Combined with Ackman’s well-wrought pleas and references to his
family history, it seemed a reasonably eective presentation. But the
media and investors didn’t buy it. Shares began to rise steadily during the
presentation and nished the day up 25 percent at $67.77—its biggest
one-day move ever.
The media was exuberant—perhaps deciding that Ackman’s losing
bet, which after all aected only millionaire investors, was far more
interesting than any of the frankly damaging information the rm had
revealed about Herbalife.
“The ‘Death Blow to Herbalife’ Promised by William Ackman Falls
Short of Its Billing,” the New York Times headline read.
“Herbalife Rallies in Face of New Attack by Ackman,” said the Wal l
Street Journal.
Federal investigators reportedly began looking into whether peo-
ple hired by Pershing Square made false statements about Herbalife to
regulators. The nutrition company, for its part, has been investigated
by both the Justice Department and Federal Trade Commission. While
12 THE MOST DANGEROUS TRADE
Ackman’s short campaign against Herbalife remains a work in progress,
it speaks emphatically to the dynamics of a nancial system that seems
to work relentlessly to punish those like Pershing Square that bet against
stocks, rather than in favor of them. Ackman is no neophyte. In addition
to MBIA, he has made successful wagers against the Federal Agricul-
tural Mortgage Corp., or Farmer Mac, which makes loans to agricultural
enterprises, as well as Realty Income, a real estate investment trust, and
won big—at least as far as public documents can conrm.
Yet the vitriol heaped upon Ackman and his creed speaks volumes
about the powerful forces that are aligned to defend even the most prob-
lematic companies—often helped as they are by a coterie of high-priced
lawyers, like lobbyist Lanny Davis and Marty Lipton of Wachtell, Lipton,
Rosen & Katz, and public relations powerhouses like Michael Sitrick’s
Sitrick and Company. It also shows a marked preference by many, though
certainly not all, mainstream journalists to align themselves with estab-
lished corporations rather than secretive Wall Street short sellers who can
prot mightily when frauds are exposed. No matter that most so-called
“dedicated” short sellers, those who, unlike Ackman, bet exclusively
against stocks, seem inevitably to crash during extended bull markets.
James Chanos, for example, who went on to found the preeminent
short-selling rm Kynikos Associates, was prominently mentioned in
a 6,057-word cover story in the Wall Street Journal by reporter Dean
Rothbart in 1985, as the decade’s stock market bubble was rapidly inat-
ing, quoting him extensively when examining the allegedly gamey tactics
used to drive down share prices by short sellers. “They use facts when
available, but some of them aren’t above innuendo, fabrications, and
deceit to batter down a stock,” Rothbart wrote. Chanos was working at
a Deutsche Bank subsidiary at the time—and was immediately informed
his contract would not renewed.
In March 2006, correspondent Lesley Stahl of CBS News’s 60 Min-
utes aired a segment accusing a research rm, Gradient Analytics, of
working with hedge fund rm SAC Capital Advisors to drive down
the stock of Toronto-based drugmaker Biovail Corp. by publishing crit-
ical reports on the company. Two years later Biovail settled an SEC suit
alleging accounting fraud for $10 million without admitting or denying
the allegations.
More recently, and again in the midst of an expanding market bubble,
Bloomberg News, in the September 2006 issue of its monthly magazine,
Ackman: The Activist Grandstander 13
Bloomberg Markets, published “Games Short Sellers Play.” The article
alleged that billions of dollars of phony sell orders were ooding the
market and destroying promising young companies through the prac-
tice of n---d shorting—selling a stock without rst locating an investor
willing to lend it. It quoted a single short seller, Chanos himself, who
dismissed the issue as a red herring—and relied on data that showed
mostly that Wall Street settlement practices are sloppy, which they are.
But the story was notable in quoting an executive named Patrick
Byrne, the CEO of a then-struggling e-commerce website called
Overstock.com. The target of several short sellers, including David
Rocker of Rocker Partners LP, it failed to note that Byrne’s company
had repeatedly missed its own earnings and revenue targets by wide
margins over the years.
Nor did it mention that Byrne had told a skeptical accounting
analyst that “you deserve to be whipped, f----d, and driven from the
land.” Or that Byrne had publicly declared on a conference call that an
unnamed “Sith Lord” was orchestrating short-selling campaigns. Or that
he had accused a female Fortune writer investigating Overstock.com of
engaging in fellatio with various, unidentied Goldman Sachs traders.
Bloomberg TV used the story early the next year as the basis of a
special report, hosted by Michael Schneider.
Other publications, especially those with limited expertise in cover-
ing Wall Street, were ready and happy to drive sales and circulation by
blaming the shorts in a sort of bear-bashing cavalcade. Bryan Burroughs,
co-author of the monumentally brilliant Barbarians at the Gate: The
Fall of RJR Nabisco (Harper Collins, 1990), wrote a story for Vanity
Fair in August 2008 laying blame for the collapse of investment bank
Bear Stearns Cos. earlier that year at the feet of, predictably, unnamed
short sellers. And Matt Taibbi—whose description of Goldman Sachs
Group as a blood-sucking “vampire squid” would eventually go down
in history—in October 2009 rehashed the same notion that it was n---d
short-selling that had brought down both Bear and Lehman Brothers
Holdings, failing to note their wildly extended balance sheets, with
debt-to-equity ratios that topped 40 to one. Later, it turned out that
Lehman had doctored its books each quarter.
The bad press may have prompted some monumentally dun-
derheaded regulatory moves. Amidst the collapse of Fannie Mae,
Freddie Mac, Lehman, and American International Group, Wall Street
14 THE MOST DANGEROUS TRADE
executives, including Morgan Stanley’s CEO John Mack, knowing they
might be next in line to be brought down by panicked sellers, implored
the SEC to ban the short selling of their company shares. In conjunction
with the U.K. Financial Services Authority, SEC chairman Christopher
Cox did that, albeit on a temporary basis, singling out 799 nancial
institutions—later expanded—for special protection from short sellers
starting September 19, 2008, and ending October 2. Institutional
investors were also required to disclose all new short positions.
In a study entitled Shackling Short Sellers: The 2008 Shorting Ban,
released shortly after the restrictions were lifted, Ekkehart Boehmer of
Mays Business School at the Texas A&M University, Charles M. Jones, of
Columbia Business School, and Xiaoyan Zhang of the Johnson Graduate
School of Management at Cornell University showed that while prices
rose briey, spreads widened and price impact increased, as did intraday
volatility. Subsequent studies backed their conclusions.
Cox himself called it a mistake. “While the actual eects of this tem-
porary action will not be fully understood for many more months, if not
years, knowing what we know now, I believe on balance the commission
would not do it again,” he told Reuters. “The costs appear to outweigh
the benets.”
Still, it remains a shame that so many juicy but dubious anecdotes
have been written about short sellers, since the practice, regardless of
whether one believes it healthy or harmful to the markets, has a fas-
cinating history as it stands on its own merits—with good guys, bad
guys, and mostly, and here’s where it gets interesting, a whole range
of characters in between. These are tales of fanatically committed peo-
ple who perhaps because of the enormous pressures they endure year
after year sometimes evolve into emotionally aggrieved and embittered
individuals. Or maybe it’s their distressed personalities that drive them
into this punishing line of work to begin with. I don’t know. Other
times, they are just people with strong opinions and insights who stick to
their beliefs.
While The Most Dangerous Trade is not a history of short selling, the
background is fascinating—certainly worthy of a book in itself. The real
stories of present-era short sellers, though, are gripping enough.
Note well: Some of the terminology is a bit scattershot or mislead-
ing. Short sellers, for example, despite common parlance, don’t actually
“borrow” shares. They contact a broker who says he or she has located
Ackman: The Activist Grandstander 15
an investor willing to lend shares, serving as a middleman for a steep
price and taking an enormous cut—20 percent annualized or more of
the amount borrowed in some cases. The shares are sold by the broker as
well. The website of a now-defunct advocacy organization, the Wash-
ington, D. C.–based Coalition of Private Investment Companies, is still
accessible and contains plenty of useful information on the subject.
Also, there are plenty of uses for short selling that have little if noth-
ing to do with the focus of this book. Convertible arbitrage, for example,
in its simplest form, involves buying a convertible bond and shorting the
company’s underlying stock—locking in the yield of the bond with-
out the stock’s risk—as a way to lock in gains with minimal volatility.
That’s no judgment on the company’s management, viability, or even the
priciness of its shares. One type of market-neutral investing balances out
bullish bets on one industry stock, say General Motors Company, while
shorting one of its rivals, such as Ford Motor Company, guring the
former is a better buy than the latter while netting out industry-specic
risk. That’s often called pairs trading and has been around for ages.
A strategy called capital structure arbitrage involves buying a par-
ticular class of bond or other corporate security because it looks rela-
tively cheaper than, say, a shorter-term bond or preferred stock, which
is shorted. And merger arbitrage often involves simply buying the stock
of a takeover candidate while shorting that of the potential acquirer,
which may be using its own shares as currency, beneting when the
spread between them disappears. The list goes on.
These are all legitimate strategies involving short selling that have
little to do with most of the protagonists who are the focus of the book.
Full disclosure: I have, embarrassingly, failed to nail down, at least to
any reasonable person’s satisfaction, the precise origin of the term short
sale. I can do what I usually do in such situations, however which is to
repeat what I read or people tell me. Unfortunately, storied linguists like
William Sare and Edwin Newman have passed on the subject.
The most obvious etymological derivation is that the term simply
comes from the expression for selling someone short—that is, ascrib-
ing a value to a person or good that is below that of what is generally
accepted, as in “Don’t sell Snodgrass short.” But that just hints at a
resolution—although one that conveniently has been in English lan-
guage usage for hundreds of years.
16 THE MOST DANGEROUS TRADE
Another, somewhat more farfetched, explanation is that while a
bullish or long investment has unlimited upside, the prot on a short
sale is limited to the amount invested—a bigger or longer upside for the
bull, in other words, and a more limited or shorter prot potential one
for the bear. A stretch? I think so.
Likewise, it could just refer to the predilection of bulls to hold on
to their investments for longer periods of time than shorts, who tend to
book their prots, if they have them, quickly and quit while they were
ahead. The English Language & Usage Stack Exchange cites a denition
from The Bryant and Stratton Business Arithmetic of 1872. (I couldn’t nd
one myself). It says simply that selling short is to imply selling before
buying—that is, selling what one doesn’t have leaving one short of the
asset in question. Think along the lines of, “Joe, I’m short few dollars.”
That works reasonably well for me and has the benet of informing
the early 20th-century proverb regarding short selling, whose attribution
has, alas, also been lost to time: “He who sells what isn’t his’n must
pay the price or go to prison.” In years past, not being able to furnish
the shares owed to the party from which they have been borrowed was
indeed a criminal oense. In some cases it still is.
(As an aside, the term “bear” probably derives from an ancient
proverb that warns of selling a bear’s skin before it’s caught.)
The history of the short sale is so similarly aged as to have been lost to
time—farmers, bankers, and merchants must have been doing it in one
form or another for ages. But some of the choice examples are sucient
to suggest it is worthy of further investigation.
For example, the Dutch East India Company, the sprawling trading
company with vast governmental and military powers that extended
throughout the Far East, had an extensive shareholder base of wealthy
and middle class investors in Holland. The stock price rose in a
bubble-like fashion as talk of enormous wealth in far-o lands circu-
lated. Some skeptical Dutch investors initiated short positions in 1609,
most notable among them a merchant named Isaac LeMaire—who had
a nose for sning out trouble and was not above spreading rumors.
Shares tumbled and directors of the company complained to the
Amsterdam stock exchange that they were the victims of a short-selling
attack, which was bankrupting widows and orphans. The exchange
responded that “the decline in the corporation’s shares has been due to
Ackman: The Activist Grandstander 17
unsatisfactory business conditions,” according to The Art of Short Selling
by Kathryn Staley (John Wiley & Sons, 1997). Nevertheless, regulations
against shorting were imposed the next year, and soon abandoned.
There was no lesson learned: Tulipmania followed, beginning in 1634.
Britain eectively banned short selling in 1734 following the burst-
ing of the similar great South Sea Bubble, in which shares of the South
Seas Company tumbled from 1,200 to 86 pounds and short sellers were
naturally blamed. The ban was widely ignored; although a new one
focusing on banks was enacted following a major bank panic of 1866.
That too was repealed in 1878, after a commission determined the col-
lapse of the principal bank involved was a result of poor management
and lending practices, not short sellers. It’s always a question of shoot-
ing either the messenger or the short seller. While most people know
John Maynard Keynes as the founder of Keynesian economic theory, he
was also an active short seller, betting against the German mark during
Weimar Republic years of hyperination in the 1920s only to be wiped
out. “The market can remain irrational longer than you can remain sol-
vent,” he is said to have quipped. Keynes redeemed himself through his
management of a Cambridge University endowment, the Chest fund,
which returned more than 12 percent annually while he oversaw it from
1927 through 1945.
France experienced its own bubble decades before the French rev-
olution. Much like the Dutch East India Company and the South Seas
Company, the Mississippi Company, eventually called the Compagnie
des Indes, generated enormous investor demand. A rakish Scotsman
named John Law, one of the earliest proponents of paper, or at,
currency persuaded the French government to issue bank notes backed
by precious metals. As the power of Compagnie des Indes grew, it
assumed greater power to collect taxes and print its own coinage. The
French population was soon buying shares by the bushel full and prices
soared, minting new millionaires daily. In 1720, as people tried to
redeem the shares and the at currency Law had sold them, he devalued
both. Compagnie des Indes shares collapsed to less than one twentieth
of their peak value. Millionaires became paupers, short sellers were
again blamed, and France entered a profound, extended depression that,
according to some historians, was a fundamental cause of the French
revolution. An anti-short selling rule was instituted in 1724.
18 THE MOST DANGEROUS TRADE
Napoleon Bonaparte, incidentally, harbored a deep animosity toward
short sellers because he believed they were interested in driving down
the prices of government securities. That in turn would make it more
dicult for him to nance La Grande Armée’s campaign of conquest
across Europe and was therefore treasonous. Once again, restrictions
were enacted and later abandoned.
In America, the history of short-selling is more colorful still—dating
back nearly to the days of Wall Street’s famed buttonwood tree, under
which the New York Stock Exchange’s predecessor was founded. During
the War of 1812 with Great Britain, for example, the New York leg-
islative branch banned short selling as way to forestall panicked selling
of bank shares. The prohibition was widely ignored, though it took
until the late 1850s before the ban was formally repealed. As in other
nations, it was a pattern that was to be repeated time and again over
the decades.
Until the establishment of the SEC, in 1934, U.S. markets were, for
all intents and purposes, unregulated—a Wild West free-for-all bereft of
rules. That left the eld open for blatant market manipulation—often by
the renowned robber barons of the Gilded Age. This occurred in both
inating and driving down stock prices. In a so-called corner, one or
two investors would buy up all available shares of a company, forcing the
short seller to buy to cover at outrageous mark-ups. (A squeeze involves
multiple participants.) There were a variety of shenanigans, including
bribes and rumors, according to All About Short Selling by Tom Taulli
(McGraw Hill, 2011).
Famed nanciers Jay Gould and Jim Fisk teamed with Daniel Drew
to ood the market in the late 1860s with new issues of Erie Railroad
shares, driving its market capitalization to $57 million from $34 million,
not to mention $20 million in convertible bonds that were sold abroad.
They then yanked millions from banks, creating a panic that drove down
share prices, and secretly covered their short positions on the railroad.
The pair then turned against Drew, who had remained short, and engi-
neered a massive short squeeze that cost him $1 million.
Corporate insiders also got in on the short-selling act. President
John Gates of American Steel and Wire Company, a barbed-wire
monopoly, shorted his own company’s stock amidst a softening business
and layos—cashing in as share prices fell. A storied gambler—known
Ackman: The Activist Grandstander 19
as Bet-A-Million Gates—he eventually sold the company to John
Pierpont Morgan in 1901, and it became part of U.S. Steel Corp.
The greatest stock short seller of the 20th century was undoubtedly
Jesse Lauriston Livermore, the “Boy Plunger.” Born in 1877 into a farm
family near Worcester, Massachusetts, he ran away from home at age 14
to take a job posting quotes at the Boston branch of the brokerage rm
PaineWebber. He dabbled in dubious securities proered by unsavory
dealers known as bucket shops, yet somehow managed to prot.
In 1906, he is said to have shorted Union Pacic Corp, the San
Francisco railroad giant, the day before the great earthquake. No one
can explain why. The next year, he shorted the market during the panic
of 1907, noting that speculators had overextended themselves and were
subject to margin calls. Livermore only covered his short positions at the
request of John Pierpont Morgan himself, realizing he wouldn’t be able
to collect his gains if the brokerage rms he traded with went belly up.
His net worth: an estimate $3 million, or $75 million in 2014 dollars, an
amount he subsequently lost on cotton speculation, ling for bankruptcy
in 1915.
Livermore was down but not out. He borrowed money and eventu-
ally left the stock market to trade commodities and eventually recovered.
He codied his trading strategies in a 1923 book, Reminiscences of a Stock
Operator by Edwin Lefevre, and claimed all of his mistakes derived from
not following them. Investors today still refer to it. He made money in
the bull markets of the 1920s, and became close friends with Bernard
Baruch, the nancier and philanthropist who served as an advisor to
Presidents Woodrow Wilson and Franklin D. Roosevelt. Baruch was also
a noted short seller himself—booking gains on Brooklyn Rapid Transit
and Amalgamated Copper, while failing to do so on Radio Corporation
of America. By 1929, Livermore had noticed many of the same market
characteristics that had preceded the panic of 1907—rising margin debt,
pricey stocks, exuberance. He shorted stocks and made $100 million, or
$1.37 billion in 2014 dollars.
What happened next is, from what I can gather, unknown. Liver-
more was a famed womanizer, with a yacht, houses around the world,
and an armada of limousines. He was on his fth marriage, but by
1934 he had managed to lose the $100 million. No one knows how,
though trusts he had set up kept him from any real nancial hardship.
20 THE MOST DANGEROUS TRADE
He committed suicide with a revolver in the cloakroom of New York’s
Sherry-Netherland hotel on Fifth Avenue in 1940. His farewell note to
his wife read: “Can’t help it. Things have been bad with me. I am tired
of ghting. Can’t carry on any longer. This is the only way out. I am
unworthy of your love. I am a failure. I am truly sorry but this is the only
way out for me. Love Laurie.”
There were other famed short sellers of the crash—“Sell ‘em”
Ben Smith and the president of Chase Bank, Albert Wiggen, who bet
against his own bank using money he borrowed from it. Republican
President Herbert Hoover believed that a cabal of Democratic short
sellers were aligned against him, aiming to bring down the markets
to support Franklin Delano Roosevelt—and railed against them. The
Pecora Commission, headed by Ferdinand Pecora, counsel for the
Senate Banking and Currency Committee, found that it was the gov-
ernment that was involved in double dealing and new disclosure rules
were enacted.
The 1934 founding of the SEC under Roosevelt helped bring at
least a semblance of order to the wild speculation, promotions, and
manipulations of the stock market. Its rst chairman: Joseph Kennedy,
the former prohibition-era bootlegger and father of President John
F. Kennedy. He too had been a successful short seller—and there was
undoubtedly an element of Roosevelt hiring the fox to guard the
henhouse. One often-cited but probably insignicant change: the uptick
rule, which barred the shorting of a stock unless it had moved higher in
its previous trade. That stayed on the books until 2007, leading some to
conclude its repeal was a factor in the 2008–2009 collapse. I’ve seen no
evidence to support that view.
The Investment Company Act of 1940 severely restricted diversied
mutual funds from shorting. The 1949 launch by former Fortune
magazine editor Alfred Winslow Jones of what is generally considered
the rst modern day hedge fund, which typically buys some stocks
while shorting others, using leverage, was a game changer. “The Jones
that Nobody Keeps Up With” was what Carol Loomis, a now retired
Fortune writer, dubbed him in a deliciously revealing article. Slowly at
rst and then in increasing numbers, others emulated Jones and shorting
became, if not pervasive, at least an established part of the sophisticated
investors’ arsenal.
Ackman: The Activist Grandstander 21
Today there are more than 8,000 hedge funds, according to Hedge
Fund Research, a Chicago form that tracks them. Most engage in some
form of shorting.
Short selling was continually investigated as a source of market
volatility—or at least downward movements in stocks, since nobody
ever seems to protest when stocks rise sharply. The October 19, 1987,
crash was fueled by a bubble of optimism, in part because of the
spreading popularity of so-called portfolio insurance, which promised
to short stock indexes in the event of a market sell-o, thereby locking
in gains. Institutional investors threw caution to the wind. Following
the crash, a House of Representatives Committee looked into the
impact of short sellers on the meltdown. The ultimate conclusion was
that their contribution was negligible. So-called circuit-breakers were
instituted to halt trading when the market plunged precipitously—the
triggers have been updated periodically.
In 1992, George Soros, with billions of dollars in his Quantum
Fund, believed a sharp currency move was in the ong. The British
pound was part of the so-called European Rate Mechanism—designed
to keep European currency exchange rates in narrow ranges. Prime Min-
ister Margaret Thatcher was bent on keeping the pound pegged to the
German deutsche mark at a rate above 2.7 marks to the pound. Yet
the U.K. ination rate was three times that of Germany.
While the U.K. raised interest rates to entice investors to buy the
pound, some investors, notably Soros, believed such a move was unsus-
tainable. In what became known as the Black Wednesday Currency Crisis,
the U.K. raised rates from 10 to 12 percent and then promised 15 percent
to entice investors to buy pounds. The move failed. Soros shorted an
estimated $10 billion in pounds in the market and ultimately forced
the U.K. to withdraw from the ERM. The fund pocketed more than
$1 billion from the trade—costing the U.K. government many times
that. The move earned Soros the sobriquet “The Man Who Broke the
Bank of England.”
The move didn’t earn Soros many friends. When Malaysia’s currency
collapsed in 1997 amidst the Asian contagion, the country’s Prime Min-
ister, Mahathir bin Mohamad, accused Soros—a Holocaust survivor with
a history of championing human rights and open societies—of targeting
the nation. “It is a Jew who triggered the currency plunge,” he said.
22 THE MOST DANGEROUS TRADE
The technology bubble of the 1990s eviscerated short sellers or even
just value-conscious investors—despite Fed chairman Alan Greenspan’s
1996 warning of irrational exuberance. Famed hedge fund manager
Julian Robertson of Tiger Management mothballed his business as
stocks like Microsoft, Intel, and Sun Microsystems soared, not to
mention Internet companies with more dubious business models like
theglobe.com, Pets.com and Etoys.com, which often did not generate
earnings all. Being correct brought little satisfaction. Loews Corp,
headed by famed value investor Larry Tisch, initiated a giant short bet
against the S&P 500 beginning in 1996. He nally closed it out in
March 2000, the very month the NASDAQ Composite Index reached
its peak. The bet cost the storied conglomerate some $2 billion.
Following the terror attacks on the World Trade Center and
Pentagon on September 11, 2001, which shut down the U.S. stock
markets, Wall Street brokerage rms asked short sellers not to seek
prot from the anticipated sello in share prices when markets opened,
which they did three days after the attack. It would be an interesting
exercise to see who did or did not.
There were reports, including some in major media publications,
that Al Qaeda-linked groups may have shorted stocks or used put options
in advance of the attacks, with some less-established outlets asserting that
they had specically targeted the airlines involved and insurers that had
underwritten catastrophic claims against the towers. Nothing I have read
lends credence to this notion.
In 2004, the SEC approved a new rule, Regulation SHO, designed
to reduce n---d short selling, that is, selling a stock without rst having
a broker locating a holder willing to lend it within a three-day window,
or settlement period. The rule requires that the SEC publish a list of the
stocks with the most violations of this settlement matter. Again, whether
this rule has had any impact remains dubious.
There was a major irony in the temporary ban on shorting nancial
stocks on September 19, 2008. The move was taken at the behest of
investment banks that had been making hundreds of millions of dollars
from hedge funds lending them the stocks they were shorting, including
their own. The banks argued it was short sellers, not genuine market fear
of their outrageous leverage, driving down share prices.
Ackman: The Activist Grandstander 23
The SEC also required institutional money managers to report new
short positions—another way to quash short sales.
Short sellers will never be in the clear. The Financial Crisis Inquiry
Report ascribed the 2008–2009 nancial crisis to regulatory failures,
poor corporate governance, and, of course, widespread excessive bor-
rowing. Short-selling isn’t mentioned even as a contributing factor to
the crisis. Yet, it’s a truism that such investors will be blamed in any
market pull back.
On a clear chilly morning in December 2012, Dave Davidson, a
continent away from Ackman, is in his smallish, bare one-room oce in
Greenbrae, California, tucked under the 101 Freeway that leads from San
Francisco through undulating hills and mountains to points in northern
Marin, Sonoma, and beyond. It’s just a rented desk from a rm called
Banyan Securities, where partner Claudio Chiuchiarelli seems to have a
soft spot for taking in orphan contrarian market thinkers.
There is a view under that dark ribbon of asphalt and concrete across
Larkspur Creek to Corte Madera. Davidson is an aging jock. He has
given up rugby but still believes competiveness is the key to success on
Wall Street. Davidson wears a eece-lined vest, shorts, and sneakers as he
focuses intently on his computer. His $66 million fund is losing money as
the market climbs relentlessly in late 2012. How could it not? The Fed-
eral Reserve has interests at about 2.0 percent and is furiously buying
up Treasuries and mortgage-backed securities as part of its quantitative
easing program. This infuriates Davidson; it’s an example of nancial
repression, in his view—deliberately keeping rates low as a means of forc-
ing investors to buy stocks. “Where is the sanity?” reads the greeting on
Davidson’s Bloomberg terminal page. The future embodies devastating
deation and nancial collapse.
Davidson graduated in 1977 from the University of Southern
California in Los Angeles and worked as a medical technician before
hitting Wall Street as the bull market shifted into high gear in 1984,
taking on a string of sales positions—rst in retail at PaineWebber and
Donaldson, Lufkin & Jenrette Securities and then in institutional sales
at Montgomery Securities and Volpe & Covington. He co-founded
Pacic Growth Equities and then decided to manage money for himself
and others through his own rm, SC Capital Management.
24 THE MOST DANGEROUS TRADE
In 2000, he briey hooked up with short seller Bill Fleckenstein of
Fleckenstein Capital’s R.T.M. Fund in 2000, playing the macro expert,
he says, to his colleague’s fundamentalist approach—as the technology
bubble collapsed. The two split over a disagreement about R.T.M.’s
management fees. Davidson started Shoreline Fund I with $10 million
in assets under the SC Management brand in December 2004.
Davidson’s process, which he refreshingly talks about at length and in
depth, is elegantly simple—which may be precisely why he has trouble
pulling in money from big name investors, who sometimes prefer reams
of fundamental research from an analyst team. Davidson focuses on those
stocks with the largest market capitalizations of $5 billion or more, and
generally requires short candidates have 1 million shares a day in trading
volume to ensure liquidity. It isn’t brain surgery, but may require more
of a stomach.
Davidson looks at former market leaders whose technical charts,
100-day moving averages, say, are falling amid strong daily volumes.
Momentum is a positive force. “It’s my belief that price and volume
predict change,” he says. He points out that he also takes heed of fun-
damentals like earnings and sales growth.
At his desk, he excitedly points to brightly lit red companies that
t the descriptions. He typically focuses on a list of 70 to 100 compa-
nies, in six to nine sectors. Today, it’s Apple and Micron Technology, for
example, that are sells for the moment. That can change, but Davidson
believes it is a good indicator of future share prices. “My process is a
predictive system,” he says.
Broadly speaking, Shoreline I actually does what it is supposed to
do—it is up when the S&P 500 is down, sometimes by a far greater
amount than the inverse would suggest it should be. Since inception it
has lost to the benchmark HFRI index of short-biased hedge funds in
just 2 of 10 years. Overall, Shoreline I has returned 2.62 percent versus
a loss of 20.6 percent for the short index. In 2008, the worst year of the
nancial crisis, Shoreline I gained 56.9 percent, double the 28.4 percent
gain for the short index—versus a 37 percent plunge by the S&P 500.
Shoreline I also sometimes rises when the S&P 500 does, because
of Davidson’s willingness to cut and run. By remaining in liquid stocks,
he can get out quick. “I can take my positions out to the trading desk
and be out in 30 minutes,” he says with an air of satisfaction. One of
Ackman: The Activist Grandstander 25
his adages undoubtedly helps. He says he won’t ght the general market
trend, major economic indicators, or Federal Reserve moves. Davidson
covers his shorts and waits. “When things don’t work, just take your
exposure o,” he says. “You wait until something turns your way. If I’m
wrong, I just get out of the way.”
Investors, though, aren’t so patient—they seldom are with short sell-
ing strategies. Shoreline assets were down from $200 million, and that in
itself is an added pressure for Davidson. “We had a 40 percent redemp-
tion in 2010,” he says, as investors pulled out in the midst of a rollicking
bull market. In 2012 he predicted another 20 percent redemption for
the year.
And 2013 brought still worse news. A big Shoreline investor, a fund
of funds, got tangled up in an unrelated management scandal and with-
drew millions from the various funds it invested in. Much of that was
pulled out in 2014 from Shoreline. And so despite such monster years as
2000, 2002, and 2008, when Shoreline posted returns of 46.5 percent,
37.2 percent, and 56.9 percent, respectively, Davidson is now down to
just $2 million in assets in early 2015, essentially his own money.
Davidson, and other short sellers, for all their steely determination,
will have their mettle tested daily. After all, they ply the stock market’s
most dangerous trade.
Chapter 2
Asensio: Exile on
Third Avenue
T
he meeting turned nasty even before it began. Manuel Asensio
walked o the elevator wearing a gray-striped Norman Hilton
suit into the National Association of Securities Dealers (NASD)
oces at One Liberty Plaza—a hulking black steel skyscraper in lower
Manhattan. He was an hour late and oered no apologies.
As the dapper Asensio entered the lobby, a NASD case manager
walked up to greet him, extending his hand as he did so. Asensio ignored
it, and turned to his lawyer.
“I can’t believe that this guy thinks I’m going to shake his hand,”
he told him. There were really no reasons for niceties from Asensio’s
perspective. The NASD had been routinely badgering him for thousands
of pages of documents over the years, and he thought their goal was to
drive him out of business.
The NASD had summoned Asensio in September 2004 to answer
questions about his short-selling rm as well as six research reports
published on the Asensio.com website. The research was part of
27
28 THE MOST DANGEROUS TRADE
a series describing alleged Medicare fraud at PolyMedica Corp, a
NASDAQ-listed telemarketer of blood glucose test kits.
Then things got ugly. At the hearing, Asensio wouldn’t respond
when asked about ownership of his rm, Integral Securities. Because
it wasn’t an NASD member, he said he didn’t have to answer. In his
street-inected Brooklyn accent, he called the proceedings “a fraudu-
lent, corrupt, intentional attempt to discredit my rm, keep me from
doing my work.” Asensio declared that the American Stock Exchange,
NASD, and New York Stock Exchange were all guilty of harassment.
Asensio accused the NASD ocers of staring, “making faces,” and
“mocking” him. They were “hostile,” “crooks,” and “corrupt regu-
lators.” After two hours of interrogation by NASD ocers, Asensio
announced that he had “provided more than enough time.” He got up
and stalked out of the conference room.
The eruption cost him dearly. A NASD panel decided that Asensio
had violated rule 8210, failing to respond in full to questions. Asensio says
NASD ocials oered him a deal: Pay $15,000 to settle and the matter
would be eectively dropped. But that would not prevent the organiza-
tion from coming after him in the future whenever he tried to uncover
fraud. Asensio says he refused.
NASD’s sentence: the organization’s version of capital punishment—
a lifetime bar from the securities industry.
“I call it ‘the evil decision,’” says Asensio. “It’s corruption, and that’s
what it should be called.”
At the same time, today he says he is contrite. Asensio wishes passion-
ately that he had handled the situation more delicately. “It was a colossal
error in judgment,” he says. “I was there after two years of persecution.
At that point, I went ballistic.”
Provocateur, Internet personality, and invective-throwing activist,
Asensio has for years been among the most contentious players in a
contentious industry—a paradigm of high-decibel short-selling. With
his streetwise demeanor, Asensio has personally harangued the CEOs
of companies he targets, yelling at one of them in court: “You are the
devil incarnate.” He keeps a Cuban passport, rides a vintage BMW R65
motorcycle, and once declared to the Wall Street Journal: “God has given
me this power—It’s the power of good versus evil.”
Asensio: Exile on Third Avenue 29
Since the bar, however, Asensio’s short-selling has been drastically
sidelined and his strident advocacy muzzled. Funds, endowments, and
family oces have shuttered accounts. Others have yanked money from
his rm, which at its peak had more than $500 million in assets.
During what Asensio describes as his heyday, he was dubbed the
“Demolition Man,” and could send a stock plummeting with a single
research report. Even since the bar, it still remains foolhardy to ignore his
calls, such as one in December 2010 when he pegged Netix, trading
at $150, as overpriced. Though the stock barely moved at the time, one
year later it was trading at $29. In early 2015 Netix traded above $650.
Asensio calls the investigation a retaliation designed to punish
him for his advocacy eorts. The NASD, whose regulatory powers
were incorporated into the Financial Industry Regulatory Authority
in 2007, at the time described the probe as part of a routine sweep
to gauge compliance with a new regulation separating research from
investment banking adopted following the analyst scandals of the
early 2000s.
Asensio says that is nonsense. None of the rms he ran—
Asensio & Company, Integral, or the website Asensio.com—did any
investment banking business, either underwriting securities or providing
advisory services.
“They created a frivolous investigation,” Asensio says. “These regu-
lators are private organizations that have been given the same powers as
a government entity without the checks and balances.”
Asensio’s modus operandi is to research and identify what he consid-
ers frauds and then expose them in the media, on his eponymous website,
or in the courts, driving down their share price along the way. He has
made millions doing so. He used to call the strategy “hostile adversar-
ial.” He now prefers the more academic-sounding term “informational
arbitrage.”
Asensio is the acknowledged pioneer. A working paper by the
National Bureau of Economic Research from January 2014 looked at
the performance of 17 rms that publish negative research reports from
July 2006 to December 2011. It found that 60 days after the initial
report, the stock of companies Asensio targets fell 58.9 percent, more
than any other rm.
30 THE MOST DANGEROUS TRADE
All told, he calculates a total of more than 50 full-edged short
campaigns, more than half of which have resulted in share declines of
75 percent or more. These have provoked more than a half-dozen law-
suits, usually in the wake of screaming publicity battles.
Regulators often fare no better—Asensio prompted an investiga-
tion into American Stock Exchange listing standards and accused the
U.S. Securities and Exchange Commission (SEC) and its then-chairman,
Mary Schapiro, of lying about nancial dealings when she headed the
NASD. He helped launch an advocacy group, Alliance for Economic
Stability, that accuses her of a variety of ethics violations.
“He’s highly intelligent, works like a dog, but has utterly no common
sense,” says Richard Getty, a lawyer who represented Asensio in one of
the litany of suits he has endured over the years.
Asensio sometimes exults in his outsider status and makes no attempt
to sugarcoat his approach. “Money managers and regulators despise us
because we upset their system,” he says, carefully enunciating each word
for eect. “We bring chaos to the system. We bring volatility. We are
hostile to the system.”
In the case of PolyMedica, the Federal Bureau of Investigation (FBI)
raided its oces beginning on August 16, 2001. The company settled
the fraud charges—among other things, it had been improperly sub-
mitting reimbursement claims and had violated the False Claims Act by
not obtaining signed doctors’ orders or prescriptions for the products
it sold—and paid a $35 million ne. That wasn’t enough for Asensio,
who had called for at least $400 million in nes and described the out-
come as “entirely a function of a political process.” PolyMedica was
bought by Medco Health Solutions in August 2007. Express Scripts
bought Medco in 2012, and PolyMedica eventually led for chapter 11
bankruptcy after it was purchased in connection with a management-
led buyout.
Many, though not all, short sellers shun publicity, operating
beneath the radar. Not Asensio. “He is the intellectual godfather of the
Internet-enabled investor,” says one fellow short seller. “He pulls no
punches. He says, ‘This is the guy who is lying.’”
Before the NASD barred him, Asensio’s nose for fraud had attracted
an impressive client list, including John Paulson, founder of hedge fund
Asensio: Exile on Third Avenue 31
Paulson & Co., who made more than $7 billion in the sub-prime collapse
of 2008 and other prominent managers.
Even today, fans include Leon Cooperman of hedge fund Omega
Advisors. “When he gets into something he’s really obsessive,” says
Cooperman, who has knows Asensio socially and does not invest with
him. “If he was shorting something and I owned it, I’d really grill my
analyst to make sure he knew what he was talking about.” Asensio
won’t disclose current or former clients.
Asensio’s trail of “hostile adversarial” campaigns goes back to 1996,
when he issued a “strong sell” recommendation on NYSE-listed Diana
Corp., a Milwaukee-based meat distributor that was, on the cusp of the
Internet bubble, trumpeting a new phone switch design that it claimed
had revolutionary features demanded by Internet service providers.
Asensio canvassed equipment makers like Flextronics, who told him
the switch design was unbuildable. Asensio issued a 16-page report,
detailing its technological aws. Shares eventually fell to 7 cents from
$100 when he issued the report.
Other frauds, or “promotes” as shorts call them, followed: A chain
of laundromats, a maker of dubious engine turbochargers, and myriad
technology companies are among the companies Asensio helped expose.
So too was a Bronx, New York, outt making a device to measure jaun-
dice in newborns based on 1950s-era gadgetry. The claims of promoters,
it seems, was limited only by their greed.
“On a case-by-case basis, his record is almost perfect,” says one rival
short seller, who asked not to be identied. “That’s incredible.”
Ultimately, Asensio’s line of work has made him accustomed to mak-
ing enemies. Lawsuits and inquiries have dogged him throughout his
career. Among the insults target companies and others have used to
describe him: “liar,” “thief,” and “Ass-ensio.”
On a broiling August afternoon, Asensio is slouched in a black oce
chair at his Manhattan oce. With shaved head and dressed in cuto
shorts, laceless sneakers, and a rumpled polo shirt, he looks more like a
beachcomber than a Wall Street shark. At ve feet eleven inches and a
lithe 165 pounds, Asensio sizes up visitors with deep-set brown eyes.
Mia, his daughter’s longhaired Chihuahua, playfully yelps. “She likes
you,” he observes. “That’s unusual.”
32 THE MOST DANGEROUS TRADE
The threadbare oce speaks to Asensio’s outsider status. On the
walls, instead of slick corporate art, are social-realist posters. “Work
Better. Live Better,” they read.
There are also old stock and bond certicates from the land of his
birth: Cuban Cane Products Co. and Blanco Territorial de Cuba.
Like a lot of immigrants, Asensio worships the American work ethic.
On a visit to a local sandwich shop, he points to the lone counterwoman.
“Do you see how she’s running this place all by herself?” he marvels, and
then lapses into Spanish as he chats her up about business. Later, walking
through a park frequented by transients, he shows his disdain for what he
perceives as slackers: “The sense of entitlement of these guys is amazing.”
Friends shrug it o. “Manuel denitely views the world as black
and white,” says Allan Block, a friend and CEO of Block Communi-
cations Inc., a Toledo, Ohio Communications Company that owns the
Pittsburgh-Gazette, which often publishes op-ed pieces by Asensio. “Well,
the world is not black and white.”
Though he doesn’t like to talk about it, short selling has made Asen-
sio wealthy; he keeps an apartment on Manhattan’s eastside and a luxury
apartment in Miami, and dines at the nest steakhouses. He collects the
artwork of contemporary Cuban artists like Alexis Leyva Machado and
when in South Florida zips around on a classic 1979 BMW R65 motor-
cycle. But to hear Asensio tell it, uncovering fraud is less a career than a
cause—part of the eternal struggle between right and wrong.
“Morality is important to me,” says Asensio. “Whether you’re deal-
ing with FINRA, a court, or a short sale.”
As he grapples with his exile high above Third Avenue, it’s a subject
he returns to again and again. He shows a black loose-leaf binder with
articles by sociologists on the subjects of why people do what they do. It
includes a paper by Ziva Kunda, the late social psychologist known for
her work in motivational reasoning, and another by Jonathan Haidt, a
New York University Stern School of Business professor who specializes
in the psychological bases for morality across dierent cultures.
Asensio says he understands “instinctive” decision making”—what
psychologists describe as the tendency of people to stick by choices they
make on impulse. By contrast, “deliberative” decision-making requires
time, and results in a more nuanced, balanced outcome. “The person
making the instinctual decision will always make up a reason not to
Asensio: Exile on Third Avenue 33
change that decision,” Asensio says. Ergo, FINRA is unlikely to ever
reverse its ruling.
Psychology aside, Asensio had been a thorn in the side of FINRA
and other regulators for years. The targets of his short campaigns were
often listed on the NASDAQ Stock Market, which was for a long time
part of FINRA’s NASD predecessor. The association ned him for myr-
iad infractions over the years.
Beginning in 2000, Asensio let loose a blistering series of letters
to regulators of the American Stock Exchange (AMEX) criticizing
the market’s lax listing standards. At the time, AMEX was a NASD
subsidiary. “We believe that the AMEX’s leaders have intentionally
protected certain stock scams,” Asensio wrote in a November 2000 letter
to Representative John Dingell, chairman of the House Committee on
Commerce, who launched an investigation into AMEX practices.
The specics of Asensio’s answers to the NASD—the basis of its
ruling to bar him—are opaque based on available documents. Transcripts
of such hearings are not posted, and the whole process of adjudication by
so-called self-regulatory organizations like FINRA is cloaked in secrecy.
Excerpts from NASD transcripts show that before the hearing that
led to the ban, Asensio & Company changed its name to Integral Securi-
ties, that would not be a broker-dealer. “There was nothing underhanded
or contrived about it,” says Asensio. “It was for the purpose of eliminat-
ing NASD jurisdiction.”
Regardless, he has suered the blowback. Appeals have all proven
fruitless. When Asensio applied to FINRA in 2009 to be reinstated,
under the sponsorship of a new company, ISI Capital, he was rejected.
FINRA created a new rule to prevent a disbarred member from ever
rejoining. He calls it “the Anti-Asensio rule” (an SEC commission
scuttled the proposal after Asensio opposed it). Asensio next appealed
his bar to the SEC, of which Schapiro had been named chairman,
which backed FINRA’s bar (Schapiro recused herself). Then, in 2012,
Asensio’s appeal to the U.S. Court of Appeals for the 11th Circuit was
also denied.
Asensio has spent millions on his eorts. The opportunity costs are
far greater. The bar means he was preoccupied and in the penalty box
during the credit-fueled stock market meltdown of 2007–2009, when
34 THE MOST DANGEROUS TRADE
hedge funds managers like Paulson and Jim Chanos of Kynikos Asso-
ciates pocketed billions.
He blames the bar for trashing his peace of mind. Mostly, though,
he acknowledges the stain on his credibility and his family honor. “It
struck at my heritage,” he says, drawing on a Montecristo cigar. “I have
a lot of pride in my family name.”
The bitter lesson learned by Asensio is that for regulators, cracking
down on short sellers produces little, if any collateral damage. “It’s an easy
political win to go after these guys,” says Daniel Celeghin, a partner at
consultant Casey, Quirk & Associates in Darien, Connecticut. “There is
always this shoot the messenger mentality.”
The bar against Asensio is testimony to how arbitrarily and capri-
ciously such sanctions are applied. “Discretion without oversight is the
enemy of fairness,” he says. With hearings closed to the public, there is
zero transparency. Dynamics like that conspire to sink a defendant who
is disliked, uncooperative, hostile, or simply combative. Asensio is all of
the above. “These cases are decided on a case-by-case basis,” says pro-
fessor Jill Fish of the University of Pennsylvania School of Law. “When
you’re dealing with a regulator, that can be a strategy that backres.”
It certainly did for the pugnacious Asensio—who seems to have been
battling one system or another from his earliest days.
His tale begins in Batista-era Havana, where Manuel Pedro Asensio-
Garcia was born in 1954. Asensio’s father, Manuel Sr., and his uncle
Abilio worked in an export–import business. His mother, Caridad,
was a social worker and a descendant of Vicente Garcia Gonzalez, a
nationalist hero of the Cuban Ten Years’ War who was later reportedly
poisoned by the Spanish with ground glass in 1886. Asensio still carries
a Cuban passport.
After Fidel Castro overthrew Batista in 1958, his father supported
the revolution. Asensio’s pragmatic mother was skeptical as rst oppo-
nents of Castro and then former allies were rounded up and summarily
executed. His parents bundled the 6-year-old Manuel onto a steamer to
Venezuela with an aunt and uncle, who ocially adopted him to make
the ight easier.
Asensio recalls embarking passengers being relieved of their jewelry
by Castro’s paramilitaries at the dock. He said goodbye to his father.
“That was the last time I cried as a child,” says Asensio.
Asensio: Exile on Third Avenue 35
After a spell in Caracas, his aunt and uncle dispatched him by plane
to New York.
His new home was with his mother’s sister Josephine, a factory seam-
stress, in the working-class Brooklyn neighborhood of Borough Park.
His mother soon joined them, and the extended Asensio clan settled
into the bustling Jewish and Italian area of brick row houses, where the
elevated subway clattered away day and night. His father, jailed for a spell
in Cuba on political charges, eventually joined them,
Despite the poverty, it was one of the happiest times of his life.
“None of the diculties touched us,” Asensio says. “We went to school
together. We went to church together.” He played stickball on the streets,
always outnumbered by the local Jews. To make money, Asensio worked
as a “Shabbat Goy,” earning money by lighting ovens and turning on
lights for orthodox Jews, who are forbidden from doing so on the day
of rest. Only recently has he discovered that the Garcia side of his family
has extensive Jewish roots, of which he is proud.
Asensio attended rst public school and then St. Francis de Chantal,
a nearby Catholic elementary institution overseen by a faculty of dis-
ciplinarian nuns. “If we are ignorant, she is the seat of wisdom,” reads
an inscription by Saint Jane Frances de Chantal on the façade of the
four-story, mid-century building. “If we are weak, she is strong.”
From there it was on to the Bishop Ford Bishop Diocesan High
School, where Franciscan brothers were in charge. As a freshman, Asen-
sio became a track star clocking a half mile sprint at under two minutes.
As always, he and his cousin were the only Cubans.
Asensio hustled for pocket money, working at a Carvel’s ice cream
shop, delivering groceries, or hawking newspapers. In 1970, his father,
then working hourly jobs, scored a solid administrative post at IBM
Corp.’s new personal computer factory in Florida. They were o to Boca
Raton, where Asensio graduated from the local high school and began
taking classes at community colleges. He worked at every opportunity,
saving what he could.
From there, Asensio headed north to Philadelphia, to attend the
Wharton Evening School, the business school’s continuing education
program. Scoring straight As helped him swing a transfer to the Wharton
School proper on a work-study scholarship, graduating in 1977 with the
degree he thought would be a passport to a Wall Street career.
36 THE MOST DANGEROUS TRADE
That didn’t happen. He still remembers the withering comment of a
Morgan Stanley junior partner eyeing his cheap suit during the interview.
“There’s only so many investment bankers in the world and I don’t think
you look … thetype,”herecallsthepartnersaying.Theremarkstill
stings. “In 1977, there were no spics on Wall Street,” he says.
Bitter but wiser, Asensio left for Caracas, a stable and vibrant city
at the time, awash in oil money. He landed a job at age 22 at an Alcoa
subsidiary, arranging a long-term consumer nancing. “I was the one
who could speak English,” Asensio chuckles. He later landed a superior
spot at Société Financière Union.
Two years later, though, oil prices began to plummet. Asensio saw
political-economic storm clouds gathering, and took his Venezuelan
wife-to-be to Boston and Harvard Business School.
There, Asensio stumbled upon the kind of trade that comes along
once or twice in a lifetime. It was 1981, and Seagram Company Ltd.
and DuPont Company were in a contest to acquire Conoco Inc., the
oil giant. Seagram was oering $110 a share when DuPont appeared as
a white knight. In a two-step transaction that was pioneered by First
Boston mergers and acquisitions co-heads Bruce Wasserstein and Joseph
Perella, DuPont quickly bought 51 percent of Conoco’s stock and
oered the equivalent of $67 a share in DuPont stock for the balance.
Since DuPont already controlled a majority of shares, those holding
the rest would have to accept the $67 oer—a “cram down” in Wall
Street parlance.
Unaccountably, Seagram left its $110 share oer on the table, even
though it was virtually certain that it would be forced to accept the $67
DuPont stock cram down. The confusion helped prop up Conoco stock,
which, illogically, was trading at $90 or so.
Asensio was busy calling investor relations, brokers, and merger arbi-
trage desks for insight into the deal. He also managed to nd some
put options that would give him the right to sell shares of Conoco
at $90. The cost: $1 a piece. So, once Seagram’s oer lapsed, some-
one on the other side of the trade would be forced to pay Asensio $90
for a $67 stock, locking in a prot of $23, for a mere $1 outlay, or a
2,300 percent return.
Asensio researched everything himself in his student dormitory.
“I was reading the proxies, the 10-Qs, talking to companies and
Asensio: Exile on Third Avenue 37
arbitrageurs,” he says. Asensio says he bought as many puts as he could,
and made nearly a half million dollars on the trade.
It was his rst short investment—and it made him rich. “It allowed
me to not have to worry about getting a job during recruiting season,”
he says.
The Cuban immigrant who couldn’t get hired as a Morgan Stanley
associate found himself on top of the world—in the ivory tower of
capitalism. And Asensio wasn’t shy about letting his classmates—who
included JPMorgan Chase CEO Jamie Dimon and General Electric
CEO Jerey Immelt—know about his success. Some resented it.
Asensio’s machismo irked some people. On one occasion, his section
was studying a case history of a woman executive who overcame a thorny
business problem. Asensio declared: “I’ve been very impressed by the
little lady.” The class hissed. “He got notoriety for his politically incor-
rect statements,” chuckles Glenn Wattley, a fellow classmate.
After Harvard, Asensio headed back to Boca Raton to set up First
Boca Raton Investment Corp. It was not a runaway success. He provided
advice to venture stage companies, which had begun to sprout in the
area, as had a whole crop of dubious companies across South Florida.
“This was my introduction to penny stock fraud,” he says.
First Boca steered clear of them but did help to raise money for a
dicey company called Therapeutic Technologies, which made machines
to exercise the muscles of paralyzed patients. The company stied First
Boca Raton on its bill, so Asensio had a local sheri’s department to haul
away Therapeutic’s oce equipment.
The episode was recounted as a “bright” in the Wall Street Journal.
Asensio was mortied.
In 1987, Asensio sold First Boca Raton, heading north to New York
and Bear Stearns, a rm known for taking bets on unconventional hires.
“In my case, a bad idea,” Asensio writes in his autobiographical book,
Sold Short (John Wiley & Sons, 2001).
John Paulson, the hedge fund manager, was Asensio’s boss in Bear
Stearns’ mergers and acquisitions department. Asensio was struck
by Paulson’s fastidiousness. “He was meticulous. He always held the
pen upright and then drew circles around what he had written,” says
Asensio. “John Paulson was always philosophical and thoughtful.”
Paulson, who later briey shared oce space at Asensio & Company,
38 THE MOST DANGEROUS TRADE
through a spokesman declined to comment about his relationship with
the short seller.
Asensio gravitated toward corporate iconoclasts, even the most
unpopular ones. These included Charles Hurwitz, the CEO of Maxxam
Inc., a Bear Stearns client reviled by environmentalists for his eorts to
cut down groves of California redwood trees in the 1990s.
“I liked Charles,” says Asensio. “He was able to get control of com-
panieswithassetsandcashowsandshakethemupincreativeways.”
Asensio says he wasn’t a t at Bear Stearns and set o to do some-
thing “entrepreneurial.” He set up shop at a small brokerage, Baird,
Patrick & Co., splitting his commissions with the rm. Every six months
or so he would move on to a dierent rm to get higher payouts from
his investment banking deals—Steinberg & Lyman, Moseley Securities,
Ladenburg Thalmann, Thomson Mckinnon Securities, and so on. His
autobiography skips over these years.
Asensio & Company opened its doors in 1992. The goal was to build
a traditional brokerage. With the rm’s certication as a minority-owned
business, it was able to snag the role of lead manager for a $200 mil-
lion underwriting of New York State municipal bonds, the ultimate
low-margin, boring transaction.
With a four-person sta, Asensio & Company soon issued its
rst equity research report—surprisingly, a buy recommendation on
Coca-Cola. The stock had nearly doubled over the previous three years,
and with its P/E teetering at 27.4 times trailing earnings, many value
investors gured it was overpriced. Asensio, however, forecast 15 to
20 percent earnings growth over the next four years as Coke expanded
into more emerging markets, and he put a buy on it. Coke stock
doubled over the next two years.
Still, with dozens of brokerage rms covering big companies like
Coca-Cola, Asensio needed a way to dierentiate his rm. With markets
surging, one way to do that would be to nd candidates for short selling.
The vitamin industry seemed like fertile territory, since the reg-
ulatory tide seemed to be turning against it. By 1995, the Food and
Drug Administration was pushing for warning labels on diet aids, even as
several states had moved to ban ephedrine, often used as an appetite sup-
pressant. Asensio thought this boded poorly for the industry and began
to dig for specic short candidates.
Asensio: Exile on Third Avenue 39
Insider selling provided a warning ag at a company called General
Nutrition Companies, a Pittsburgh-based vitamin store chain. The
previous November, General Nutrition’s CEO had sold 80 percent of
his shares and two vice presidents had sold all of theirs. Those were not
votes of condence. The company, a Wall Street darling, had saturated
the country with 2,400 stores, yet average store sales were just $450,000.
The stock had doubled the previous year and traded at a price earnings
multiple of 29. With a market capitalization of $1.8 billion, General
Nutrition’s tangible net worth was just $2 million. To top it o, the
company had already issued an earnings warning for the fourth quarter
of 1995.
As Asensio talked to people in the industry, he heard talk of a
study underway looking into the ecacy of vitamins sponsored by
the National Cancer Institute. He began cold-calling NCI employees,
searching for anyone with knowledge of the study. Finally, an associate
of the study’s director answered the phone and Asensio began peppering
him with questions.
The study was shaping up as bad news: It was looking into the
long-term eects of beta carotene on smokers and nonsmokers and
included a control group receiving placebos. The study was halted
when it became evident that those receiving placebos were faring much
better than those getting the vitamin. The question for Asensio—how
to prot from it?
Any negative news for the vitamin industry was bound to be even
worse for General Nutrition, with its poor fundamentals, Asensio rea-
soned. When the NCI announced a special press conference, Asensio
knew it would be big and bad. The rm put together a draft research
report outlining its case against General Nutrition’s fundamentals, and
left space for the NCI ndings.
On January 18, 1996, the NCI released not one but two studies—
one suggesting that the use of beta carotene provided no benets for
heart or cancer patients and the other showing it actually to be harmful.
“U.S. government ocials were telling consumers that beta carotene was
just a fraud,” Asensio recalls.
He quickly wrote the studies’ results into the Asensio & Company
research report and sent out his “strong sell” recommendation via PR
Newswire. The result: Nothing. Bullish Wall Street rms used the
40 THE MOST DANGEROUS TRADE
opportunity to reiterate their “buy” recommendations, saying such
studies are routine. The stock closed up 35 cents at $21.25.
Frustrated, Asensio issued a second report the next day. “Investors
continue to listen to analysts who have no choice but to continue to
recite the company’s position,” it read.
The oce phone rang. Finally, a response. “It was the general
counsel calling to threaten litigation right away,” Asensio says. The call
was a rude welcome to the world of short selling. Yet Asensio’s view
was eventually vindicated. In May, when the company reported second
quarter same-store sales would fall as much as 6 percent, Alex. Brown,
PaineWebber, and Smith Barney cut their ratings, and the stock fell to
$14 from $18.50.
Like a lot of investors, especially short sellers, Asensio discloses few
specics about his tactics—partly to avoid being accused of solicitation
of customers, partly for competitive reasons. “We are constantly under
scrutiny,” he says. Asensio declines to reveal the assets he manages, or
the number or names of his investors. He won’t say when he opened
any particular short position or when he covered it.
These positions are large, Asensio says, and he moves in and out
of them quickly, both to take advantage of changing information and
market swings and to minimize the borrow, or interest on borrowed shares
to short, which can amount to 40 percent annualized. The Asensio.com
website shows the price of target companies at the time Asensio issued its
rst report, its subsequent low, and the percentage decline to that low.
It doesn’t show any subsequent rebounds and warns that the numbers
should not be viewed as indicative of investor returns.
Among other things, Asensio says he runs special purpose vehicles
for larger pools of capital. In some circumstances, there are “carve-outs”
to these, or walled-o money, for which Asensio & Company will sur-
render its carried interest, the 20 percent of any prot he normally keeps,
if the name of the targeted short company becomes public. Some clients
don’t want to be associated with short sales. The website also refers to a
rm proprietary short-selling account whose returns, it says, are greater
than the calculated returns on its website.
Deep dive research drives all of his short investments, especially those
involving suspected fraud. “I like to drill down for months to make an
Asensio: Exile on Third Avenue 41
investment without speculation,” Asensio says. “You need to have all the
information, whether it’s relevant or not.”
Asensio says he prefers shorting a fraudulent company to one that is
merely overvalued, like General Nutrition. “An overvalued company
is an opinion where someone has miscalculated future earnings;
valuation is a judgment,” he says. “With fraud, you can have more
conviction.”
That preference for fraud led Asensio to Hemispherx Biopharma,
a Philadelphia drug development company that was to become one of
his most bitter and longest running campaigns. The obvious tip-o for
Asensio was the drug maker’s underwriter, Stratton Oakmont, a Lake
Success, New York brokerage notorious for its pump-and-dump stock
schemes and the subject of The Wolf of Wall Street, the 2013 lm directed
by Martin Scorsese and starring Leonardo DiCaprio. Indeed, Stratton
Oakmont was expelled from the securities industry by the NASD just a
year after taking Hemispherx public in 1995. “You look at the people,”
Asensio says. “Tigers can’t change their stripes.”
The focus of Asensio’s analysis was Hemispherx’s drug Ampligen,
which by 1998 had been nearly 30 years in development. The com-
pany’s CEO, William Carter, helped discover it while a 20-something
researcher at Johns Hopkins University. Ampligen is a real chemical com-
pound, described by Hemispherx as an antiviral drug that can stimulate
the immune system and keep cancer cells from reproducing, among a
wide variety of other possible uses.
Yet the Food and Drug Administration (FDA) has never given mar-
keting approval to Ampligen for any use whatsoever, although it has been
studied as a treatment for AIDS, hepatitis B, chronic fatigue syndrome,
and a host of other maladies. Amazingly, Hemispherx had never even
led a new drug application with the FDA for Ampligen. Wags called it
acureinsearchofadisease.
Asensio began digging into Ampligen’s history—trawling through
medical and legal records. What he turned up wasn’t pretty.
In 1986, Carter and colleagues had conducted a study on 10 patients
with AIDS or similar diagnoses and published the encouraging results
in the Lancet, the prestigious British medical journal. Based largely on
that study, DuPont invested $30 million into Hemsipherx’s predecessor
42 THE MOST DANGEROUS TRADE
company, HEB Research, to gauge its ecacy in treating HIV. When
DuPont tried and failed to reproduce Carter’s results, it accused him of
falsifying research and sued to recover its investment, eventually settling
the case.
In 1987, Peter Frost, a Houston AIDS patient, sued Carter, saying he
had bought $157 worth of Hemispherx stock from him for the inated
price of $1 million in exchange for Carter admitting him into an Ampli-
gen HIV study. Carter, though admitting the stock sale from his own
personal account, denied the quid pro quo, and Frost dropped his suit,
only to die shortly thereafter.
After that, HEB’s board red Carter, who sued the company and
won his job back.
What Asensio desperately needed to be sure was that Ampligen
was not a viable drug. He talked about Ampligen with doctors and
drug industry scientists. The key takeaway: Ampligen is composed of a
double-stranded ribonucleic acid, or RNA, a type of molecule that has
a tendency to be extremely toxic. Accordingly, it was quite unlikely to
ever receive an approval from the FDA. The drug did serve one non-FDA
approved purpose—it gave Carter an excuse to sell more stock.
On September 22, 1998, Asensio posted his rst Hemispherx
research report on the Internet. He wrote that Ampligen was of “no
medical or economic value” and that Hemispherx “had made fraudulent
misrepresentations about Ampligen’s FDA ling status.” He also said
that the company was “promoting futile projects simply in order to
enable insiders to sell their otherwise worthless stock to the public.”
The shares fell to $4.51 from $8 over three days. Hemispherx shot
back with a press release accusing Asensio of being part of a conspir-
acy to manipulate its stock price. But that was just the opening volley.
The shares were soon seesawing amid back and forth press releases from
Asensio and the company. The stock would climb, for example, on a
Hemispherx release promising a new clinical study, racking up losses for
Asensio. It would then trade down, often after an Asensio.com post.
Over the years, Asensio continued to relentlessly bird-dog Hemi-
spherx, exposing bogus company claims, for example, that Ampligen
had been endorsed by an organization supporting research into chronic
fatigue syndrome and revealing that the FDA had censured Carter
for making inappropriate claims about Ampligen’s safety. Surprisingly,
Asensio: Exile on Third Avenue 43
patient advocacy groups were wont to support Carter, desperate as their
constituents were for cures.
Asensio confronted Carter personally at one conference, shouting at
him, “You belong in jail.” Hemispherx sued Asensio in Federal Court
in Philadelphia for fraud, defamation, and violation of the Racketeer
Inuenced and Corrupt Organizations Act (RICO). Though the court
dismissed the fraud and RICO counts, the defamation claim was moved
to state court. The jury ruled in Asensio’s favor, though Hemispherx’s
appeals continued until 2010. Ultimately, it’s the market’s verdict that
counts: Hemispherx shares in March 2015 traded for 25 cents.
Asensio says he can’t remember what led him to start looking at
KFx Inc., a Denver energy company that claimed to have a process
to turn low-quality coal into clean fuel. That is not as surprising as it
might sound. Short sellers share tips about potential frauds and other
opportunities among themselves. Among the short-selling rms Asen-
sio has worked with are Kingsford Capital Management in Richmond,
California and the now-defunct Rocker Partners. A clutch of research
rms also specialize in shorts, including Muddy Waters LLC, Citron
Research LLC, and Integrity Research Associates.
That ecosystem gives ammunition to anti-short advocates, includ-
ing stock promoters, like Carter, who warn ominously of an amor-
phous cabal of short sellers manipulating the market. Investors often
believe it.
By early 2005, high-prole hedge funds had bought into KFx,
including such dizzyingly successful ones as Perry Corp; Kingdon
Capital Management, LLC; and Ritchie Capital Management, LLC.
Since KFx went public via a reverse merger with a penny-stock shell
company in 1998, shares had grown at a rate of 25 percent annualized.
The KFx story was premised on the dynamics of the coal markets.
Nearly 50 percent of the world’s coal is of the sub-bituminous, brown,
or lignite variety—low-quality stu that is saturated with moisture, pol-
lutes heavily, and at $6 a ton costs about one-tenth what high-quality
coal does. The moisture makes it more costly to transport and decreases
its eciency.
KFx held a patented process, dubbed K-Fuel, to remove the mois-
ture using heat and pressurization and was building a plant in Gillette,
Wyoming to test it. Entrepreneurs had tried to clean up low-grade coal
44 THE MOST DANGEROUS TRADE
for decades—it can be done but at a cost that was and remains wildly
uneconomical.
The problem has to do with the moisture. When it falls below a cer-
tain level, the coal begins to reabsorb it from the atmosphere, increasing
the chances of spontaneous combustion. That’s not good.
Drying the coal also produces clouds of dust—which is both an envi-
ronmental problem and a safety hazard, since such dust contributes to
spontaneous combustion. Amazingly, KFx would eventually spend an
astounding $166.1 million on the new test plant, even though at least
some of management must surely have suspected that the process wasn’t
economical. The rst run was scheduled for late 2005.
Asensio was no coal expert. He found a Department of Energy white
paper that detailed the problems of cleaning coal. He also tracked down
an executive he calls his “Deep Throat” at an electric utility that used
dried coal in its own operations and so was schooled about the diculties
involved. “We would talk day and night, weekends, about how much
trouble they had,” Asensio says. He declines to identify the executive.
Beginning October 1, 2004, Asensio went hostile, issuing reports
that cast doubt on KFx’s progress and credibility. The reports detailed
failed eorts by KFx and predecessors to market their K-Fuel technology.
Asensio questioned the stock deals of KFx executives and aired K-Fuel
criticism by rival mining industry experts.
KFx nevertheless announced the start up of the Gillette K-Fuel plant
on December 10, 2005.
At an upbeat conference call on January 12, 2006, KFx chairman
Ted Venners described the initial run as a success. “The main purpose
for having operated the plant at that point was to verify that the product
was stable and that it was less dusty,” he said. “We had no dust.” The
stock surged.
When the Gillette plant nally shipped coal in July 2006, Asensio
was ready. He had surreptitious video crews on hand, ex-FBI agents, to
tape the shipment, destined for a terminal owned by a large utility called
First Energy Corp.
He also arranged for them to take a sample of the coal—about
10 cents worth by his estimate—and have it analyzed by a laboratory,
SGS North America. This was the same coal KFx had claimed was
clean, dust-free, and not susceptible to spontaneous combustion. SGS
Asensio: Exile on Third Avenue 45
said otherwise. “The tests showed that it was not any of those things,”
Asensio says.
An e-mail from Asensio detailing the results was leaked to KFx
management, which sued the SGS laboratory, seeking the return of the
coal—and demanding that it name Asensio & Company as its client.
On September 18, Asensio posted the video on Asensio.com, with
swelling background music, showing dark plumes of coal dust, visible
for miles, as they billowed from the shipping containers. A haze hangs
over the plant. The stock tumbled.
The suit by KFx was running into trouble. A lawyer for the com-
pany deposed a former Asensio & Company employee, inducing him to
violate a nondisclosure agreement—a possible criminal oense. Asensio’s
lawyer threatened a suit against KFx.
By the end of September, the promotion was falling apart. KFx,
which changed its name to Evergreen Energy, acknowledged dust and
other problems in its coal shipments, and the hedge funds were selling.
Short interest rose to 28 percent. By the end of the year, Perry, Kingdon,
and Ritchie had all exited their Evergreen positions.
At that point, Evergreen shares had fallen 41 percent from their
highs, to $8.25. Asensio privately reached a settlement with Evergreen in
April 2007. The next month, he terminated his Evergreen Energy cov-
erage with shares at $6.50. “I oer Evergreen my best wishes,” Asensio
said in a statement at the time.
Today, Asensio won’t disclose the terms of the settlement. Ever-
green CEO Mark Sexton was red the next month, and the company
led for bankruptcy liquidation in January 2012, its K-Fuel dreams up
in smoke.
PolyMedica’s reputation was already in tatters by the time Asensio &
Company issued its rst research report on the Woburn, Massachusetts
company in October 2001. A year earlier, Barron’s had reported that the
Federal Bureau of Investigation was investigating PolyMedica for possible
Medicare fraud, and the stock lost half its value. Asensio says he may have
helped instigate that investigation since he had been in touch with the
local oces of both the bureau and the Justice Department concerning
PolyMedica well before that. In July 2001 the NYSE abruptly rejected
its listing application. And in August, the Wall Street Journal reported a
grand jury subpoena had been issued in a criminal investigation of the
46 THE MOST DANGEROUS TRADE
company. The next week, 85 FBI agents raided eight of PolyMedica’s
Florida oces over a two-day period. The stock fell 45 percent to $9.20
on that news.
At its core, PolyMedica was a simple telemarketer, selling blood glu-
cose test kits at prices well above the going rate. In the process, it was
bilking Medicare—not just because of what it charged, but because it was
shipping kits with no doctors’ orders to people who hadn’t ordered them,
or in some cases to people who had died. When kits were returned,
as many inevitably were, PolyMedica was not reimbursing Medicare
for them.
In the weeks following the terror attacks of September 11, 2001,
though, PolyMedica shares rallied 78 percent, to $16.50. The unpleas-
ant truth: Investors were betting that the war on Al Qaeda would take
precedence over the PolyMedica investigation.
Asensio sensed a short opportunity. His sources told him the FBI
investigation had been only temporarily delayed—and it certainly galled
him to watch investors proting from 9/11 in such a fashion. PolyMed-
ica’s results were agging too: Prots fell 36 percent to $4.7 million in
the quarter ended September 30.
For Asensio, the challenge was determining how deep the fraud ran
at PolyMedica. A Justice Department slap on the wrist, say a $50 mil-
lion ne, would have little impact on Polynesia’s share price. Still, such
an investigation might require Asensio canvassing hundreds of sources.
“They have tens of thousands of customers, so I knew verication was
going to be dicult,” he says.
In addition to doctors, Asensio talked to customers who had received
kits they hadn’t ordered and former PolyMedica employees who, dis-
gusted by the blatant Medicare rip-o, described company policies in
detail. Asensio swapped information with FBI agents, who were keen
on nailing what they considered a particularly agrant Medicare fraud.
The key was gauging rsthand the volume of returns the com-
pany was experiencing. Asensio drove to a PolyMedica warehouse in
Port Lucie, Florida. Camera in hand, he snapped away as trucks full of
returned glucose kits drove by and began unloading. Asensio chatted up
warehouse workers on their cigarette breaks. A security guard confronted
him and Asensio was briey taken into custody, where a local police
ocer issued him a bench summons.
Asensio: Exile on Third Avenue 47
Asensio waited until PolyMedica’s earnings release to issue his
October 25, 2001, report. “Based purely on fundamentals and irrespec-
tive of the likelihood that a federal indictment will result from PLMD’s
alleged criminal misconduct, we believe PLMD shares are worth less
than $1 per share,” he wrote. Asensio & Company put a “strong sell”
rating on the stock.
Almost immediately, events began turning against Asensio and his
fellow shorts. The research report had no discernable eect on the com-
pany’s stock, which, after a brief rally, closed out the year at $16.60. Then
began a slow-motion version of a short seller’s nightmare. Over the next
36 months, no matter what damaging revelations surfaced—subpoenas,
missed earnings estimates, or more evidence of fraud—PolyMedica’s
shares continued to rise.
The company’s CEO, Steven Lee, resigned without explanation. The
stock hit $24.
A federal study found abuses in the test kit industry. The stock rose
to $28.
The SEC questioned PolyMedica’s accounting for marketing costs.
The stock hit $44.
After a round of layos and the resignation of the president of the
test kit subsidiary, Polymedica hit $53.
What investors had begun to suspect was this—that under Presi-
dent George W. Bush, an anti-regulation, free-market advocate whose
brother Jeb was Florida’s governor at the time, there was scant interest
in prosecuting PolyMedica.
By now Asensio’s views too had begun to change. His sources in
the FBI had turned increasingly skeptical that the local U.S. Attorney,
Marcos Daniel Jimenez, was interested in punishing a local business—
especially in what by 2004 was an election year.
PolyMedica’s acting CEO, Samuel Shanaman, behind the scenes
had been working to assuage the U.S. Justice Department and had
increasingly been dropping references in conference calls to the
“useful” dialogue he was having with authorities. A source close to
the company said PolyMedica’s investors were won over by the new
CEO’s eorts.
For Asensio, that was bad news. “I just eventually knew they weren’t
going to be prosecuted,” he says.
48 THE MOST DANGEROUS TRADE
That didn’t prevent him from posting increasingly incendiary
reports. “There are members of the Bush Administration who have an
interest in advocating leniency towards PolyMedica,” he wrote in an
October 20, 2004, report. Any settlement for less than $400 million
would be unfair and “questionable.” Asensio stopped reiterating his
“strong sell” rating. At this point, he wrote, the outcome was “entirely
a function of a political process.”
On November 4, 2004, PolyMedica announced a tentative settle-
ment, agreeing to pay just $35 million, less than Asensio had guessed
earlier. The same day, Asensio let loose one nal blistering report: “The
DOJ simply failed to perform its duty.”
PolyMedica shares closed at $35, or $70 on a split-adjusted basis,
up more than 400 percent from where they stood when Asensio had
rst put a strong sell rating on them. On August 28, 2007, PolyMedica
was acquired by Medco Health Solutions for $53 a share in cash, $106
split adjusted.
Asensio won’t talk about how much money he lost during the Poly-
Medica short campaign. “I didn’t trade that one very well,” he says
glumly. One friend chalks the disaster up to Asensio’s misplaced moral-
istic streak—something that is dangerous in short selling.
The PolyMedica episode, combined with his FINRA battles,
prompt Asensio to compare what he sees as moral dissipation in the
United States with what he experienced in Cuba. “I’m not quite sure
which is more evil,” says Asensio, “The evil of a hidden corruption
where everyone is looking the other way and is legal and systematic
versus a corruption that everyone knows about and isn’t hidden.”
With its cast of villains, big money wagers, and rags-to-riches nar-
rative, Asensio’s life story may seem like a Hollywood drama. It almost
came to that in 2010. Director Brad Furman approached him with the
idea for a television series portraying his short-selling exploits for HBO,
the Time Warner cable television channel.
Asensio was game. Furman worked at his threadbare oce to
get a feel for the business, chasing down leads about possible frauds
and answering phones. Comedian John Leguizamo, who starred in
such movies as Dr. Doolittle, Moulin Rouge,andtheIce Age series,
agreed to play Asensio. A pilot was written, contracts prepared, and
production set.
Asensio: Exile on Third Avenue 49
Then, by early 2012, Asensio was having second thoughts on the
project and began pushing hard on one nonnegotiable demand. He
wanted HBO senior management to intercede with SEC chairman
Schapiro to have Asensio’s bar from the brokerage industry lifted. The
project was scrapped.
Once again, Asensio wasn’t endearing himself to people. “It speaks
to the bizarre, magical realist view he has towards the world,” said
Leguizamo in a brief telephone interview. “He wasted two years of my
life. Manuel Asensio is a deeply disturbed individual.”
Asensio conrms the chain of events—but puts a dierent spin on it.
Without a reinstatement by FINRA, the series would hardly have ben-
eted him. “They’d take the glory and they’d take the money.” Asensio
wants to get back to research and investing, taking large concentrated
bets, both long and short. “I don’t want to be sued again,” he says, a
touch of fatigue in his voice. “I haven’t been sued in a long time and I
want to keep it that way.”
A happy ending, it goes without saying, would provide a better sto-
ryline. “I’m interested in clearing my name,” he says. Asensio needs a
victory and some kind of redemption. “We would not know about Plato
if the Greeks had lost the battle of Marathon,” he says. “Jesus Christ
would be just another dead Jew if he wasn’t resurrected.”
Chapter 3
Chanos: Connoisseur
of Chaos
U
nder a blue sky in Connecticut on an April afternoon, James
Chanos eases his lean six-foot-two-inch frame out of his chauf-
feured Volvo sedan and strides past the hedges of 56 Hillhouse
Avenue at the Yale School of Management. He wears thick rimless
glasses, a casual blazer, jeans, and a tan wool sweater—the template of a
hip, approachable Ivy League professor. Via the maze-like staircases and
corridors that wind through the stately 19th-century building, Chanos
arrives at room A60, where dozens of students are soon crowding
into the lecture hall, taking their seats for the eight-class course he
teaches—Financial Fraud throughout History: A Forensic Approach.
Academia is an unusual sideline for a hedge fund manager with a
net worth in the hundreds of millions of dollars—and one whose name
on Wall Street is synonymous with short-selling. Even aside from teach-
ing, Chanos keeps a schedule best described as full throttle. When not
51
52 THE MOST DANGEROUS TRADE
running his short-selling focused rm, Kynikos Associates, which man-
ages some $3 billion in assets, he can be found testifying before Congress.
Chanos is a regular at political fundraisers. He makes the rounds on
CNBC and Bloomberg TV, where his erudite analyses of overvalued
companies, regulations, and macroeconomics make him a coveted guest.
One recent theme: China’s real estate bubble—a phenomenon that has
led him to short such stocks as Agricultural Bank of China and a bevy
of other Chinese nance companies and real estate developers.
At Yale, today’s lesson includes a quick overview of choice frauds in
the 18th, 19th, and early 20th centuries. Chanos reminds the class that
afterwards, he’s holding court at Frank Pepe Pizza Napolitana (Pepe’s), a
New Haven parlor famed for its white clam pies—with one proviso. “If
anybody asks me again when I’m going to cover my China short, I’m
going to pour beer on their head,” he quips.
The hall erupts in laughter.
Chanos’s class is denitely not just fun and games. A team of stu-
dents kicks it o with a detailed 20-minute presentation dissecting the
accounting of Bristol-Myers Squibb, the drug giant. Going into 2000,
according to the presentation, the company was allegedly engaged in a
massive program of channel stung—shipping unwarranted amounts
of drugs to wholesalers as a way to boost revenues and earnings to
meet internal goals and, by extension, the over-optimistic targets of
Wall Street analysts. Along the way, the company had allegedly created
improper reserves that it tapped to pad its income.
Chanos interrupts the slide show—grilling the students. “When is
the easiest time to set up special reserves?” he demands.
Nobody answers.
“Usually there is an event when they will set up reserves. What is
it?” he repeats.
The classroom remains silent, either too shy or intimidated to ven-
ture an opinion.
“Acquisitions,” he declares. “This is a key point to watch out for,
both in your projects and going forward when analyzing businesses, is
when companies use acquisitions to classically cloud what’s going on in
their core existing businesses by taking broader restructuring charges.”
Bristol-Myers had bought the DuPont Pharmaceutical Group for $7.8
billion in mid-2001, having previously sold o a pair of shampoo
Chanos: Connoisseur of Chaos 53
and medical devices businesses, muddying its nancial comparisons in
the process.
“Management has a lot of latitude,” he warns. “It’s always a good idea
to scrutinize companies that grow by acquisitions a little more closely.”
Chanos continues, weaving the science and art of fraud detection
into the students’ presentation. “Beware also the serial restructurer,
where the company is constantly taking restructuring charges and
getting used to the idea that this is something you should ignore. And as
a partner of mine once said very aptly: Recurring restructuring charges
are reserves for bad business decisions. You give companies credit for
good business decisions.… Somehow, they want you to disregard any
reserves for bad business decisions: small acquisitions that are written
o, unsold business inventories, plants they built that they never should
have. This gives them the latitude to report the numbers in the best
possible light.”
Another piece of advice: Don’t think for a moment that having a
respected money manager invested in a stock is the same as a clean bill
of health. “Most every successful short we’ve been involved with has had
a big-name backer,” he says.
Bristol-Myers ultimately settled with rst the U.S. Securities
& Exchange Commission (SEC) for $150 million in 2004 without
admitting or denying guilt and later with the Justice Department for
$300 million more, under a deferred prosecution agreement—a slap on
the wrist. There was also the matter of disgorgement, the surrendering
of illegal prots: Those totaled precisely $1. Chanos, for one, did not
nd that surprising given that the CEO during the period when much
of the channel stung occurred was Charles Heimbold Jr., a major
donor to the Republican Party. “Republican prosecutors decided to go
light on the company,” Chanos opines. The New Jersey U.S. Attorney
at the time: Chris Christie, current governor of New Jersey.
In late 2001, the Bush administration named Heimbold ambassador
to Sweden. The patsies: the former president of Bristol-Myers world-
wide pharmaceuticals group and its ex-CFO, who were eventually
indicted for federal securities violations. “They only went after the
people who were red or left the company,” Chanos pointed out. And
Bristol-Myers eventually was forced to restate earnings for 2000 and
2001. Kynikos did not short Bristol-Myers.
54 THE MOST DANGEROUS TRADE
Certainly, Chanos belies the old platitude that those who can’t do,
teach. At age 57, he’s the longest running short-selling act of any sig-
nicance. Chanos has been at it for more than 30 years, overseeing a
pure short-selling fund, Ursus, since 1985 and a more recent vintage
long-short fund called Kynikos Opportunity. In addition to his myriad
public appearances, he founded the Washington, D.C.-based Coalition
of Private Investment Companies, an advocacy group for short sellers
and other hedge funds.
To his critics—including rivals—he sets a dazzling yet awed
example. Chanos admits to being an epic partier. He has also been
known as a major-stakes gambler, often blackjack, frequenting the
high-roller tables at Las Vegas casinos.
Ashley Dupré, an alleged escort, house sat Chanos’s Easthampton
estate in 2006. Her relationship with then-New York Governor Eliot
Spitzer lead to his abrupt resignation in 2007. Chanos was divorced from
his wife, Amy, in 2006.
Chanos says he won’t discuss his personal life on the record. He does
mention that bench presses 340 pounds at a Manhattan gym he owns.
Chanos defenders—and there are legions—say all this is totally irrel-
evant, both professionally and, for that matter, ethically, since we know
very little about his private life. “It’s absolutely nobody’s business,” said
Doug Millett, a former research chief for Kynikos in an interview in
March, 2013, who died later that year of cancer. Certainly he is man of
striking contradictions. Chanos has four children. He is president of the
board of trustees of The Browning School in New York and a trustee at
The Nightingale-Bamford School and the New-York Historical Society.
Chanos agreed to serve as Millett’s godfather when the latter weighed
converting to Greek Orthodox Christianity in 2013. “He said ‘I’m happy
to do this for you, but I’m not lifting you into the water,’” said Millett,
who is widely regarded as having done the legwork which uncovered the
accounting irregularities of Enron Corp.—Kynikos’s most famous short.
And for the record, Chanos is wealthy. In addition to his sprawl-
ing estate on Further Lane in East Hampton he owns a triplex on
Manhattan’s Upper East Side. Chanos dispenses money freely to
politicians, mostly Democrats.
The pressures of the business undoubtedly take their toll. “Short-
selling is a physically brutal thing,” says Jim Smith, a former short seller
who has known Chanos since the 1980s. “It’s high emotional contact.
Chanos: Connoisseur of Chaos 55
It’s brutal on the brain, the emotions, the lifestyle. The wear and tear
couldn’t be clearer.”
What is undeniable is that Chanos has shaped the profession—
providing the gravitas to counterbalance the promotional froth of
financial markets as well as the incessant criticism of the practice.
He has been both pointed and eloquent in his demands for fairness,
transparency, and accountability on Wall Street and with Washington
regulators. In addition to his now moribund advocacy group, Chanos
serves on a New York Federal Reserve Bank advisory committee.
Less well noted is that in Kynikos Associates, he has forged a success-
ful enterprise in an environment designed to undermine the skeptics of
the investing world. Chanos has built a distinct corporate culture, com-
pensation schedule and research capability that has proved its mettle over
not years, but decades. Says Smith: “If you want an allocation to the short
side, you want to be with Chanos.”
James Steven Chanos’s journey into the sharp elbowed world of
short-selling began in Wauwatosa, Wisconsin, outside Milwaukee. The
oldest of three sons, his father, a second-generation Greek immigrant,
ran a chain of dry cleaners. “It made us comfortable,” says Chanos. His
father sold the dry cleaning business to work in the corporate world
at BASF, the German chemical company, and the family soon moved
to Birmingham, Michigan. His mother was an oce manager at a
steel company. Chanos eagerly devoured the investing books his father
checked out for him at the local library.
Chanos also learned the value of manual labor, taking on jobs as a
busboy and, later, at a dye manufacturing plant in Germany over the
summer, living with a local family. That helped spark a lifelong fascina-
tion with European history. Aided by his towering physique, Chanos was
a passable forward on his high school basketball team—an acquaintance
describes his distinctive jump shot.
From there, it was o to Yale, where his initial direction was
pre-med. He worked summers in the steel industry, nding temporary
employment at Inland Steel’s Babcock & Wilcox division. Even into the
late 1980s, Chanos was a dues-paying member of the local Pipetters
and Boilermakers Union. Not a typical hedgie, in other words.
It may be that the rigor of his studies at Yale baked into Chanos a
wariness of consensus. His interests turned from pre-med to economics
and political science. One major inuence was the investing books
56 THE MOST DANGEROUS TRADE
he read, which further stoked his interest in the markets. Another
was Edward Tufte, a professor of political science, computer science,
and statistics, who became renowned as trailblazer in the eld of data
visualization—looking for new ways to present information through
graphics. “He might have noted my skepticism toward conventional
wisdom and concern about the lack of evidence of quality and integrity
in human aairs,” says Tufte.
Then there was Richard Levin, Chanos’s professor for intermediate
microeconomics who went on to become the longest-serving president
of Yale, from 1993 to 2013. “He did make an impression,” Levin
says. “Jim likes getting into a good intellectual dispute. He’s like a
good professor.”
It was to Levin that Chanos rst proposed teaching a course on nan-
cial fraud. Levin, reportedly asked: “You’re not going to teach them
how to commit fraud, are you?” Chanos is one of several Yale alumni,
including Thomas Steyer of Farallon Capital Management and Dinakar
Singh of TPG-Axon Capital Management, who have managed money
for the school’s $24 billion endowment. Yale chief investment ocer
David Swensen was a pioneer in hedge fund investing.
Keith Allain, today coach of the Yale national championship winning
ice hockey team, recalls Chanos, his freshman year roommate, and his
ability to pack in enormous amounts of studying and partying—excelling
at both. “He had this incredible ability to burn his candle at both ends,”
Allain recalls. Chanos was famous for the postgame parties he orga-
nized for the Bulldog hockey team, in particular his carefully recorded
party tapes.
After graduation, in 1980, Chanos turned to Wall Street, with the
economy mired in recession at the tail-end of an extended bear market.
His rst job was as a junior-level corporate nance analyst at the Chicago
oce of what soon became known as PaineWebber, the big retail broker-
age rm. With a paycheck of $12,000 a year, he was discouraged, given
the grunt work of crafting deal book pitches for corporate clients, mostly
xed income. Chanos was far more interested in stocks, and chatted up
Bob Holmes, a banker on the equities side of the business, with one point
of interest being the phenomenally successful stock buybacks of Henry
Singleton at Teledyne Technologies a conglomerate, which were making
shareholders rich.
Chanos: Connoisseur of Chaos 57
Chanos was drafted to write the pitch book for a McDonald’s Corp
bond oering. His analysis showed that rather than issuing debt at 12 per-
cent, the fast food chain would be far better o buying back its shares, like
Teledyne. “The earnings per share went up much higher on a buyback
than a debt deal and they didn’t need the cash at the time,” he recalls.
He went to talk to his boss. “Have you ever looked at asking them
about a buy back?” Chanos asked.
“Why would we do that?” his boss asked.
“Here are my numbers,” Chanos responded, showing him his
calculations.
“Don’t ever show that to the client,” his boss snapped. “We’re here
to do a bond deal.”
Chanos recalls going into Holmes’s oce and asking him, “What
value am I here?”
Holmes and a New York partner, Ralph Worthington, soon left
PaineWebber to set up Gilford Securities. The boutique rm, with
oces in New York and Chicago, was named after the seaside town of
Guilford, Connecticut, but the lawyer misspelled it.
Chanos’s luck was about to change. At Gilford, he was assigned to
cover MGIC Investment Corp, a former Nifty-Fifty insurer that was
soon subsumed into a fast-growing company called Baldwin-United,
whose ticker symbol was BDW.
Baldwin was a well-known piano maker that in the spirit of the times
had morphed into a fast-growing seller of annuities—in this case, essen-
tially certicates of deposit wrapped in an insurance product. They were
specically called single premium deferred annuities or SPDAs, which
for an initial premium of, say, $21,000 or so paid a market rate of 14.25
percent with the rate guaranteed not to fall below 7.5 percent for the
rst 10 years.
There were also minimal withdrawal and surrender penalties for
purchasers. Other Baldwin-United business lines included property
and casualty insurance, a saving and loan business, and trading stamps.
Everything except the annuity business was declining when Chanos
began looking into the business. He learned the intricacies of statu-
tory accounting, the complex set of bookkeeping rules that govern
insurers rather than standard generally accepted accounting principles,
or GAAP.
58 THE MOST DANGEROUS TRADE
The rst problem with Baldwin-United was that although the
life insurance business of which the SPDA operation was comprised
accounted for 70.7 percent of revenues, tax law changes by the Internal
Revenue Service were about to make the annuities much less attractive
for investors—including fat penalties for early withdrawals and changes
in their tax treatment. People knew this, and sales of SPDAs were
plummeting.
The capital structure of the rm was wildly out of whack with
the competition too. Firms like Aetna, General Re, and Travelers
sported debt-to-equity ratios that ranged from one to ten or less.
Baldwin-United’s was more than ve to one.
Soon Chanos received a late night phone call.
“Are you Jim Chanos?”
“Yes.”
“Are you the one asking the questions about Baldwin-United?”
“Yes.”
“Do you know about the les at the Arkansas State Insurance
Department?”
“No.”
“You should ask for them. They are public information.”
Despite the more than three decades that have passed, Chanos still
bubbles with excitement when he describes the twists and turns of
uncovering his rst fraud—jumping up like a schoolboy from his seat
to sketch out the complicated scheme on a white board in his midtown
Manhattan oces.
After laboriously piecing together details of Baldwin-United’s
$1.17 billion purchase of MGIC, Chanos zeroed in on the fact that
the rm was using cash from its SPDAs to buy money-losing MGIC
real estate and equity in other Baldwin-United subsidiaries, a gambit
to fund the annuities. More than half the premiums invested in 1981,
according to Chanos’s research report, “represented net transactions in
Baldwin’s aliates.”
The rm was using insurance money to in eect keep the SPDA
balloon inating, and nobody seemed inclined to pop the bubble. It also
didn’t help that Baldwin-United’s chief nancial and accounting ocer
was in the process of resigning—always a bad sign. “The handwriting
is already on the wall. Regulators in both Arkansas and Wisconsin have
Chanos: Connoisseur of Chaos 59
informed us they intend to screen BDW’s future internal nancing plans
very closely, and may require outside collateral (bank letters-of-credit,
etc.),” he wrote.
The stock was trading at $24 a share when Gilford published the
report on August 17, 1982. He forecast a near-term target price of $10
to $15. “At a recent price of $24 per share, the case for selling BDW
shares is most compelling,” his report concluded. Of course, the 1980s
bull market was just beginning.
By early December, shares had risen to $44 even as the junior
analyst—he was just 25—had begun to sharpen and focus his analysis.
As the stock price rose, Chanos was derided by bullish analysts. In a
new report, he now pointed out that net income gures were unreliable
because of Baldwin-United’s dubious tax accounting, cash ow was
declining, and, again, that the insurance portfolios were stued with
securities of aliated companies or their holdings. He also showed that
even using the company’s own income statements it was losing money
on an operating basis.
Gilford hired Ray Dirks, who had famously uncovered the Equity
Funding scandal in the 1970s, to look into Baldwin-United. His verdict:
Chanos’s work was awed. “The kid’s all wet,” Dirks told the New York
oce. “The company’s ne.” Baldwin-United shares eventually hit $56.
On Christmas Eve, Chanos received a stunning holiday gift—a
phone call. “The Arkansas insurance regulators just seized the Baldwin-
United insurance subsidiaries,” a voice said. Baldwin-United the next
year led for bankruptcy, the largest in U.S. history up until that time.
Shares ended up close to zero.
Hedge fund managers had been following the Baldwin-United case,
and soon job oers piled in. Chanos remained loyal to Gilford. He fol-
lowed up his Baldwin-United call with an impressive victory lap of other
short calls, with sell recommendations on Coleco Industries, maker of
the disastrous Adam Computer, and Waste Management, a trash-hauling
roll-up.
Gilford, though, was changing its focus. Rather than churn out
deeply researched reports on dubious companies, the rm wanted to get
into the lucrative business of underwriting stocks. Chanos was assigned
by Gilford to serve as the junior banker for the initial oering of a
Huntington, Long Island company named CopyTele—which had no
60 THE MOST DANGEROUS TRADE
products and no sales but was being hyped as the next Xerox. The
company claimed to be developing a high-resolution computer screen
that Chanos describes as a “blank piece of plastic.” One version was
supposed to replace the top of copier machines, allowing for the print-
ing of images from a computer and ushering in a new age of graphics
reproduction.
Chanos remembers his dismay after realizing the product was
baloney: “I told Bob Holmes ‘There’s nothing there! I can’t do
hard-hitting research and do IPOs.’”
The loyal Chanos nevertheless helped CopyTele go public, after
which it became the subject of scathing articles in, among other
places, Fortune magazine. Ironically, it also set o a battle between short
sellers and those attempting to squeeze them—one of whom took
out full page newspaper ads reading “Here’s a Stock Thomas Edison
Would Buy.”
Chanos was mortied. “I’ll always carry the millstone of being one
of the junior underwriters on one of the great shorts of all time,” he says.
CopyTele still loses millions of dollars a year and continues to trade on
the OTC bulletin board at a price of 8 cents a share as of March 2015.
CopyTele hastened Chanos’s decision to leave Chicago for New
York, where he landed an analyst position at Atlantic Capital, a
broker-dealer subsidiary of Deutsche Bank that had been grandfathered
to avoid Glass-Steagall rules separating commercial and investment
banking. There his boss, Jim Levitas, encouraged him to pursue his
skeptical research. Sometimes, as in the case of United-Baldwin, the
job required ungodly amounts of fundamental research and sleuthing.
In other cases, it was breathtakingly simple. For example, one short
selling idea that Chanos carried over from Gilford was Coleco. Its Adam
home computer was supposed to be shipped in early 1983, but pro-
duction problems kept delaying it, eventually threatening the critical
Christmas season.
Meanwhile, the home computer craze was in full bloom, with the
IBM PC Jr. and Commodore 64 ying o store shelves. An Adam proto-
type that appeared at a consumer electronics show in 1983 was rumored
to be lled with the innards of an Apple II. When the Adam nally
debuted that year it was skewered mercilessly in the media. “Consumer
Reports just panned it,” Chanos recalls. “They said do not buy this.
Chanos: Connoisseur of Chaos 61
It’s buggy and it crashes.” How tough is it to write a sell recommendation
based on a downbeat Consumer Reports article?
Plenty, as it turns out. True, Coleco’s electronics business, including
the disastrous Adam, collapsed with sales plunging from $404 million in
1984 to $100 million in 1985 and just $56 million in 1986.
Yet, as the Adam’s bust was making headlines, Coleco was success-
fully ramping up the inexplicably popular Cabbage Patch Kids, “must
have” dolls for the under-10 set that would prove a far bigger hit. Sales
of the dolls soared from $67 million in 1983 to $540 million in 1984 and
$600 million in 1985, when the fad eventually began to run its course.
The stock price fell by nearly 50 percent from its November 1984 high
of $19.125 to $10.125 in 1985. It then powered back before Coleco
eventually was forced into chapter 11 bankruptcy in 1988. “We rode a
bubble and then it collapsed, but then we stayed too long for another
bubble on top of that,” Chanos recalls.
Atlantic clients appreciated Chanos’s bearish analysis—even if the
upstart, who sported a thick mustache at the time, didn’t always score.
Many were already legends of the hedge fund industry—the volatile
Michael Steinhardt; the former Hungarian refugee and macro investor
George Soros, who himself would later make $1 billion shorting the
British pound in 1992; and Julian Robertson, founder of Tiger Man-
agement LLC, which served as a storied training ground for dozens of
hedge fund stars. Chanos at the age of 27 had carved out a comfort-
able niche for himself on Wall Street, with a deep-pocketed backer in
Deutsche Bank and an impressive customer base who would channel
commissions to the rm’s trading desk.
Then in early September 1985 came a front-page story in the Wall
Street Journal that would change everything. It was a 6,000-plus word
front-page takedown of short sellers, featuring Chanos as one of the
few willing to be quoted by name. Written by reporter Dean Rothbart,
the article accused Chanos of being part of something he called “the
network”—a group of secretive short sellers who shared ideas about
which companies might be overpriced for whatever reason:
To their critics, Wall Street’s short sellers are worse than ambulance-
chasing lawyers. Not only do they seek prot from others’
misfortunes, but, the critics say, a new breed of activist short sellers
tries to help the bad news happen.
62 THE MOST DANGEROUS TRADE
Chanos didn’t help his case when he joked about his profession.
“People think I have two horns and spread syphilis,” he said.
One corporate chairman of a New York Stock Exchange–listed
company, who is not named in the article, described Chanos thus: “This
guy has caused us such grief. We can’t stand this guy.” Rothbart went
on to write, with no apparent chagrin, that the chairman’s company
was one of several that helped nance or aided a private investigation
of Chanos as a way to shut him down. The story quoted a detective,
describing what he found. “Chanos lives a nice, quiet yuppy existence,”
the gumshoe said.
Ironically, the article cited at least three maligned companies—
insurer First Executive Corp, real estate syndicator Integrated Resources,
and Coleco, that were targeted by Chanos or other short sellers. All
three companies later led for bankruptcy.
Deutsche Bank ocials were not amused. They immediately told
Chanos that his contract at Atlantic would not be renewed, but the bank
would pay him through the end of the year. Surprisingly, Chanos bears
Deutsche no animosity. “I understand from their perspective, they didn’t
really know what we did made a lot of money,” he says. “I think from
their perspective they said, ‘Look we have corporate business, we want
to stay on the right side of U.S. regulators—why do we need this?’”
Now he was jobless—the victim of a juicy newspaper hatchet job.
Yet he still had a loyal client base that was in need of a service he was
skilled at providing. Ross Hall, a Dallas-based fund of funds managed by
Bill Brown and Glen Vinson, was looking for a manager to run a short
portfolio for a wealthy family. Chanos’s reputation from Baldwin-United
drew Brown, but so did his gimlet-eye worldview. “He was a person you
had to prove your position to,” Brown says. “Everything was a hypoth-
esis. You might call that skeptical.”
Brown recalls Chanos taking a while to ponder the oer. “He’s a
cautious guy,” says Brown. “He wanted to think about it. It took him a
week or two.”
Chanos denitely didn’t want to get in over his head—and asked
to bring in his boss Levitas as a partner. “I said, ‘Look I don’t anything
about trading, I don’t know anything about back oce, I don’t know
anything about the guts of Wall Street,’” Chanos says. “‘Could I bring
Jim in as a partner?’ And they agreed.”
Chanos: Connoisseur of Chaos 63
Kynikos, named after the ancient school of Greek skeptics who
sought truth at the expense of status, popularity, or wealth, was born.
The initial capital was certainly skimpy enough, just $16 million—
$1 million from Chanos and Levitas and the rest from Ross Hall. The
initial oce was at 2 Rector Street, an elegant turn-of-the-century
skyscraper that had seen better days, standing in the shadow of the
towering World Trade Center and, appropriately, just around the corner
from the graveyard at Trinity Church.
Today, Kynikos’s ninth-oor oces are a bit more upscale, but not
by much. The rm’s name is spelled out with inexpensive-looking brass
letters. The entrance through the cramped vestibule is a glass-paneled
wood door that wouldn’t look out of place in a suburban dentist’s oce,
circa 1985. Perhaps the rm’s lean years have left a mark.
The mood darkens further when a visitor scans the rows of dog-eared
books lining Kynikos’s spacious but threadbare conference room—which
could have used a makeover a decade or so ago as well. The titles say it
all: On Risk and Disaster, TheDarkSideofValuation, Origins of the Crash,
House of Cards,andHow Markets Fail.
Chanos today is wearing a gray suit, white shirt, and blue-patterned
tie. He stretches out his lanky frame in a chair at the conference table as
he describes Kynikos’s early years and its evolving philosophy. Late 1985
was just about the midpoint of the 1980s bull market, and it might seem
a poor time to kick o a fund dedicated to short selling. What Chanos
learned early, however, was that there are dierent avors of short selling
opportunities—some not dependent at all on the direction of the overall
market, although of course it’s helpful to have wind at your back as a
bear in a collapsing equity market.
There are four kinds of short sale opportunities, Chanos says. First
are accounting frauds, like Baldwin-United, and later Enron and Tyco
International. Someone cooks the books or omits material informa-
tion. Then there are consumer fads—represented by the likes of Coleco’s
Cabbage Patch Kids. Consumers and investors get caught up in a new,
trendy product with limited staying power or, better still, restaurants or
food chains that ourish until people tire of, say, Krispy Kreme dough-
nuts. Third are broken industries, collapsing in the face of changing
technologies or new competing business models that render them obso-
lete, regardless of turnaround eorts or how cheap their share prices.
64 THE MOST DANGEROUS TRADE
Eastman Kodak is an example of this, as are a number of notable com-
puter companies.
Chanos’s favorite varietal is what he calls “booms that go bust.”
Think China today or the home mortgage originators in the run-up
to the 2007–2009 housing meltdown and subsequent nancial crisis.
“Booms that go bust,” emphasizes Chanos. “That’s the big one. And that
was our rst big success at Kynikos in 1985 and 1986 in Texas.” That
was after he paid $1 to buy out Levitas, who didn’t have the stomach for
short selling.
Chanos had gotten a taste of excesses growing in the real estate mar-
ket as far back as 1985 when he researched Integrated Resources, a real
estate syndicator nanced by Drexel Burnham Lambert underwritten
junk bonds. But Jim Grant, a Chanos friend and editor of the perenni-
ally bearish Grant’s Interest Rate Observer, put him in touch with Frederick
“Shad” Rowe, a Dallas short seller and author of a particularly lucid and
witty column for Forbes magazine.
The epicenter of the real estate bubble wasn’t New York, Florida,
or California, but Texas, coming as it did o the tail of the oil boom of
the late 1970s and early 1980s. The Tax Reform Act of 1986 basically
ended the tax shelter status of most real estate deals—spelling disaster for
the syndicators—but it took awhile to sink in.
Chanos remembers calling Rowe.
“Jim Grant wants me to give you a call on Texas real estate.”
“Chanos, you’ve got to come down here,” exclaimed Rowe, a
notably exuberant type. “This is insane.”
Chanos jumped on a plane and was soon touring Texas exurbs—the
kind of kick-the-tires investigation that can be just as important as pour-
ing over a company’s footnotes, balance sheets, and cash ow statements.
“It was on-the-ground research,” Chanos says. “Shad drove me
around for three days and we went around from building to building as
they were already being called ‘see-throughs.’”
Many of the shiny new buildings were open for business. There
might be a dozen cars in the parking lot, and Chanos and Rowe would
go into the building and see ve or six new businesses—most of them
appraisal companies, title insurers, syndicators, or other real estate-related
companies. “So it was all this self-fullling boom,” Chanos recalls.
Chanos: Connoisseur of Chaos 65
The popular wisdom at the time was that Japanese investors, ush
with U.S. dollars, would put them to work buying up the commercial
real estate. It was just a matter of time. Hadn’t they already purchased
trophies like Rockefeller Center in New York and the Pebble Beach
golf course in California?
The Texas banks had gotten very big, swollen with deposits. Credit
was phenomenally easy. Meanwhile, in what would play out some years
later, the saving and loans (S&Ls) had been deregulated under the Reagan
administration and were moving beyond issuing simple home mortgages
to investments in junk bonds, stocks, and commercial real estate. Some
sported trading desks that resembled those at Wall Street trading rms
like Salomon Brothers.
“It was our rst sort of thematic short, but based on fundamentals
in terms of looking at the companies that were either owners of the real
estate or lenders to the real estate, and realizing that the cash ows from
the buildings wasn’t supporting the debt being incurred,” says Chanos.
“So you end up with a sort of Ponzi nance of borrowing money to
service your interest. And inexorably, in those kinds of situations, the
equity usually gets wiped out.”
Up until now, though, Chanos had been an analyst, not a busi-
nessman. He had to learn the ropes not only of entrepreneurship,
but the details and pitfalls of locating stock to borrow, covering
positions, and pressing them or expanding his positions as stocks
careened downward. He started out focused on Texas, shorting real
estate developers like Southland Corp. and SouthMark Corp. in early
1986. From there, he expanded into banks like Texas Commerce
Bankshares and MCorp, and nally into dozens of S&Ls. Then Kynikos
expanded geographically into other parts of the country, includ-
ing Arizona, that were experiencing similar, if less spectacular, real
estate bubbles.
“Our timing was lucky,” says Chanos. “It was Shad. That didn’t have
to do with me. A smart guy happened to bring me down there to look
at this.”
The upshot was that even though the Standard & Poor’s (S&P)
500 was powering ahead through 1986 and into 1987, Chanos’s fund,
Ursus, posted dazzling returns in its infancy—33.4 percent in 1986 and
66 THE MOST DANGEROUS TRADE
23.7 percent in 1987, when the fund also beneted from the October
19 stock market meltdown, when the Dow Jones Industrial Average
tumbled a record 22.6 percent in a day.
Chanos was in Dallas the day after the crash riding an elevator to
the lobby with Jim Smith, a broker who worked closely with Kynikos.
“Whatever you do,” Chanos told Smith following the Dow Industrials’
508 point plunge, “Don’t let them see you smile.”
Part of Kynikos’s success may be due to the fact that the amount of
money invested in short strategies probably shrank during this period,
leaving the eld open for Chanos. Still, the S&P 500 powered ahead
in the years that followed—Kynikos and its Ursus fund still generated
positive returns, based on the spreading real estate collapse and the S&L
crisis. It posted gains of 13.5 percent in 1988, 30.6 percent in 1989, and
a sizzling 68.6 percent in 1990, a year when the S&P 500 lost more than
3 percent.
After Ross Hall’s exclusivity agreement lapsed in late 1987, big name
investors came knocking—among them, many of the hedge fund man-
agers who had read his research: Soros, Steinhardt, and Robertson, and
some years later, the storied Zi Brothers, whose combined wealth was
recently pegged at $14.3 billion by Forbes magazine. Assets ballooned
past $600 million.
In retrospect, though, Chanos was engaged in risky business. The
fund was leveraged, using borrowed money to amplify returns; some
positions approached 10 percent of assets—a serious situation if a target
was acquired or subject to a squeeze, in which bulls collude to drive a
stock up by snapping up shares and essentially forcing short sellers to
cover their positions or face outrageous, theoretically unlimited losses.
Kynikos was headed for a comeuppance.
Following the rst U.S.–Iraqi Gulf War of 1990–1991, the American
economy spring-boarded out of what turned out to be a mild recession,
triggered as it was by a brief spike in oil prices, which soon declined
after the United States–led coalition’s unexpectedly quick victory. When
the economy revved back to life, so too did the market for equities—
with a vengeance.
The S&P 500 soared 30.2 percent in 1991, followed by gains of
7.5 percent and 10 percent the following two years. Kynikos suered
consecutive losses of 31.8 percent, 16.5 percent, and a stunning
Chanos: Connoisseur of Chaos 67
44.5 percent in 1991, 1992, and 1993 respectively. The early part of the
decade still brings to mind memories of searing pain for Chanos, who
calls them “the dark ages.”
What insights and anecdotes can he share on the subject?
“Nothing,” Chanos chuckles. “As you will see from my numbers, it
was a very dicult time. One thing we did wrong was we were leveraged
from 1990 to 1994 and paid that price because the market just took o in
1991.” The NASDAQ Composite was up nearly 80 percent that year.
“From 1991 to 1993 there was just no place to hide . . . . Everything
went up.”
One particularly galling loss was against McDonnell-Douglas, the
military airplane maker, which was experiencing cost overruns on its
C-17 transport planes. Chanos bet against the company, only to lose
money when it posted a remarkable turnaround. It turned out later that
the Defense Department had improperly accelerated payments to the
company.
The drawdown on Kynikos’s assets, from a combination of market
losses and withdrawals, was brutal. They dropped from $660 million at
the end of 1990 to less than $175 million at the bottom of 1993. And the
worst of it was that the terms under which Chanos was managing those
millions prevented him from playing defense. “We had a mandate to be
short,” he says. When the stock screens on his computers turned green in
the morning—signifying a run up in shares—he was not even supposed
to cover his positions since he had been hired for the express purpose of
shorting stocks, almost always as a hedge for bigger investors, who were
invariably long to a far greater degree in their overall portfolios.
The year 1994 proved a watershed—giving the rm an opportunity
to regroup. With the U.S. central bank raising the Federal Funds Target
Rate six times, to 5.5 percent from 3 percent, the 10-year U.S. Treasury
bond lost more than 8 percent in 1994 and stocks were basically at,
eking out just a 1.3 percent gain. Ursus returned 44.5 percent. “We had
a monster year,” Chanos recalls. It was certainly a much-needed respite.
With losses mounting, he had been paying the Kynikos sta out of his
own pocket. Ursus was structured as a traditional hedge fund, charging
a 1 percent management fee and 20 percent of any prots. But that’s
clearly not a fee structure that can withstand an extended bull market.
“We said, ‘What did we do wrong here?’” Chanos remembers asking.
68 THE MOST DANGEROUS TRADE
“We’re surviving, but how are we going to prosper if the market just
goes up forever again?”
In 1995, Chanos began an overhaul at Kynikos. First was to dis-
pense with leverage. The rm would no longer borrow money to goose
returns. Secondly, the company would diversify its portfolio. Instead of
a maximum of 10 percent of assets in a position, Ursus would limit itself
to just 5 percent. That meant expanding the number of holdings from
30–40 to 50–60.
Lastly, and most importantly, Kynikos changed its fee structure.
Instead of the standard management fee and carried interest for its
managed accounts, the lion’s share of its business, Kynikos would earn
20 percent of the inverse of the S&P 500’s gain for a year. By way of
example, if the S&P 500 gained 30 percent and the Ursus fund lost 5
percent, it would be treated as a 25 percent gain, with the rm entitled
to 20 percent of that amount.
The fee structure helps account for Kynikos’s longevity, since it gives
the rm the chance to earn performance fees in extended bull markets.
Few, if any, other short sellers have adopted a similar fee structure, usu-
ally complaining about the complexity of accounting for the fee, which
must be calculated on a monthly basis. Chanos himself is mystied why
nobody has followed his lead. “I have no idea,” he says, shaking his head.
Fees aren’t the only thing setting Kynikos apart. Chanos runs the rm
in a fashion at odds with other asset managers. He jumps up again to a
white board to map out a diagram with stick gures, arrows, and light
bulbs. As at most asset management rms, everything ultimately comes
down to corporate culture. “That’s a lot of who we are,” Chanos says.
Most money management rms charge analysts with the role of gen-
erating investment ideas. Chanos calls that a bad proposition. “It has to
do with culture, I think, and human motivational behavior,” he says,
lapsing into one of his frequent philosophical musings. Typically, ana-
lysts research industry, economic, or corporate developments and pitch
a stock to a portfolio manager with the notion that buying or shorting
a stock will generate a prot. “The whole initiative is for these people
at the bottom, who are typically your younger and more inexperienced
people, of coming up with ideas and giving the ideas, sending them up,”
he says. Chanos points to a light bulb he’s drawn on the white board. “It’s
what I call intellectual ownership of an idea.” The analyst who generates
Chanos: Connoisseur of Chaos 69
the idea gets credit or blame for it, and is very much incentivized to
defend a position—even when new developments turn unfavorable or
run counter to his thesis.
The analyst is on the hook. “Well from then on, if anything happens
relating to that, everyone looks at you, right? You brought it in,” Chanos
says. “In that shop, you have intellectual ownership of the idea.”
Then he points to the stick gures at the top of his white-
board—representing him and his partners. “The problem is that the
economic ownership of the idea resides up here,” Chanos said. “In
eect, if things go well, everybody does well. But if things don’t go
well, guess who gets looked at and blamed? You’ve put the onus of
prot and loss and origination on the most junior members of the team.
But if it all works out, a disproportionate share of the economic gain
goes to the person at the top of the pyramid.”
“If things are good—ne,” he adds. “When things start going bad,
that’s a very unstable model.” Analysts get blamed, responsibility denied
and people red.
This is why turnover is so high at hedge funds; it’s also why they
fold so quickly when trouble hits, Chanos says. Moreover, it encourages
analysts to withhold important information that may run contrary to
their original thesis. “It’s creating a silo,” he says. “You don’t want to
give bad news.”
At Kynikos, the onus of developing investment ideas mostly rests
with the partners, of which today there are six. The three big idea
generators among the partners include Chanos himself, managing direc-
tor Charles Hobbs, and research director chief David Glaymon. Other
partners include Brian Nichols, who wears three hats as chief nancial,
compliance, and operating ocer, head trader Bob Veninata, and head
of stock loan Alan Best. A hedge fund with a partner totally devoted
to locating and borrowing stock? “Absolutely,” says Chanos. “It isn’t at
most rms, but it is at ours. Alan’s been on the Street since 1966 or 1967,
training most people in stock loan on the Street.”
The partners may get their ideas just about anywhere—tips from
other short sellers, economic reports, conferences, just an unreasonably
sharp rise in a stock price, a newspaper article, or perhaps even a cocktail
party conversation. They may spend a weekend reading through stacks of
10-K or other lings, do background research or ruminate. Then, if one
70 THE MOST DANGEROUS TRADE
of them thinks there’s merit to an investment thesis, the partner assigns
an analyst to do the grunt work—gather up sell-side research; interview
customers, rivals, and suppliers; attend industry conferences; scout out
company locations if necessary. The analyst will do web searches, map
out spreadsheets to compare the stock with those of its peers, and learn
the industry top to bottom.
An analyst has no idea where a protable insight might surface, but
he or she increases his or her chances by working overtime. All the infor-
mation is channeled to the partner who makes the ultimate decision of
how much capital, if any, to risk on a position.
The analyst’s job is designed as a sta position, not generally a
stepping stone to partner or a portfolio management slot—although
David Glaymon is an exception. “We’re up front with our analysts,”
says Chanos. “We do tell them that this is dierent than 99 percent of
most money management rms or hedge funds, where the model is the
guys at the top expect the guys at the bottom not only to work on the
ideas but come up with the ideas.”
There’s an added benet for analysts. “I will never yell at an ana-
lyst if a stock’s not working out,” says Chanos. “That’s my job, that’s my
responsibility. I will get mad at an analyst if I don’t get information. So it’s
a much truer sta model. And because all of the analysts are compensated
not on their stocks but on the protability of the rm, it generates lat-
eral information ow. Someone sees something, hears something—they
make sure the analyst covering it sees it and gets it to the partners.”
While the partners have relatively conventional backgrounds—
Deutsche Bank, Morgan Stanley, PaineWebber, and JPMorgan Chase—
the analysts come from a variety of disciplines. “Hiring analysts, the
thing we want to see most of is real intellectual curiosity,” he says.
“Assuming they have certain base quantitative skills, they know a little
bit about corporate balance sheets and accounting and have done
spreadsheets and things like that, but almost everybody we interview
has that level of capability. We want to see some evidence, whether in
written work or whatever, of the ability to ask questions and to follow
inquiry if they don’t know something or if something appears out of
whack. Almost everything else we can teach.”
Millett was a trader at the Chicago Board of Trade. Steve Schurr
wrote for the Financial Times. Lily Jong curated the Zi family art
Chanos: Connoisseur of Chaos 71
collection when the Kynikos oces were located at Zi Brothers Invest-
ments. She spent her lunch hours asking about the short-selling business,
Chanos recalls. “And she turned out to be one of my greatest analysts
ever,” he says. “She was an art history major from Columbia. But she
was just always asking the right questions and just had that sixth sense.”
Unusually, Chanos seems as eager to talk about his losing bets as his
winners. That may be that he is simply bored repeating such famed suc-
cessful shorts as Enron and Tyco International. It may be fear of lawsuits.
Or it may be because he, like many of us, has learned more from his
duds than his hits.
America Online is a case in point—especially as recounted by
Katherine Burton in her book Hedge Hunters (Bloomberg Press, 2007).
America Online, now known as AOL, posted sales of $1.1 billion in its
scal year ended June 1996, nearly tripling from $394.3 million the year
earlier. Research and development (R&D) costs and other expenses had
risen in tandem, but AOL under CEO Steve Case had simply decided
to lengthen the time over which it would expense those costs, giving
the impression of far faster-growing earnings than a true assessment
would suggest. (Around the same time, short seller David Rocker of
Rocker Partners LP was questioning issues pertaining to the pricey CD
ROMs AOL was mass mailing to prospective customers, which the
company, in like fashion, booked as capital expenditures, even though
logic would state they should have been treated as simple marketing
costs, again allowing the company to post inated earnings).
AOL continued to rise, gaining 20 points over a matter of months.
Chanos got persistent phone calls from one particular investor, a
well-known hedge fund manager, grilling him on the AOL position.
Why was it losing money? Merrill Lynch loved it. The business was
booming. Was Chanos sure he was correct?
The Kynikos short portfolio overall in 1997 was in positive terri-
tory and plenty of his other short positions were working out, including
Boston Chicken, Oxford Health, and Sunbeam. The hedge fund man-
ager persisted in badgering him about the AOL position, pointing to
sell-side research.
The calls were frequent and annoying, and when the investor
called on a Sunday night, the normally easygoing Chanos became irate.
The New York Times had just written an upbeat AOL story, the client
72 THE MOST DANGEROUS TRADE
said. “I just wanted to talk to you about it,” he pleaded. Chanos said if
he received one more phone call, he would return his client’s money.
Less than a week later the client called again. “I know what you said,
but we have to talk about America Online,” he said.
“No, we need to talk about getting you your money back,” Chanos
said, laughing. Being constantly interrogated about his investments was
not part of the Kynikos job description. He declines to identify the
investor on the record.
AOL was eventually forced to restate earnings because of its
accounting fraud, but managed to buy Time Warner with over
$100 billion of its own dubious stock in a deal announced in January
2000, just three months before the Internet-fueled market collapse.
To critics, CEO Steve Case may go down in history as an ethically
challenged executive—but he certainly made money for his AOL
shareholders by nding in Time Warner a buyer for his inated shares.
While AOL ultimately turned out to be a money loser for the
rm, Chanos and his colleagues are proud to have nailed it, albeit years
too early. AOL, later spun o from Time Warner, agreed to be bought
by Verizon Communications in 2015.
Undoubtedly, Kynikos is most famous for its short on Enron. For
those interested in the gripping details of the rise and collapse of the
Houston energy trading giant, with its cast of thieves and larger than life
miscreants, no better source exists than the rollicking tale as told by two
Fortune writers, Bethany McLean and Peter Elkind: The Smartest Guys
in the Room (Portfolio/Penguin, 2003). It should be required reading for
every M.B.A. candidate and every stock market investor. There’s also an
Oscar-nominated documentary based on the book.
Though doubts about Enron’s opaque accounting had surfaced in
the media as far back as the 1990s, it was an article by Jonathan Weil in
September 2000 that caught Chanos’s eye. Or rather, the article was for-
warded to Chanos because it appeared only in the Texas regional insert
of the Wall Street Journal. Weil, who had a juris doctor degree from
Southern Methodist University, certainly knew his way around a bal-
ance sheet. His article focused on the use of gain-on-sale accounting at
three Houston-based companies—El Paso Energy, Dynegy, and Enron.
All three companies had transitioned from hard asset energy
providers with pipelines and storage facilities, to nancial rms—traders
Chanos: Connoisseur of Chaos 73
of energy-based contracts and derivatives as well as a variety of other
instruments linked to commodities or interest rates. They were printing
money amidst the deregulation of the U.S. energy markets at the
time: A sharp spike in natural gas prices was goosing their reported
earnings and share prices. The stock of Enron, the biggest such trader
in America, had almost doubled year to date by the time Weil’s story
appeared and was trading at $84.875, or 60 times earnings.
The problem, Weil pointed out, was that all these companies used
gain-on-sale accounting when calculating their earnings. Enron and the
other companies were booking prots on electricity and other contracts
that could run for 20 years or more—requiring them to estimate prices
decades out. This was dicey. Further, all the companies declined to dis-
close their formulas or methodologies for producing those estimates. In
other words, they had a license to report whatever earnings they felt
like. “Our interest in Enron and other energy companies was piqued,”
Chanos told an SEC roundtable in May 2003. “In eect, ‘earnings’ could
be created out of thin air if management was willing to push the enve-
lope by using highly favorable assumptions.” (After a series of other jobs,
including one as Bloomberg News’ star columnist, Weil joined Kynikos
as a senior analyst in 2014).
It was time for serious nancial digging—and that began with 1999
10-K lings, released in early 2000. Enron’s return on capital was roughly
7 percent. That means that for every dollar invested, Enron was earn-
ing just seven cents. “Would you put your money in a hedge fund
earning a 7 percent return?” Millett asked Fortune’s McLean. Enron’s
traders, after all, as the book title proclaimed were, “the smartest guys in
the room.” Yet they couldn’t keep pace with the long-term average of
the S&P 500. The best estimate Kynikos could come up with was that
Enron’s cost of capital—that is, what it paid on a blended basis for its debt
and equity—was 9 percent. So, even including the dubious gain-on-sale
accounting, the rm was losing money in real terms.
Chanos also was wary of some vaguely dened “related party transac-
tions” described in the 10-K and then in the quarterly lings, or 10-Qs.
What were they? What was their purpose? “We could not decipher what
impact they had on Enron’s overall nancial condition,” Chanos told the
roundtable. “Enron had organized these entities for the apparent pur-
pose of trading with their parent company.” They were run by Andrew
74 THE MOST DANGEROUS TRADE
Fastow, Enron’s CFO. It turned out that they had some wonderfully
colorful names, to the delight of journalists, like Raptor, Talon, and
Timberwolf. Although it was not clear at the time, they were designed
to hide mark-to-market losses—and paid Fastow millions in the process.
It didn’t take long for Kynikos to act. “We began shorting Enron
common stock in November of 2000,” Chanos said.
Most of everything else that Chanos and his colleagues found only
added to their negative outlook—it was much like peeling an onion
gone bad, whose every layer revealed more rot and questionable activ-
ities. Chanos likes to say that when he builds an argument for a short
position, it’s not a criminal case, from the Kynikos outlook, but a civil
one. Chanos needed only a preponderance of evidence—he did not have
to prove his case beyond a reasonable doubt. But the scary, if circum-
stantial, evidence on Enron piled up. Corporate insiders were selling
shares—not a smoking gun because energy executives, obviously, need
to nance homes and yachts. But it was nevertheless suspicious.
More damning: Enron executives had in late 2000 been talking at
conferences about the great opportunities they foresaw in broadband,
that is data communications capacity, which it was building out at a rapid
pace—and claiming it already added $20 to $30 to the value of Enron
stock, a gure it would later boost to $40. The company had acquired
a small ber optic network in the purchase of utility Portland General
in 1996.
The Internet bubble had long since collapsed, however, and Kynikos
was already investigating short positions on telecommunications compa-
nies based on the titanic oversupply of such Internet-dependent broad-
band capacity. Management was either lying or totally out of touch with
the telecommunications market. (CEO Jerey Skilling was, perhaps, a
technophobe and refused to use the Internet or e-mail).
In late January, the company declared at an analyst conference in
Houston that its shares, which had begun the year trading at $85 share,
should be trading at $126—a bizarre assertion to make from the very
parties that stand to benet from making such a claim.
In February, the New York Times ran a story concerning the Cal-
ifornia energy crisis—a shortage of electricity that many attributed to
the deregulation of the electricity prices. The article pointed out that
Enron had invoked a clause in its contract with consumers that allowed
Chanos: Connoisseur of Chaos 75
it to back out of its middleman position between the buyers and power
providers, many of whom at that point were bankrupt. “Enron’s credibil-
ity in the entire energy retail business began to crumble simply because
the company refused to recognize sure losses in California,” Chanos told
a congressional committee in February 2002.
At the time, Chanos held an annual February “Bears in Hibernation”
conference in Florida with a varied group of hedge funds managers. He
laid out his suspicions about Enron. Apparently, many of the participants
agreed because the short interest on Enron soon rose sharply.
In early March 2001, Fortune published a short article by McLean
simply questioning Enron’s high stock price, which had tumbled to
$59. People were still calling it the “Goldman Sachs of energy trad-
ing,” the piece pointed out, but its shares were trading at a multiple of
55 times trailing earnings, more than three times those of the storied
investment bank.
Moreover, Enron simply wouldn’t disclose how it made its money
because, according to CEO Skilling, the company viewed that infor-
mation as a competitive advantage—something it did not want to share
with rivals. Chanos and Kynikos were big sources for the Fortune story,
but remained anonymous at the time. Again, there was no major reac-
tion to Enron’s share price by investors, nor apparently by Fortune itself,
which itself named Enron a “digitizing superstar” a few weeks later.
(Chairman Ken Lay later reportedly had to be painstakingly airbrushed
out of a group photo, which also included Time Warner’s Levin, of “The
Smartest People We Know,” an article that was a November 2001 cover
story). But investor uneasiness grew.
By the summer of 2001, natural gas and electricity prices began to
tumble. As Chanos noted to the SEC and in subsequent congressional
testimony, almost all trading rms claim to be suciently hedged in
such situations to protect earnings. They seldom are. “Trading opera-
tions always seem to do better in bull markets and to struggle in bear
markets,” he said. Enron’s stock was down to $44.
The company’s 2001 second quarter 10-Q, released in August, also
fueled rumors that Enron’s falling shares could trigger a cash squeeze
because some of the terms of the o-balance-sheet partnerships refer-
enced the stock price. Most devastating however, was the unexpected
resignation of CEO Skilling, the most vocal of those obsessed with the
76 THE MOST DANGEROUS TRADE
company’s share price. He cited “personal reasons.” Shares tumbled from
$46 to $35 that month. “Because we viewed Skilling as the architect of
the present Enron, his abrupt departure was the most ominous devel-
opment yet,” Chanos said. Kynikos increased its short position further,
although it has not disclosed by how much.
And just in time too. On October 16, Enron reported an unexpected
loss of $618 million. Shares inexplicably rose slightly. But the next day
Wall Street Journal reporters Rebecca Smith and John Emshwiller, who
had spent months developing sources and parsing through leaked and
public documents, published the rst of a devastating series, detailing
the fraudulent accounting of the Raptor and other partnerships and the
litany of Enron misstatements to both the SEC and the public.
Although plenty of other details would surface in the months
and, indeed, years ahead, the series denitely pushed Enron over the
precipice. The stock went into free-fall, hitting $13 by the end of the
month. The company led for bankruptcy on December 2. In May
2006, Skilling was convicted of multiple counts, including securities
fraud, insider trading, conspiracy and making false statements to an
auditor. He is serving time in Montgomery Federal Prison Camp in
Alabama and is scheduled for release in 2019.
As for Ken Lay, he was also convicted of 10 counts of securities fraud
or related charges—but died of a heart attack that year. A judge vacated
the convictions.
Enron’s auditor, Arthur Andersen, was found guilty of criminal
charges involving its auditing of Enron. The verdict was later over-
turned, but the former “big ve” accounting rm surrendered its
licenses to practice. Its employee count is down from a high of 85,000
worldwide to just 200.
Chanos, a fan of ironic twists, relishes a delicious denouement. As
Enron careened toward bankruptcy, a copycat company named Dynegy
oered to buy it. Incredulous investors asked whether it had properly
scrutinized Enron’s nancials. Dynegy responded that it had—and that
it was reassured because both rms used identical accounting method-
ologies. Chanos promptly proceeded to short Dynegy, which irted with
bankruptcy in 2002. Chanos says Kynikos made as much money on Dyn-
egy as it had on Enron. Dynegy eventually did le for bankruptcy in 2012
reemerging the same year.
Chanos: Connoisseur of Chaos 77
Kynikos missed out on the proverbial inverse “10-bagger” with
American International Group Inc., or AIG—a short position that
Chanos hasn’t talked about much. As the expert behind Baldwin-
United, Chanos personally was the point man and took responsibility
for the position. The famed insurance giant, founded in Shanghai’s
bund in 1919 by Cornelius Vander Starr, had over the decades expanded
into a global behemoth with its ngers in virtually every corner of
the insurance industry—property & casualty, life, reinsurance and even
beyond, into elds like aircraft leasing.
Its CEO, the famously aggressive Maurice “Hank” Greenberg,
pushed his people relentlessly hard, built obscure lines of business, and
forged new ones. With dozens of interconnected subsidiaries—National
Fire Insurance Company of Pittsburgh, SunAmerica, America General
Life, Lexington Insurance, aircraft lessor International Lease Finance,
even the ski resort of Stowe, Vermont—most analysts threw up their
hands. It wasn’t a company but a vast feudal nancial empire—and
because one of its holdings included a tiny S&L, it was overseen not by a
major regulator but the tiny Oce of Thrift Supervision. “Regulatory
arbitrage,” it was called.
Chanos thought he was up for the challenge and looked closely at
the rm’s nancial services division, expending enormous energy and
man hours trying to gure it out.
Chanos got close. One thing he knew was that AIG was big on
what is known as nite reinsurance—that’s when an insurer transfers the
risk of a policy, typically over a certain amount it’s on the hook for,
to another insurer or third party as part of a deal. The counterparty
then receives the ongoing premiums and pays the policy o if necessary.
There’s often a payment made to the company that assumes the policy, or
vice versa.
In one such nite reinsurance deal, AIG under Greenberg sold the
risk to Berkshire Hathaway’s General Re subsidiary, which paid it a
$500 million premium that AIG used to bulk up its loss reserves, bolster-
ing earnings. (Several General Re executives, including its CEO, were
convicted of what was deemed to be a fraudulent transaction. The case
was overturned in 2011.) Under pressure from then–New York State
Attorney General Eliot Spitzer, the AIG board forced Greenberg to
resign in 2005.
78 THE MOST DANGEROUS TRADE
Ultimately the rm, in Chanos’s estimation, just stank. “There was
a culture there of aggressiveness,” he says. Chanos turned his attention
to what was in eect nite earnings reinsurance to high-tech companies
during the turn-of-the-century technology bubble. “They had a unit
that sold reinsurance that was in eect coverage to high-tech companies
who needed to meet earnings forecasts,” he says.
Even today, Chanos admits it was an ingenious scam. AIG
would cede, for example, $500 million of an insurance policy to
a high-technology company. The tech company would collect the
premiums and pay any claims. But most importantly, AIG paid the
technology rm, say, a $25 million ceding commission. That would
usually nd its way into the technology company’s earnings statement
under “other income” but was not generally disclosed otherwise.
Mirabile dictu: The tech company would hit its target earnings. The
terms, however, were ultimately extremely advantageous to AIG.
“That was the rst sign that there was a culture here of these guys
selling a product that just doesn’t pass the smell test. And by the way, [it]
was probably wildly protable for them,” Chanos says. “And that’s what
got us going on AIG.”
Chanos and his colleagues also made a valiant eort to untangle
the AIG Financial Products unit that famously sold some $62 billion of
credit default swaps—insurance protection—on toxic collateralized debt
obligations, sales that ultimately blew up, leading to AIG’s government
takeover. But Kynikos gave up well before that. “It was a black box,” he
says, referring to AIG Financial Products. “And the nancial disclosures
weren’t great.”
“We were short it before the crisis because of accounting issues, and
we knew something was wrong in nancial services, but I could not
prove it,” he says. “I could not get a smoking gun and we ended up
covering too early. Looking for certainty is a fool’s errand. You’re never
going to get it. You can get some really great ideas that get you closer
to 100 percent certainty, but you’re never going to get to 100 percent
certainty.”
After the company disclosed that it received subpoenas from the
SEC and then Attorney General Eliot Spitzer in February 2005, shares
plunged more than 10 percent. The board red Greenberg in March
2005, and the stock continued to decline, hitting $63 in March, but
Chanos: Connoisseur of Chaos 79
then more or less moved sideways for more than a year under Greenberg’s
replacement, Martin Sullivan.
Kynikos covered its short position in late 2006 and early 2007 as
what he felt were more promising nancial services stocks began to show
signs of stress. Kynikos made a small prot on the position but nowhere
near what he could have had he maintained or pressed his AIG position.
As part of the $182.3 billion bailout, the government took over 79.9
percent of the stock in the September 2008 deal, reducing the value of
the remaining position by nearly 80 percent in a single swoop. In this
case, Chanos decided to move on too soon.
There were plenty of other opportunities—banks, loan originators,
homebuilders, and Freddie Mac and Fannie Mae among them. Chanos
spread his bets. Not surprisingly, the Ursus fund cleaned up in 2007
and 2008, generating returns of 26.4 percent and a sizzling 60.2 per-
cent, respectively. Remember, those were years in which the S&P 500
returned just 5 percent and lost 37 percent, respectively, and Kynikos
was getting paid on the dierence. The long-short Kynikos Oppor-
tunity, with a more traditional fee structure, gained 13.4 percent and
15.9 percent, respectively, those years. For most shorts, it was like shoot-
ing sh in a barrel.
Chanos, like his rivals, was prevented from initiating new short posi-
tions on nancial stocks due to a short-term September 19, 2008, ban
by the SEC on such bets, made in collaboration with the U.K. Financial
Services Authority. The U.S. ban ended on October 2, and a 2012 report
by the New York Federal Reserve Bank conrmed what most every-
body knew—that it was totally ineective in stopping or even slowing
the decline of nancial stocks. The ban did have the eect of lowering
liquidity and driving up trading costs, the report concluded.
The rebound from the nancial crisis, beginning in March 2009,
proved more challenging for Kynikos, and Ursus lost 30.5 percent
that year, though the long-short Kynikos Opportunity fund gained
15.1 percent.
It certainly made sense to focus on accounting frauds rather than
asset bubbles in a market quickly regaining its footing in the aftermath
of the Great Recesssion. The Federal Reserve, after all, was buying back
hundreds of billions of Treasury and mortgage bonds in its bid to keep
interest rates low—the policy of quantitative easing that had some short
80 THE MOST DANGEROUS TRADE
sellers gnashing their teeth. Treasuries were yielding close to zero, vir-
tually forcing investors into the stock market. Wagering against dubious
accounting seemed a wise course in this era of nancial repression.
Even with world stock markets battered, Kynikos came across a veri-
table gem of a fraud—one that ultimately led Chanos to a second greater
short against one of the legends of the U.S. technology industry. The rst
dubious target was Autonomy Corp, an English software rm spun out
from its parent, Cambridge Neurodynamics, a ngerprint recognition
rm, in 1996. Autonomy listed its shares on NASDAQ two years later
and made its founders rich, as shares soared more than tenfold in the
technology bubble.
Autonomy by 2009 had a compelling business tale for investors, spe-
cializing in pulling vast amounts of data from myriad sources—databases,
e-mails, text or audio les, websites—and then repurposing what it
culled into usable and marketable information and services: market ana-
lytics, search engine optimization and even video surveillance. The space
is called e-Discovery. Yet, underneath the brilliant code writing, Auton-
omy was, according to Kynikos, a classic serial acquirer of tech companies
or “roll-up”—and was using accounting trickery to snooker investors.
Chanos has a special place in his heart for roll-ups—and it is nei-
ther warm nor cuddly. The purpose of such acquisitions is often, as he
explained to his students in New Haven, to obscure poor underlying
fundamentals in a core business. Often purchases are accompanied by
restructuring charges and write-os, which investors are encouraged to
ignore. Serial acquirers encourage investors to look at earnings without
anyofthebadstu.
And Autonomy, under its shiny-headed, smooth talking CEO,
Michael Lynch, was an exemplar of the process. The rm acquired
at least eight businesses from its inception until 2011—including its
former parent. The idea was to take over the targets’ customer bases and
integrate their products into Autonomy’s agship product, the IDOL
search engine. The evidence of misleading accounting in this case gave
Chanos enormous condence. “It was our biggest position in Europe
in 2011,” he says.
Chanos is also quick to point out that neither he nor his principal in
London, Glaymon, were the rst to take aim at Autonomy. “We weren’t
Chanos: Connoisseur of Chaos 81
the only ones,” he says. Paul Morland, an analyst at brokerage Peel Hunt,
wrote six research reports beginning in 2008 that on several occasions
brought up accounting maneuvers, all of which had the eect of over-
stating performance, according to newspaper reports.
For this Morland was banned from Autonomy analyst calls, and
employees were forbidden to speak to him. Two other brokerage
analysts, were also deemed personae non gratae—Daud Khan of
J.P.Morgan Cazenove and Roger Phillips at Merchant Equity Partners.
So some in the City were wise to Autonomy, but the rm generated
sucient fees from its purchases to cause most to look the other way.
Similarly, industry technology analysts who questioned Autonomy’s
IDOL search engine were blacklisted, too. IDOL, Lynch claimed, had
near-magical powers due to its harnessing of Bayesian analysis, a sta-
tistical approach pioneered by the 18th century English mathematician
Thomas Bayes that updates statistical probabilities as new information is
introduced.
While noting that customers were far less enthusiastic about IDOL
than the company was, Kynikos got short Autonomy in early 2009,
mostly focusing on a laundry list of accounting and disclosure issues.
“There were lots of issues,” says Chanos, pausing for eect. “I mean lots
of them.”
Autonomy claimed a 40 percent market share of the e-Discovery
market—an industry space that included such heavyweights as Microsoft,
EMC, and IBM. Likewise, claims of 20 percent revenue growth were far
greater than those of rivals. In an opaque and early-stage industry, it was
easy to make such assertions, but hard to believe or eectively disprove.
Autonomy’s nancial disclosure was abysmal, failing to provide stan-
dard metrics like maintenance revenue or details of its myriad acquisi-
tions, which were typically of small private companies. And always in
cash, since that meant the target would not engage in due diligence.
Much of what it did disclose was made verbally in conference calls, not
regulatory ling—license revenues, cash collections, subsidiary revenue
contributions.
Nevertheless, what Autonomy did claim was indeed outstanding:
margins of 44 percent in scal 2009. Those compare to just 36 percent
for both Google and Oracle in the same period. By its own admission it
82 THE MOST DANGEROUS TRADE
was generating returns of just 14 percent on its net business assets. That’s
compared to about 48 percent for Google and 23 percent for Oracle.
One area of Kynikos’s focus was deferred revenue growth—that is,
the gain in sales and services that have been booked but not yet paid for
because they have yet to be delivered. It’s a key metric for software rms,
especially when looked at as a percentage to realized revenues, because
it signies the company’s growth trajectory—the higher the percentage,
the better. Kynikos noted that whenever deferred revenue growth dipped
below 70 percent of that of recognized revenue, Autonomy would make
another purchase and the percentage would, not surprisingly, shoot up.
Most of Autonomy’s purchases were of smaller private companies
or divisions of companies like CA or Iron Mountain, without exten-
sive published nancial data to check on its claims. Chanos didn’t trust
the accounting of two private companies Autonomy acquired, Meridio
and Zantaz, in 2007. He counted $111 million more in goodwill and
intangibles than there should have been as a result of the purchases.
This allowed Autonomy to keep costs of its income statements low,
inating earnings.
Kynikos got more clarity on this maneuver in early 2009, when
Autonomy spent $775 million to buy Interwoven, a publicly-traded U.S.
company, with detailed nancials that he could verify. In this case good-
will and intangibles were overstated by a whopping $195 million. At this
point it was clear that Autonomy would have to continue to buy bigger
companies to boost its deferred revenue growth or nd some other way
to cover up the weakness of its underlying business.
Chanos initiated his short at 1,253 pence a share, but the share price
quickly rose, hitting 1,500 in early 2010. In June 2011, Autonomy paid
$350 million for Iron Mountain’s digital archiving business, and shares
hit 1,788 pence. Chanos’s pain was severe.
But Lynch was about to make things much, much worse. “The only
thing you can do in this kind of roll up is a) either sell yourself or
b) change the strategy and hope the street doesn’t notice,” says Chanos.
“That’s what Tyco tried to do and of course blew up.”
Enter Hewlett-Packard, the oundering American computer maker,
under the stewardship of it new CEO, SAP veteran Leo Apotheker,
intent on decisively shifting the storied computer maker away from hard-
ware into software. Stunning the technology industry, in August 2011
Chanos: Connoisseur of Chaos 83
he purchased Autonomy for a whopping $11.7 billion, a 64 percent pre-
mium over its market value at the time, in a deal that translated to 2,550
pence a share.
There was little Chanos could do except try and alert Hewlett-
Packard’s seemingly somnolent board of directors. “I even sent our
write-ups to friends I had who I know had friends on the Hewlett
board,” Chanos says. Quoting some of his missives: “I don’t get it,
I don’t understand it—what are you people looking at that I’m not? At
the same time we’re saying are you kidding me? This is a disaster. Why
are you doing this? Have you looked at the numbers here?”
The deal closed anyway. “That was one of our biggest losers in
our global portfolio in 2011,” Chanos says, losing nearly 2 percentage
points of performance. Thirteen months later, Hewlett-Packard took
an $8.8 billion impairment charge to cover accounting irregularities it
found at Autonomy and Apotheker was sent packing, replaced by former
eBay chairman Meg Whitman. It issued a statement: “HP now believes
Autonomy was substantially overvalued at the time of its acquisition due
to the misstatement of Autonomy’s nancial performance, including its
revenue, core growth rate, and gross margins, and the misrepresentation
of its business mix.”
Three investigations were launched, respectively, by the U.S. Justice
Department, the SEC and the U.K.’s Serious Fraud Oce. Lynch said in
a website interview: “HP is looking for scapegoats and I’m afraid I’m not
going to be one of those.” Chanos indulged in a bit of schadenfreude,
e-mailing memos to the street: “I said, ‘By the way, you could have seen
this beforehand.’”
The U.K. Serious Fraud Oce dropped its investigation of Auton-
omy’s alleged accounting fraud in January 2015, saying, “there is insuf-
cient evidence for a realistic prospect of conviction.” Hewlett-Packard
continues to pursue its own case against Lynch.
Ironically, it was Autonomy that put Chanos on course to a major
payday. “We were already at that point, in mid-2011, beginning to get
concerned about Hewlett because of their inkjet business,” Chanos says.
Sales were declining and margins squeezed in the division. Kynikos had
already been short printer maker Lexmark. More critically, Kynikos was
worrying about a nascent global shift away from the personal computer
(PC) altogether. “It was becoming apparent to me and some of the other
84 THE MOST DANGEROUS TRADE
people in the rm that the PC was on its way out, that in fact, the
unending growth in PCs and notebooks was going to end because of
the advent of mobile and smart phones and the cloud,” he says. “We
began doing a lot of work on the PC space directly.”
The Autonomy purchase prompted an even more thorough, top to
bottom reassessment of Hewlett-Packard. “Basically, I think, ‘If they are
dumb enough to buy Autonomy, what else have they been doing?’”
says Chanos.
Indeed, Hewlett-Packard had been through three CEOs in ve
years. Its board of directors included executives who had presided
over high-prole failures, including Ken Thompson of Wachovia and
Patricia Russo of Alcatel-Lucent.
Most important, was the analysis of the company’s acquisitions.
It started with the 2002 purchase of Compaq Computer Corp for
$24.2 billion, which required a $1.7 billion write down, after massive
layos and declining earnings. That led to the board of directors’
ouster of CEO Carly Fiorina, who was soon replaced by Mark Hurd.
Under Hurd, Hewlett-Packard bought Electronic Data Systems for
$13.9 billion in 2008, which required an $8 billion writedown. The
company’s $1.8 billion purchase of smartphone maker Palm Inc and its
WebOS operating system in 2010 resulted in a $1.7 billion write down
and impairment, with the operating system soon abandoned.
Hurd was widely acclaimed for his turnaround eorts—but he was
forced to resign after being accused of inappropriate sexual advances by
a woman he had hired. Apotheker was drafted to take his place, with
only a cursory search by the board.
While others lauded the Hewlett-Packard turnaround, Chanos did
not see it. “We looked at Hewlett and realized, my God, these peo-
ple have been acquiring all their R&D through the years,” Chanos says.
“They spent almost nothing on R&D, 2 percent, unlike IBM and Sam-
sung, who spend 6 percent. And the dierence they make up by buying
companies. Well, they have not bought good companies, and they have
not integrated these companies.”
Bulls pointed to Hewlett-Packard’s low price to earnings (P-E)
multiple of just 5.2 times forecast 2012 earnings, declaring it a bargain.
Chanos instead called it “the ultimate value trap” and pointed out that
focusing on P-E ratios ignored the company’s deteriorating balance
Chanos: Connoisseur of Chaos 85
sheet, with debt to total capital increasing from just 6 percent to
40 percent since 2006 and tangible equity tumbling to a negative
$6.3 billion. “Hewlett-Packard has essentially devolved into a tech
roll-up whose constantly changing management team has wrecked the
balance-sheet in pursuit of growth,” was how one Kynikos research
report summed it up.
Hewlett-Packard’s shares fell from $29.51 at the time of the Auton-
omy acquisition to a low of less than $12 in late 2012. Kynikos cov-
ered some of its position at that point, but was still short shares as of
April 2013, as he wrapped up his class at Yale. The rm was still short
Hewlett-Packard in early 2015 even after the company’s announcement
of plans to split in two, with one business focused on corporations and
the other on PCs and printers.
At 56 Hillhouse, afternoon light is ltering into the lecture hall.
Chanos continues pacing back and forth, detailing frauds of an earlier
era—he refers to John Kenneth Galbraith’s concept of “the bezzle,”
the frauds that build up in ush economic times only to be discovered
when markets collapse, much like Bernard Mado ’s Ponzi-like enter-
prise, which unraveled only amidst the 2008–2009 nancial collapse.
“What was the bezzle in 1719 Paris?” he asks the class.
“The French national debt?” a student responds.
“The French national debt and … what was the scheme to reduce
the French national debt?” he asks. “An equity-for-debt swap, right?”
France in 1715 was groaning under the debt incurred during the
War of the Spanish Succession. Enter Scottish nancier John Law, who
soon became a trusted nancial advisor to the French government under
King Louis XV. Law created a company that became known as La Com-
pagnie des Indes, acquiring the trade and development rights along the
French-ruled Mississippi river. Through Law’s connections, the com-
pany soon gained the right to collect taxes rst in French North America
and then around the world.
Then Law launched a plan to swap French sovereign bonds for shares
in the La Compagnie de Indes.
“How did he persuade people to do that?” Chanos asks. “He inated
the prospects, to be generous to Mr. Law. The rivers of gold, the moun-
tains of silver. Fields studded with emeralds. Friendly Indians. Soil that
would grow anything.”
86 THE MOST DANGEROUS TRADE
Law oered shares in his company at 500 livres in January 1719,
the French currency at the time, and they hit 10,000 by the end of
the year. Peasants became phenomenally wealthy—until some of some
of them actually began taking their prots. Company shares soon col-
lapsed, the peasants were peasants again, and France entered a sustained
economic depression.
Chanos goes on to briey describe the Great South Sea Bubble and
the land grant scandals that corrupted the construction of the United
States’ transcontinental railroads, via Crédit Mobilier. He also touches
on the legendary Charles Ponzi, who claimed to be buying discounted
postal reply coupons and redeeming them at face value in the United
States And there were the nancial manipulations of Ivar Krueger, the
Swedish “Match King,” who used a variety of tools, including the very
rst B shares, with lower voting rights and phony subsidiaries as part of
his scheme, which collapsed in the Great Depression. Kreuger commit-
ted suicide in Paris, under mysterious circumstances, in 1932.
“Consistent stories, dierent stories, dierent technologies, but still
the suspension of disbelief leading to disreputable people actually crossing
the line and deceiving people,” Chanos says.
Nothing, in other words, is to be taken at face value, in a changing
world. That’s a recipe for chaos.
Chapter 4
Einhorn: Contrarian
at the Gates
T
he crowd at the Marriott Marquis Hotel was on tenterhooks as
David Einhorn stepped up to the podium.
It was the Value Investing Congress, and the president of
Greenlight Capital had set o reworks at the same conference three
years earlier, in 2007, using his accounting insights to dissect dubious
risk management practices at Lehman Brothers, among other rms. That
ended spectacularly badly for the storied investment bank—less than a
year later it led for chapter 11, ushering in the 2008–2009 nancial
crisis and great recession that followed. Einhorn soon ascended to a sort
of demigod status on Wall Street.
Now, as the clock ticked toward noon on a cool October morn-
ing in 2010, the thin, boyish-looking Einhorn was set to unveil a new
target—one that could mean millions in prots for the audience gath-
ered in the soulless, burgundy-draped conference hall. The BlackBerrys
were out as Einhorn, then 41, cleared his throat.
87
88 THE MOST DANGEROUS TRADE
First came perfunctory disclaimers, and a round of thanks for his
analysts’ hard work. Einhorn, dressed in a dark suit, white shirt and
patterned tie, added that the company he was about to talk about had
declined to meet with him. The slide on the screen behind him read
ominously: “Field of Schemes.” Attendees were almost giddy with antic-
ipation. Why shouldn’t they be? They had front row seats to a Wall Street
beheading.
“The topic of today is the St. Joe Company,” Einhorn began, in his
distinctive high-pitched tone. “The ticker is ‘JOE’ and the stock trades
at about 24 and a half dollars a share.”
In a ash, the audience was clicking away on their smart phones—
and St. Joe shares, already down by double digits that year, went into
free fall. Einhorn, who had built a hefty short position in the stock, then
launched into a damning exposé.
St. Joe’s tale was one of ambition gone awry. Once a sleepy
lumber company owning tracts of Florida acreage, St. Joe was recast
into a high-octane real estate developer under a former Walt Disney
executive named Peter Rummell, whose previous credits included
the entertainment giant’s starchitect-studded planned community,
Celebration, Florida (population: 7,427). Now St. Joe was aggressively
building towns—though without the Disney cachet, and largely in
Florida’s downmarket Panhandle—the so-called Redneck Riviera. The
two most prominent were Port St. Joe and WindMark.
Rummell was now out of the picture, having retired two years
earlier, and Einhorn couldn’t resist poking fun at him. He ashed a
quote by the former CEO on the screen behind him from a 2007
St. Joe’s earnings call: “This stretch of beach will be branded a national
destination with the same kind of recognition as Nantucket, Hilton
Head Island, or Napa.”
Then, after posting lush, green photographs of Napa vineyards and
the white sands of Hilton Head and the shingled cottages and vibrant
blue surf of Nantucket, Einhorn clicked to the decrepit main streets
of St. Joe and WindMark. There was an abandoned movie theater,
vacant oce space, and “For Sale” signs interspersed among forlorn
and spindly palm trees—an almost derelict vision. “This is Port St. Joe
and WindMark,” he chuckled. “We visited it and took some recent
Einhorn: Contrarian at the Gates 89
pictures.” The audience found the sorry depictions hilarious, exploding
with laughter.
It was a great opener. Einhorn’s homespun Midwestern disposi-
tion belies polished speaking skills. But it’s really his contrarianism—the
enthusiasm with which he goes against the accepted wisdom—that grabs
investors’ attention. The audience knew that his skill at parsing nan-
cial statements and accounting trickery—notable in that Einhorn never
earned an MBA—had paid o time and again. He now launched into
a full bore attack on St. Joe, displaying the kind of analytical repower
that so often turns target companies into Wall Street roadkill.
Einhorn’s rst point was really an obvious one, apparent to any-
one ipping through recent company annual reports: While St. Joe’s sale
of vacant land had generated $724 million in prots over the previous
10 years, the company had lost $99 million building residential commu-
nities during that time. Simply put: Development was a money-loser.
Things were going from bad to worse. In 2008 and 2009, in the
midst of the nancial crisis, ballooning losses in the real estate business
had swamped the parent company, resulting in overall pre-tax losses for
St. Joe of $61 million and $205 million. The enterprise as a whole was
also a shrinking asset. The sale of the cheap land had reduced total St. Joe
acreage to 577,000 from 1,086,780 ten years earlier.
Powerful forces were aligned against Greenlight, as they are against
virtually every short seller. In this case, a respected value manager, Bruce
Berkowitz of the $10 billion Fairholme Fund had sunk a whopping
amount of money into the company, building a 29 percent stake in
St. Joe. Bulls had put a positive spin on the story. There was a sparkling
new airport not far from Port St. Joe, Northwest Florida Beaches
International. A New York conglomerate, Leucadia National, had
purchased the old local airport in downtown Panama City with an eye
toward developing the land. The price: some $57 million, or $80,000
for each of the old airport’s 708 acres. St. Joe bulls argued that the
35,000 acres it owned around the new airport should enjoy an only
slightly lower valuation, conservatively $60,000 an acre, or a total of
$2.1 billion.
That gure was roughly equivalent to St. Joe’s entire market capital-
ization. So by this rather simplistic sum-of-the-parts calculus an investor
90 THE MOST DANGEROUS TRADE
was getting the rest of St. Joe and its vast acreage, properties and planned
communities, for free. What wasn’t to like in this stock?
The key dierence, Einhorn dryly noted, was that the old airport
was smack in the middle of a bustling metropolis (Panama City had a
population of 143,000)—not vacant scrubland like the new one. St. Joe
itself had donated 4,000 acres to get the Northwest Florida airport built.
Now, that same land deeded to the new airport was competing with
St. Joe for commercial tenants: The Airport Authority was able to issue
tax-free bonds to developers, giving it an advantage St. Joe couldn’t hope
to match. Indeed, the value of St. Joe’s acreage was, if not worthless,
close to it.
As his presentation gathered steam, Einhorn shot eeting smiles to
the audience—clearly enjoying himself. As an experienced high school
debater, Einhorn knew rsthand that the best speakers always seem con-
dent, aable. And he certainly did that afternoon. There was a lot of
ground to cover and Einhorn labored to keep everyone amused, pep-
pering his speech with tweaks at the company’s marketing, mixing in a
cartoon slide or two into the presentation, particularly with a sardonic
eye for accounting matters.
There was better to come. Maintaining a measured pace, Einhorn
zeroed in on the meatiest portion of his argument—backing it up
with the meticulously detailed analysis, illustrated with photographs
and embellished with on-the-ground reporting by Greenlight’s team of
eld analysts. Though Einhorn didn’t mention the word fraud,hecast
a skeptical eye on the company’s rose-colored accounting, especially its
balance sheet.
The big issue for St. Joe was the lack of impairments, or markdowns
on its properties. The year was 2010. Yet even after the greatest real
estate collapse since the Great Depression, the company pretended as if
the bust simply hadn’t happened.
Exhibit A lay south of Jacksonville, in a landlocked St. Joe project
called RiverTown. Here, just 215 of the planned 4,500 planned units had
been developed, and of these, just 30 had been sold—less than 1 percent
of the expected grand total. St. Joe had estimated it would cost $81,111
to develop the average lot. Yet, by August 2010, they were selling for a
paltry $31,250, a theoretical loss of nearly $50,000 each.
Put another way, by the time Einhorn was giving his speech, the
county RiverTown was located in had nearly nine years of housing
Einhorn: Contrarian at the Gates 91
inventory to work o, even without any new construction. Yet, St. Joe
carried RiverTown residential lots on its balance sheet for $74.5 mil-
lion or the equivalent of $400,000 per developed lot. In fact, the 185
remaining developed lots could plausibly be worth no more than their
going price of $31,250, or a total of $6 million. “We believe there should
be an impairment,” Einhorn declared—a refrain he would repeat again
and again.
Then there was a development called SummerCamp Beach, where
St. Joe was carrying $41.8 million of residential real estate on its balance
sheet. Einhorn valued it at $14.9 million. “There’s nothing going on at
thesite,”hesaid.
Finally, at WindMark, St. Joe had marked the residential portion of
the development at $164.5 million. Einhorn pegged it at $17.8 million.
“This is a ghost town,” he said, clicking on a slide of an empty beach
club and vacant retail space.
The upshot was simple: St. Joe’s economics were disastrous—and
there was no way out. “It costs more to turn raw land into a nished
lot than the lot is worth,” Einhorn said. “Joe needs to take substan-
tial impairments and once you take that into account the returns are
quite negative.”
By Einhorn’s calculations, the company’s remaining 577,000 in rural
acreage was worth $650 to $950 million, or $7 to $10 a share, with
some additional value in 41,000 other acres that St. Joe had prepped
for development. The irony was that St. Joe’s then relatively high share
price would preclude it from nding a buyer. “Joe is stuck, “Einhorn
said. “It can’t build, it can’t sell and it can’t generate the value to cover
its operating costs.”
As Einhorn thanked his audience, one attendee stood up to gleefully
announce that the stock had already fallen more than $5. Shares closed
that day at $20.03, down more than 10 percent. By November they were
trading at $17. The company hired Morgan Stanley to nd a buyer, but as
Einhorn had predicted, the investment bank was unable to rustle one up.
St. Joe would prove to be no pushover. Soon, shareholder Berkowitz
was scrambling to rescue his investment, rst joining the St. Joe board,
only to about-face, resign, and campaign to oust his former fellow
directors—including the CEO. Berkowitz then took a formal role
as non-executive chairman at the company. He lured a new CEO,
and St. Joe slashed expenses 15 percent, curtailed new investments,
92 THE MOST DANGEROUS TRADE
and drafted a plan to draw retirees to its properties. Fairholme even
released its own video seeking to burnish St. Joe’s image.
What Berkowitz couldn’t do was x the dubious accounting.
Einhorn’s assessment on St. Joe’s bookkeeping was spot on. In January
2011, the U.S. Securities & Exchange Commission (SEC) opened a
probe into St. Joe’s impairments. And six months later the SEC began
a formal investigation that included Berkowitz. The stock hit a low
of $12 a share in November 2011. That calendar year, the company
racked up a loss of $330 million—this time including pretax noncash
impairment charges of $377.3 million—the same type of markdowns
Einhorn described as lacking. Shareholders sued St. Joe for fraud, based
on Einhorn’s analysis; the U.S. Court of Appeals for the 11th circuit
in Atlanta threw out the case in February 2013, since Greenlight’s
presentation was based on information that was already public.
Einhorn’s St. Joe campaign is emblematic of the deep dive research
that most hedge funds use to justify steep fees but seldom produce. “He
is ‘ready, aim, re’ kind of investor, not a ‘shoot, aim, ready’ investor,”
says Marc Cohodes, the former managing partner of Copper River Part-
ners, a now-defunct short-selling rm. “He is smart, he is ethical, he is
hardworking, he is driven. There’s no one else like him.”
The campaign is also a classic example of Einhorn’s investment
process—one that has catapulted him to rock star status. Character-
istically, his forensic work is meticulously and transparently sourced,
based on public documents. These could be from the tax assessor’s
oce or St. Joe’s own SEC lings. Greenlight eld analysts spent weeks
fanning out across Florida, building the case. It sometimes takes years of
gathering evidence before Einhorn will act on an investment. He and
his colleagues drew on Freedom of Information Act requests, Airport
Authority Board meeting minutes, myriad county appraisers’ oces,
and the ne print of municipal bond oering prospectuses. They pored
over county residential surveys and specic property deeds. Greenlight,
in its fourth quarter 2014 letter to shareholders, called the St. Joe Co.
the fund’s longest standing material investment. The stock traded at
under $16 a share in early 2015.
The most ringing endorsement for Greenlight’s process is the fund’s
own track record. Since its founding in 1996, the fund has returned more
than 19 percent annualized versus 9 percent for the S&P 500 Index.
Einhorn: Contrarian at the Gates 93
Over that span, Berkshire Hathaway’s Warren Buett, to whom some
acolytes compare Einhorn, has generated a return of just 12 percent at
his giant conglomerate.
Along the way, Greenlight assets, including borrowed money, have
ballooned to $12.3 billion by early 2015—and would have surged
higher had it not been for Einhorn’s policy of shutting Greenlight
to cash inows when he feels he cannot protably put cash to work.
These days, Einhorn’s takedowns are front-page material, earning him
a prominent place in the short-selling canon with bets against such
onetime stock market darlings as Allied Capital Corp., Green Mountain
Coee Roasters, Chipotle Mexican Grill, and most famously, Lehman
Brothers Holdings. In May 2012, his questions about marketing
expenses on a conference call for Herbalife, the nutritional supplement
retailer later targeted by rival short seller and activist William Ackman,
sent the shares plummeting 5 percent.
Despite this killer reputation, Einhorn has said he doesn’t like
being called a short seller. Indeed, Greenlight’s bullish bets have been
vastly more protable than his shorts. Telling, these include wagers
on the kinds of technology and computer–related stocks many classic
value investors tend to steer clear of, among them Seagate Technology,
Microsoft, Xerox, and Apple. It’s a distinction that places Einhorn in
a class by himself—and undermines the reexive accusations by critics
that shorts bet against stocks only for nefarious purposes. Greenlight
always has more money riding on Einhorn’s bullish bets than his bearish
ones. The hedge fund term for rms like Greenlight is long-short.
Even during the nancial collapse that began in 2008, Greenlight
maintained a net long position, though the fund escaped with a loss
only in the high teens for the year, compared to a 37 percent fall in the
S&P 500.
Nobody hits 1,000, especially in the world of investments, yet even
some of Einhorn’s failures burnish his reputation. In 2006, Einhorn
pushed successfully to win a seat on mortgage lender New Century
Financial’s board. Greenlight had been an early investor in New Century,
largely because of its status as a low-cost mortgage originator—it made
the loans to dicey borrowers and sold them o quickly. But the com-
pany had changed course and began packing its own portfolio with the
garbage loans it had made. Einhorn joined the board hoping to get the
94 THE MOST DANGEROUS TRADE
company to reverse course. After the fund manager left, New Century
later led for bankruptcy, yet Einhorn won praise for his role.
Not immune to the siren call of professional sports franchises, like
such hedge fund managers as John Henry, Mark Cuban, and David
Tepper, Einhorn in 2011 tried to buy a stake in the Mets baseball
team. The proposed deal was a gobsmacker: He would reportedly pay
$200 million for a one-third stake in the franchise with an option to
purchase a majority position over the next few years. If the owners
wanted to block him, they had to pay him back the $200 million but let
him keep his minority ownership. Greedy? Perhaps. But boosters give
this as an example of his tenacious negotiating skills.
Critics poured cold water on his public attempt in 2012 to push
Apple, Greenlight’s biggest holding at the time, into issuing a series of
preferred stock as a way to return the mountains of cash it was accumulat-
ing, mostly overseas. The proposed new-fangled shares—which Einhorn
waggishly dubbed iPrefs—would yield 4 percent. Warren Buett him-
self doused the idea, saying if he were Apple CEO Tim Cook he would
ignore Einhorn. But the iPhone juggernaut did ultimately agree to hike
its dividend and start a $60 billion share buy-back plan. Apple shares
surged, and the Cupertino, California juggernaut has since added to the
buy-back program.
Nor does it hurt Einhorn’s reputation that he is rumored by some
to have been Buett’s rst choice to help manage Berkshire Hathaway’s
stock picking—a role that was ultimately accorded to former hedge fund
managers Todd Combs and Ted Weschler. (Like Weschler, Einhorn won
a dinner with Buett in a charity auction to benet San Francisco’s
Glide Foundation). It probably helps that Einhorn’s rst cousin reigns
as Silicon Valley royalty—Facebook’s billionaire chief operating ocer
Sheryl Sandberg, author of the acclaimed book Lean In: Women, Work
and the Will to Lead (Alfred A. Knopf, 2013) about her experience as a
woman executive.
Einhorn peppers his investor letters with self-deprecating wisecracks,
and they’ve become lore in their own right, embellished with quotes
ranging from the empiricist philosopher Daniel C. Dennett to Seattle
Mariners’ centerelder Ken Griey Jr. to Lou Jiwei, chairman of the
China Investment Corp., the sovereign wealth fund. Like Buett, he’s
not afraid to be a bit corny. In early 2013, he acknowledged his soured
Einhorn: Contrarian at the Gates 95
bets against Green Mountain Coee Roasters his unsuccessful campaign
for the iPrefs. “Our coee was too hot, our apple bruised,” he wrote.
His fans—and Einhorn collects them up and down Wall Street—
describe him as a throwback to an earlier era. Most weekday morn-
ings, he boards the Metro North commuter train in Westchester County,
New York, for the 40-minute ride to Grand Central Station in Manhat-
tan. Navigating the Beaux Art terminal’s marble passageways, Einhorn
dashes across Lexington Avenue, and rides the elevator to a 24th-oor
vestibule where indirect lighting casts an otherworldly, greenish glow.
Why the name Greenlight? Einhorn wouldn’t start his own hedge
fund unless his wife, former Barron’s columnist Cheryl Strauss Einhorn,
gave her approval—or a “green light” to the new venture. “When you
leave a good job to go o on your own and don’t expect to make money
for a while, you name the rm whatever your wife says you should,”
Einhorn would later write.
Certainly, Einhorn makes an unassuming master of the universe. He
drives a Honda Odyssey minivan, plays fantasy baseball with his brother
Daniel, and generally manages to make it home for dinner each night
with his wife and three children. The Einhorns have no Hamptons sum-
mer house. He has a reputation for working strange hours; generally he
wakes up at 2:00 a.m. or so to answer e-mails and read. He supplements
with a nap in the afternoon at the oce.
On a rain-soaked morning in March 2013, Einhorn strides into
Greenlight’s oce. After pausing to adjust his tie, inadvertently looped
around the outside of his collar, he plops his wiry six-foot-one-inch
frame into a high-backed leather chair in one of Greenlight’s wood-
paneled conference rooms—each one jauntily named for a common
bookkeeping device used to dupe investors. There is the Gain on Sale
Room, a reference to a legal but dicey accounting maneuver to boost
sales; the Non-Recurring Room, a bow to common gambit to hide
losses by declaring them one-time events, and the Penny Room, a wink
at those companies that miraculously beat analysts’ earnings per share
estimates, if only by a single cent.
Einhorn, like Buett, is careful in his media interactions. An inter-
view with this author, for example, was not permitted to be taped.
Though he doesn’t talk about it, Einhorn has reasons to be wary,
as many short sellers do. Simply being pegged as a short seller can
96 THE MOST DANGEROUS TRADE
restrict an investor’s access to company management. And the press can
be unfriendly. the Wall Street Journal, in a 2002 opinion piece, called
his rst public short campaign, against Allied Capital, a “mugging.”
the New York Times described his criticisms of companies as “rabble
rousing.” And commentators widely berated him for his negative views
of Lehman Brothers’ accounting on the onset of a market downturn,
likening it more or less to shouting re in a theater.
There was also the kerfue surrounding a February 2010 Journal
story about a so-called “idea-sharing” dinner attended by Einhorn, and
assorted hedge fund representatives, including Soros Fund Management,
SAC Capital Advisors, and others. One topic: the likelihood that the
euro would weaken amidst the collapsing Greek economy. After the
story was published, the Justice Department launched an investigation
into some of the funds’ trading. Why Wall Street investors discussing the
markets would be suspicious is unclear.
Nevertheless, in Einhorn’s letter to Greenlight investors that April
he went nuclear, railing against the Journal’s “Yellow Journalism,” say-
ing the paper’s article suggested the discussion might have led to market
manipulation. He called the reporting “shameful.” The Journal stood by
its story.
One instance of bad “press” was self-inicted—whether a result of
pushing the regulatory envelope or ignorance of foreign legal norms.
Punch Taverns PLC in 2008 owned and leased out some 8,000 pubs.
In addition to a United Kingdom–wide ban on smoking in such water-
ing holes, the nancial crisis and cheap supermarket suds combined to
punish the shares. The big question was whether the leveraged com-
pany would be forced to issue new stock to shore up its balance sheet.
“It appears the stock is under pressure because the market misunderstands
PUB’s debt structure,” Einhorn wrote in his third quarter 2008 investor
letter. Punch suspended its dividend to save cash and Greenlight used
the opportunity to snap up shares at an average price of 2.83 pounds, or
just four times estimated 2008 earnings, at one point building up to a
13.3 percent stake in the company.
In June 2009, Einhorn agreed to talk by phone with Punch man-
agement and one of its bankers—under the proviso that no nonpublic
material inside information be disclosed. The pertinent term is “cross
the wall” in nancial-speak. By crossing the wall, an investor would be
Einhorn: Contrarian at the Gates 97
given privileged insight, but couldn’t trade shares until after the news
was disclosed. Einhorn absolutely wouldn’t agree to that.
Still, a transcript of the call shows that he hadn’t expected Punch’s
response to its tenuous predicament. Management, including its CEO,
indicated it was considering a plan to issue equity within a week or so
to retire debt. That meant Greenlight’s position stood to be potentially
diluted. “That would be shockingly horrifying from my perspective,”
Einhorn said on the call. He had specically asked not to be “wall
crossed,” and conrmed that no denitive decision had been made on
the matter. Within minutes of the conversation, Greenlight began sell-
ing shares, ultimately shedding 11.65 million of them over four days.
When the deal was announced, Punch stock fell 29.9 percent. Green-
light avoided 5.8 million pounds in losses.
In February 2012, the U.K. Financial Services Authority ned
Greenlight 3.7 million pounds for “market abuse.” It said that Einhorn
was not aware that what he had been told was inside information. “The
market abuse was not deliberate or reckless,” it said in its statement.
It’s strange language. In a public conference call, Einhorn railed against
the decision. “This matter resembles insider dealing about as much as
soccer resembles football,” he quipped, clearly furious.
Einhorn is succinct in answering questions. How does Einhorn
decide which of his investments he’ll talk about publicly?
“It’s if we think we have insight that will aect the discussion about
the security,” Einhorn responds curtly, making it clear earning money
on his public shorts is not a subject he cares to dwell on.
Can he talk about its benecial eects of short selling on the stock
market? “I’m not going to answer that question,” Einhorn says. “I’ll
leave it to others to make that argument.”
Einhorn avoids speaking about specic numbers, dates, and examples
when discussing stocks and investments, long or short. He has a phil-
anthropic bent, having donated his own proceeds of one shortselling
campaign against Allied Capital to a pediatric cancer charity. He often
states that he speaks publicly about fraud and deception not to make
money, but because it is “the right thing to do.”
He told Wor th magazine: “I do think there is a social value in identi-
fying companies that are doing bad things and betting against them. I’ve
seen the demise of a fair number of these companies and it’s not because
98 THE MOST DANGEROUS TRADE
we bet against them, it’s because these were awed companies. And our
country, our markets, our economy are better when companies that are
awed or cheating are replaced by better ones.”
What is undeniable is that unlike hundreds of rms that claim
unique insights into the market, under Einhorn’s leadership Greenlight
has developed a stock market discipline that sets it apart—not just from
other rms that short but also from the entire tribe of value-oriented
money managers and anybody else who trades in stocks for a living.
In its eerily quiet 24th-oor aerie, some three dozen Greenlight pro-
fessionals hone a unique craft. All value investors by denition are on the
hunt for inexpensive stocks. As Einhorn puts it: “They run screens look-
ing for things that are cheap, say less than 13 times earnings, or under 6
times cash ow. Then they say, ‘Go see if there’s anything there’.” The
process understandably can lead to a herd-like mentality.
Some short sellers, though not all, argue this type of screening
arguably works better for long investments since short-selling dynamics,
particularly the risks and costs of borrowing shares, encourage an
investor to cover and move on if overpriced shares don’t fall soon after
he or she takes a position. That’s one big reason some make a case
against a company publicly—it helps to get the message out and the
stock falling. It’s also why they talk to journalists, often on condition
that what they say not be attributed to them.
Greenlight trawls for stocks in a dierent fashion. “We tend to ip
that process around,” Einhorn explains. The rm’s dozen or so analysts
begin by developing a thesis about why a particular security is likely to
be trading at a price that does not reect its true worth—“intrinsic val-
ue” in the lexicon of investing pioneers Benjamin Graham and David
Dodd—on either the upside or downside. “We ask why is it that this
stock may be mispriced?” says Einhorn. The answer might be rapidly
evolving competition or industry fundamentals that Wall Street has failed
to appreciate. There may be company-specic characteristics, regula-
tory changes, or accounting problems that aren’t grasped by rivals. The
market may totally ub advantages, or disadvantages, of a company’s
business model.
“We think there are dynamics that lead to mispricing,” Einhorn says.
“We develop a theory as to why [a security] is mispriced, misunderstood.
When we nd a big enough dierence between what the market sees
and what we see, then we may have an investible insight.”
Einhorn: Contrarian at the Gates 99
The process works for either bullish or bearish ideas. Einhorn and
his analysts seek to nd out whether a particular insight they stumble
upon is widespread in the market. They query industry captains, cus-
tomers, rival companies, analysts, suppliers, and even other investors for
their opinions.
Einhorn uses his pulpit as a bullish one too. In 2010, for example, he
used an investment conference to argue that Apple displayed the charac-
teristics of a mispriced security, too—but the stock in this case was cheap,
in part given the mountain of cash on its balance sheet that seemed to get
ignored. More important, short investors at the time took the position
that shares of rival hardware makers like Hewlett-Packard and Nokia
were trading at well under three times book value and less than annual
sales. Apple stock was trading at more than ve times book value and
nearly four times sales.
For Einhorn, the comparison was, well, apples and oranges. Apple’s
distinct, crash-resistant operating system, smooth graphics, and unique
features like the Siri voice interface for its iPhone gave it superior charac-
teristics to pedestrian hardware makers like Hewlett-Packard or Nokia.
“It’s a software company—that makes margins higher, and revenues are
more recurring,” Einhorn explains in his oce. “We thought it was
misunderstood.” By the fourth quarter of 2012 it was Greenlight’s largest
holding, amounting to nearly 10 percent of fund assets.
Greenlight is dierent in more prosaic fashions, too. The portfolio is
concentrated, with the top ten holdings sometimes amounting to more
than half of net assets. The benets of diversication in reducing volatility
drop o sharply after the number of stocks in a portfolio surpasses eight
stocks, according to academic studies. With just 20 or so securities—long
and short—to focus on, the Greenlight analyst team can dive deeper.
Accordingly, Einhorn is especially attuned to risk. His fund will on occa-
sion buy put options, which give it the right to sell a stock at a particular
price before a certain date. That, in some situations, may give him the
opportunity to limit losses if he’s wrong or establish a short position
inexpensively.
There are subtler distinctions. Though hedge fund managers don’t
talk about it much publicly, most stock pickers in the industry, for
lack of a better term, are really long-only managers in drag. That is,
they are focused on buying stocks they think will rise and hedging
those positions, typically by shorting index futures or industry-specic
100 THE MOST DANGEROUS TRADE
exchange traded funds, like energy or technology, thus reducing the
portfolio’s overall volatility. Some are pairs traders, buying PepsiCo and
shorting Coca-Cola. In a bull market, of course, the portfolio’s short
positions on ETFs, on indexes, or on a pairs trade are an anchor, pulling
down performance.
All this can arguably be viewed as disingenuous. Hedge funds, since
the rst one was started by former Fortune editor Alfred Winslow Jones
in 1949, have typically charged 1 or 2 percent management fee and
20 percent of prots schedule by virtue of their mastery of long-short
investing. By contrast, a pedestrian mutual fund charges, say, 1 percent
of assets under management as a fee. Vanguard Group often charges
expenses of 10 basis points, or hundredths of a percentage point, or less.
So the short positions assumed by hedge funds are oftentimes simply a
way to charge higher fees.
Some hedge fund managers simply opt to outsource a chunk of their
portfolios to dedicated short sellers like Jim Chanos of Kynikos Asso-
ciates or a dwindling number of others. Though most won’t conrm
it publicly, these managers have at times included hedge fund stars like
Leon Cooperman of Omega Advisors and even Soros Fund Manage-
ment, whose founder George Soros famously made more than a billion
dollars—and history—shorting the British pound in 1992. Give them
this: Such managers who farm out their short investments understand
the distinct skills necessary to run such a portfolio.
Greenlight, sui generis, thinks dierently. Einhorn’s aim is to turn a
prot on each of the fund’s short positions, not mitigate market down-
drafts. “We do not short to hedge,” Einhorn emphasizes in his writing.
“If we are uncomfortable with the risk in a position, we simply reduce
or eliminate it.” Einhorn and his analysts constantly probe and reassess
positions in Greenlight’s portfolio, revisiting numbers and keeping on
top of a company’s rivals, suppliers, and customers—the legwork of good
investigative analysis.
The rm pays attention to investors on the other side of its trades—
those that are long the same stocks Greenlight is short and vice versa.
“We’re constantly asking. ‘Are we right?’” Einhorn says. “‘Do they think
what we think they think?’”
Greenlight is looking to ensure its analysis is at odds with that of its
rivals. There is logic to that somewhat counterintuitive insight. After all,
Einhorn: Contrarian at the Gates 101
if most investors agree with Greenlight on fundamentals and therefore
a stock’s prospects, what kind of edge can Einhorn hope to have in the
market? Not much.
There is no monopoly on truth in the stock market. Greenlight is
open to rival arguments and sometimes swayed. In 2003, Einhorn was
short Goodyear Tire & Rubber Co.—a classic rustbelt behemoth with
a unionized workforce facing mounting competition from subsidized,
lower-cost rivals overseas. The company hemorrhaged $767 million that
year, its third of annual losses. The company’s total stock market capital-
ization, the value of all its shares, had deated to less than $1.4 billion
versus $9.9 billion ve years earlier. It had all the hallmarks of roadkill.
Some insightful investors, however, saw upside—or more speci-
cally, the possibility that the storied American industrial hulk could nd
some way to rebound. Sifting through SEC lings, Greenlight analysts
saw that distressed debt wizard David Tepper’s Appaloosa Management
LP had built up a substantial position in the tire company, betting on
a turnaround that Greenlight saw no evidence of. It was confounding.
The question was, “Why?” Einhorn picked up the phone.
The Greenlight founder says he doesn’t recall details of the
conversation—and does not seem eager to share what he does. Tepper,
who describes his memory as “near photographic,” says the conversation
quickly turned to what in Wall Street–speak is sometimes called the
“optionality” imbedded in Goodyear’s stock.
Optionality is a common sense notion that works like this: Given
Goodyear’s formidable capital structure, there was plenty of money to
burn through—any bankruptcy would be in the distant future, giving
management a good shot at a successful restructuring or other opportu-
nity to turn the business around. There were factories to shutter, acqui-
sitions to make, even a possible sale. The Akron, Ohio-based industrial
icon had $1.5 billion in cash on its balance sheet and an enterprise
value of $5.7 billion. That kind of capital gave it a lot of time—and
resources—to work through its problems.
Tepper, in an interview, says he thought it wouldn’t take all that
much to do so. “Basically we thought the stock had a lot of operating
leverage and nancial leverage,” he says. “We looked at the size of the
capital structure. They had a lot of runway. There were a lot of things
that could go right.” Einhorn, for his part, says that while he recalls
102 THE MOST DANGEROUS TRADE
not being entirely convinced, Tepper’s arguments were sucient to seed
doubts in his mind. Greenlight soon covered the short position.
It was certainly the right move. Goodyear slashed capital expendi-
tures in 2003 and suspended its dividend, among other things. Shares
went on to rally, generating a fourfold return for investors from the start
of 2003 through 2007. “We change our minds frequently,” Einhorn says.
Tepper chuckles: “I’m sure he pays more attention to optionality.”
When bets do go wrong, Einhorn owns up, often highlighting them
in his letters to investors. In 2008, Greenlight went long on Nyrstar NV,
a Belgian zinc smelting company cobbled together from some cast-o
business operations of Australian miner Zinifex and Umicore, a Belgian
materials company—a carve-out in Wall Street parlance.
Greenlight’s thesis was that fresh management would turn the com-
pany around quickly. “We thought this zinc-smelting carve out’s new
CEO would create a path to stable earnings, “ Einhorn wrote in January
2010. “He didn’t deliver and the stock cratered.” Greenlight got in at
17.46 euros and sold at 7.03 euros. Einhorn doesn’t sugarcoat his errors.
He nevertheless looked on the bright side. “The good news is we didn’t
sell when the stock fell to 1 euro,” Einhorn wrote.
Publicizing such blunders does more than just inform those who
have entrusted their capital to Greenlight. It helps Einhorn avoid sim-
ilar errors in the future. “When something does go wrong, I like to
think about the bad decisions and learn from them so that hopefully
I don’t repeat the same mistakes,” he says. Characteristically he dead-
pans, with a self-deprecating tone that investors and Wall Street fans have
come to love: “That leaves me plenty of room to make fresh mistakes
going forward.”
That self-critical disposition—and willingness to change—prompted
Einhorn to a wholesale reassessment of his approach to investing after
the 2008–2009 nancial crisis. Until then, Greenlight was a strictly
bottom-up, fundamental value investment rm, albeit working both
long and short books. The focus was on a portfolio company’s balance
sheet and earnings prospects, as well as its strengths and weaknesses rel-
ative to competitors. The overall economy, interest rates, and currency
swings were of less concern—if Einhorn worried about them at all.
Like a lot of value investors of the period he was bitten—and
badly, too. An early holding was MDC Holdings, a large homebuilder
Einhorn: Contrarian at the Gates 103
based in Denver with major operations in fast-growing markets such
as Colorado, northern Florida, Las Vegas, Tucson, Salt Lake City, and
Southern California. Greenlight had begun purchasing MDC shares the
second day after the fund opened at under $6 a share and had ridden
them as housing prices rst rose, and then soared—especially in the
white-hot markets MDC operated in.
The company’s fundamentals were bullish. Unlike many rivals,
MDC had a relatively strong balance sheet, with a debt-to-equity ratio
of just 45 percent in 2005. And its business model provided it with a
competitive advantage: the company owned far less land than rivals.
It typically would not build without a rm order in hand, reducing
risk and giving it operating exibility. MDC management, under CEO
Larry Mizel, was ranked top notch and owned more than a quarter of
the company’s shares to boot.
Greenlight hung on over the years: By mid-2005, MDC shares
traded at around $70, and Einhorn gave a speech at that year’s Ira Sohn
Investment Research Conference lauding the company’s prospects.
His speech followed one by Stanley Druckenmiller, the founder of
Duquesne Capital Management and former portfolio manager for Soros
Fund Management’s Quantum Fund. Druckenmiller’s success—in
contrast to Einhorn’s—derived from prescient bets on macroeconomic
factors on world interest rates dictated by such economic factors and
GDP growth, ination, trade balances and political change—things
that drive currencies, government bonds and, yes, home building. All
big-picture stu. As a so-called macro investor, Druckenmiller used his
speech to warn about housing.
Druckenmiller’s insights fell on at least one pair of deaf ears—
Einhorn’s. “I ignored Stan, rationalizing that even if he were right,
there was no way to know when he would be right,” he said years later.
“The lesson that I have learned is that it isn’t reasonable to be agnostic
about the big picture.”
MDC nished 2008 at under $29 a share, contributing to Green-
light’s agship fund’s double digit loss for the year, the only calendar
year the fund nished in the red. The S&P 500 lost 37 percent. “Having
my eyes open to the big picture doesn’t mean abandoning stock picking,
but does mean managing the long-short exposure ratio more actively,
worrying about what may be brewing in certain industries, and when
104 THE MOST DANGEROUS TRADE
appropriate, buying some just-in-case insurance for foreseeable macro
risks even if they are hard to time.”
From there, Einhorn recalibrated, focusing on the Federal Reserve,
and how its then-Chair, Ben Bernanke, was managing the nancial cri-
sis and its aftermath. It was hard not to, given the sharply increased
correlation in the stock market. By late 2011, nearly all of a stock sector’s
price movement was due to the overall direction of the S&P 500. Many
market players say it made less of a dierence what stocks or industries an
investor chose to invest in than it normally would have since the prices
were largely determined by the direction of the stock market overall,
which itself was unnaturally dependent on the Federal Reserves’ easy
money policies—“nancial repression” to its critics.
In this environment, experts say, stock-picking skills were of rela-
tively less utility. High quality or poor, it was not a stock’s fundamentals
that determined its price but investor perception of the Federal Reserve’s
next bout of quantitative easing—its policy of buying back massive
amounts of bonds to keep interest rates low and credit flowing.
In addition to punishing xed-income pensioners, whose income
were tied to the near-zero interest rates on bonds in their retirement
portfolios, Bernanke’s policies eectively sidelined some veteran stock
pickers—and mowed down dedicated short sellers wholesale. The only
pertinent investment decision was whether to be in the market or not,
depending on the consensus opinion of the central bank’s actions—“risk
on” or “risk o” in industry argot.
Einhorn reached back to his days as a government major at Cornell
to help craft generally scathing assessments of the policies of Bernanke
and former Treasury Secretary Timothy Geithner. He likened big banks
to out-of-control teenagers who had partied wildly while their parental
regulators were away. The banks, he declared, should have been left to
pay for the mess they helped fuel. “The ATMs could have continued
working, even with forced debt-to-equity conversions that would not
have required any public funds,” he said in 2009. “Instead, our leaders
responded by handing over hundreds of billions of taxpayer dollars to
protect the speculative investments of bank shareholders and creditors.”
While continuing to invest in undervalued stocks, Einhorn steered
Greenlight into a series of macro bets, informed by the gaping decits
that the central bank’s policies were fostering. With the dollar at risk,
Einhorn: Contrarian at the Gates 105
by 2011 Greenlight held the second largest position in the SPDR
Gold Trust. “Gold does well when monetary and scal policies are
poor and does poorly when they appear sensible,” he said in late 2009,
adding that holds true whether the result is inationary or deationary.
“Holding gold is better than holding cash, especially now where both
earn no yield.”
Einhorn bought long-dated call options on much higher U.S. and
Japanese interest rates, giving him the right to prot if rates rose. By
doing so, he pointed out, Greenlight limited the possible loss to what he
shelled out to purchase the options. Shorting the underlying debt would
have exposed him to the possibilities of steep losses.
This new direction dovetailed with Einhorn’s enhanced prole as
a pundit on global macroeconomic policy and regulation. In January
2009 he co-authored an op-ed piece in the New York Times with
acclaimed author Michael Lewis. “Incredibly, intelligent people the
world over remain willing to lend us money and even listen to our advice;
they appear not to have realized the full extent of our madness,” the
op-ed said.
Soon Einhorn was developing a following among what might be
called the “macroscenti”—at least those at war with Bernenke’s quanti-
tative easing. In May 2012, he penned a takedown of Bernanke’s quan-
titative easing policy, then in its fourth year, for the Hungton Post,
when GDP was growing at a sluggish 2.1 percent annualized. It read:
A Jelly Donut is a yummy mid-afternoon energy boost.
Two Jelly Donuts are an indulgent breakfast.
Three Jelly Donuts may induce a tummy ache.
Six Jelly Donuts—that’s an eating disorder.
Twelve Jelly Donuts is fraternity pledge hazing.
The piece went viral. Wary investors—stung by the stock market
losses of the 2000–2002 technology meltdown and then again during
the 2008–2009 nancial crisis—in fact resisted stocks until the nancial
repression of low interest rates made it too painful to resist. They began
snapping up equities, arguably setting them up for the next downward
leg of the cycle.
106 THE MOST DANGEROUS TRADE
That kind of criticism has put Einhorn in an unlikely alliance with
some of the Austrian school acolytes (they’ve been dubbed “austerians”
in some circles) on the subject of Federal Reserve policy. “They
do not understand or relate to the prime component of capitalism
and a free market: Greed,” Einhorn wrote, referring to the Federal
Reserve. “And because they do not understand greed, they also do
not understand fear, which presents a double whammy for making bad
policy decisions.”
Six months later he reiterated his conclusion at a conference spon-
sored by the Economist magazine. “We would be way better o if we did
pretty much the opposite of the current monetary policy,” he said. Nobel
Prize–winning economist Paul Krugman, who argued that Bernanke
should have done far more to stimulate the economy, coined a term for
those opposed to the Fed’s policies—“sadomonetarists.” Name-calling
aside, it’s fair to say that Einhorn won’t be on any short list for Trea-
sury Secretary or Fed governor under any administration soon. But it
does contribute to the enigma of David Michael Einhorn, a man whose
DNA seemed baked through with matters of markets, balance sheets,
monetary policy, and business from childhood.
Einhorn was born in 1968, spending the rst seven years of a com-
fortable youth in Demarest, New Jersey, a prosperous suburb ten miles
from Manhattan. His father, Stephen, helped negotiate the sale of the
family business, Adelphi Paints and, enjoying the back and forth of the
process, decided to try his hand as an independent investment banker,
working out of a spare room.
To escape the nancial pressures of metropolitan New York, the
family set out for Wisconsin, where his mother Nancy had grown up.
Together, with his brother, the Einhorn family, settled into Fox Point
(2010 population: 6,100), a comfortable community on the shimmering
shores of Lake Michigan, 10 miles north of Milwaukee.
The tight-knit Einhorn family was intimately engaged in money
matters. At dinner, they on occasion chattered about business and the
stock market. Facing o at family gatherings were two contravening
forces: Grandpa Ben, on his father’s side, was decidedly laissez faire. He
distrusted the Federal Reserve, feared ination, and advocated invest-
ments in precious metals and gold mining stocks. “Grandpa was a staunch
libertarian who believed in the gold standard,” Einhorn says. By contrast,
Einhorn: Contrarian at the Gates 107
his maternal grandmother, “Grandma Cookie” as Einhorn still refers to
her, was an avid stock picker and fan of Louis Rukeyser’s Wall Street
Week, the PBS program. “I still remember the jingle,” Einhorn laughs.
Her focus was on the growth stocks of the 1970s and 1980s era: IBM,
McDonald’s, Nike, and Walgreens. Einhorn would eventually absorb
both these inuences into his worldview.
Einhorn’s father toiled to build his mergers and acquisition (M&A)
business, Einhorn & Associates. It was tough. Clients would backtrack
on the fee his rm was owed on a deal—incensing his mother, who
counseled him to demand full payment. Stephen Einhorn believed being
exible on fees would help build the business in the long term. David
Einhorn opines that he mixes his father’s long-term perspective and per-
severance and his mother’s negotiating toughness.
Today, Stephen Einhorn is also chairman of a venture capital fund,
Capital Midwest, which he oversees with David Einhorn’s younger
brother, Daniel, and another partner.
Nicolet High School in Glendale, Wisconsin, was an impressive
institution, producing a stream of overachievers destined for elite col-
leges. Alumni include Oprah Winfrey. Einhorn was unlikely to win
popularity contests. He was focused and kept to a core group of close
friends. “David had a personality where a group of people who really
liked him, did,” says Stacey Shor, a classmate who met him in third grade.
“Other people didn’t.”
Einhorn wasn’t the type to angle for mainstream acceptance. A math
enthusiast, he wore button downs, not Aerosmith tee-shirts like some
classmates, and projected a purposeful, serious air. “He was always a
mature guy,” says Shor. “There’s always been an intensity to David. He
was never spontaneous or light-hearted. ”
In Einhorn’s senior year, 1987, the four-person Nicolet debating
team made it to the state championships. At the debate, Shor recalls Ein-
horn’s condence, quick wit, and use of reams of color-coded research
material. He was an organizational whiz. She doesn’t recall who won,
but guesses it was Einhorn’s team.
Einhorn and his wife in 2006 donated $1 million to bankroll the
Milwaukee Urban Debate League.
With an impressive academic record, Einhorn was Ivy League–
bound for Cornell University, in bucolic Ithaca, New York. Einhorn
108 THE MOST DANGEROUS TRADE
earned a B.A. in government and, once again, impressed his teachers.
“He wasn’t outgoing, but I liked him because he was so f--king smart,”
says government professor Theodore Lowi. “He was just the brightest
guy around.”
At Cornell his talent for deep research became apparent. After spend-
ing a semester in Washington, D.C., Einhorn had an idea for his honors
thesis: examining the economic impact of airline industry deregulation.
Lowi recalls criticizing the proposal, arguing that the subject matter
was too big—and that as a government major, he wasn’t qualied to
analyze the nancial ramications of the subject. Einhorn produced a
project report he had prepared during his semester in Washington. “I
was absolutely amazed at the results,” Lowi wrote in a condential rec-
ommendation for Einhorn in December 1990. “What he had done was
already the equivalent of most acceptable honors theses, and it possessed
in addition to that a professional level of analysis that I don’t see among
economics graduate students.”
Not that Lowi and his student saw eye to eye—and Einhorn’s
debating skills came into play. Lowi was a virulent critic of government
backing of banks. “I thought the FDIC (Federal Deposit Insurance
Corp.) was going too far,” Lowi says. “I’m antagonistic towards how
banks are assisted.” Einhorn pushed back, Lowi recalls, besting him in
arguments by pointing out the salutary impact of government help—a
position somewhat at odds with his current views.
Ultimately, Lowi’s entreaties for Einhorn to pursue an academic
career came to naught. “I proselytized him to get him get to his Ph.D.
in economics or political philosophy,” Lowi recalls. In fact, Einhorn
was rejected by several Ph.D programs. Years later, Einhorn, by then
wealthy, bumped into his old professor at a campus dedication. “You
son of a bitch,” Lowi teased him. “You went o to get all that money.”
Cornell wasn’t all studying. It was there that Einhorn met his future
wife, Cheryl Strauss, who would go on to work as an award-winning
journalist at IDD magazine, Barron’s nancial weekly, and the television
program Inside Edition. The two are active donors to the school’s Hillel
program, the Jewish cultural organization, along with Engaged Cornell,
an initiative to encourage undergraduate community activism. The cou-
ple graduated in 1991, she magna cum laude and he summa cum laude
and a member of Phi Beta Kappa.
Einhorn: Contrarian at the Gates 109
Einhorn met with campus recruiters as he cast about for a career.
He admits to being clueless on his future. One interview was with
the Central Intelligence Agency. Wall Street was dusting itself o
from the recession that followed the rst Gulf War. The Dow Jones
Industrials was climbing toward 3,000.
As the economy picked up, so too did M&A, securities underwrit-
ings, and leveraged buyouts. Einhorn met with a recruiter for Donald-
son Lufkin & Jenrette Securities Corp., the pioneering rm founded
by William Donaldson, Dan Lufkin, and Richard Jenrette. The invest-
ment bank was known for its top-ranked stock analysis—“the house that
research built,” as it was dubbed.
Einhorn told his interviewer that he was willing to work hard. He
had no idea of the 100-hour weeks that he was expected to clock. Ein-
horn, though a diligent worker, soon came to loathe the investment
banking culture.
“The attitude was, ‘If you don’t come in on Saturday don’t even
think of coming in on Sunday,’” Einhorn recalls. His father, running his
own M&A business in Wisconsin, had usually made it home for dinner.
At DLJ’s merchant banking division, associates were expected to work
through the night to satisfy the capriciousness of their bosses. “I just
didn’t like the way people treated each other,” says Einhorn. “It was
like having 200 bosses.” Within three months, the gangly Einhorn lost
15 pounds.
Robert Medway, a DLJ colleague, recalls Einhorn being asked by
a senior vice president to compile detailed one-page analyses of each
station in a multioutlet TV broadcasting group that DLJ was considering
buying—work that had no bearing on whether the rm would proceed
with the deal.
“Why are we doing this?” Einhorn asked him.
“Because I said so,” the senior vice president responded.
Opines Medway: “People had nothing better to do than ex their
muscles.”
Einhorn does credit DLJ with teaching him some Wall Street
basics. “I learned some accounting,” he says. “How to integrate a
balance sheet with cash ow and income statements. Basic tools.” After
two years of sleep deprivation, humiliation, and make-work projects,
Einhorn jumped when a headhunter called in 1993 to ask whether
110 THE MOST DANGEROUS TRADE
he was interested in a job at a hedge fund. “What’s a hedge fund?” he
recalls asking.
Einhorn joined Siegler, Collery & Company, a fund with $150 mil-
lion in assets using a deep-value, bottom-up investment approach. The
principals certainly had pedigrees. Gary Siegler had worked under cor-
porate raider Carl Icahn, identifying cheap targets. Peter Collery had cut
his teeth at Dillon Read & Co., a white shoe investment bank.
Siegler Collery did in pairs trading in one strategy. Under Collery’s
mentorship, Einhorn learned the precepts of value investing. He
also developed the somewhat ner art of smelling out problems at
companies—ambiguities in their nancial statements that suggested
dishonesty, ascertaining when management’s interests were not aligned
with those of shareholders, or simply when industry dynamics were
unhealthy.
Einhorn would sift through SEC documents, interview man-
agement, analysts, suppliers, customers and rivals. What were the
economics of the business? How were these reected in the earnings?
Then he would write up a report and supply pages of documentation
to Collery, discussing what he had found. Overnight, Collery would
read through Einhorn’s research and arrive the next day with a list of
questions—basically, what had been overlooked. “He taught me to ask
questions—for example, ‘Why was a stock misvalued?’”
At Siegler Collery, Einhorn spotted his rst short sale—Homecare
Management, a mail-order pharmacy selling drugs to organ transplant
patients. Einhorn doesn’t recall specics but says Collery’s focus on details
stoked his skepticism. “The numbers didn’t add up between revenues,
the number of patients, and the prots,” Einhorn says. Management eva-
siveness compounded his suspicions. “They said things that were incon-
sistent.” Eventually, the CEO was sentenced to prison for fraud.
As 1995 drew to a close, two years after marrying Cheryl Strauss,
Einhorn was at a crossroads. The U.S. stock market was on re. Stocks
were up 37.5 percent for the year, with the Dow Jones Industrials top-
ping 5,117 for the rst time. It was time to strike out on his own, or in
this case, with a colleague from Siegler Collery, Je Keswin.
The two sketched out their hedge fund business on a paper nap-
kin. Einhorn would manage money and Keswin market the fund. They
secured a 150-square-foot oce at a “hedge fund hotel”—an oce
Einhorn: Contrarian at the Gates 111
building with space leased to start-ups like theirs run by a prime broker-
age, in this case Spears, Leeds & Kellogg. Initial capital: $900,000, with
more than half that from Einhorn’s relatives.
At the outset, Einhorn decided against pairs trading, guring that
with superior research he could do better. The reason was that while
one part of the trade, for example a big short on Delta Air Lines, might
comprise a great opportunity, choosing a corresponding industry long,
say, Southwest Airlines, might be only moderately attractive—if at all.
Einhorn wanted to concentrate on his best ideas only and was willing to
cope with industry risk or market risk by reducing exposures.
Greenlight started out with a bang. The fund nished its rst year
with a gain of 37.1 percent for the eight months it was in business in
1996 and $13 million in assets under management. The rm was bol-
stered by gains in small cap companies—homebuilder MDC, retailer
C.R. Anthony, and EMCOR, a mechanical and electrical contractor.
Einhorn’s focus on a handful of well-researched long and short positions
was paying o. The next year proved even better, with Greenlight gar-
nering a 58 percent return and assets surging to $75 million as word of
Einhorn’s investing prowess spread.
One early short, in 1998, was Sirrom Capital, a so-called business
development company. BDCs, as they are known, have a gamey history.
Overseen by the Small Business Administration (SBA), they bankroll
small, mostly private companies that can’t attract traditional bank nanc-
ing. BDCs often get free warrants to purchase stock in the small busi-
nesses they lend money to—kickers, in Wall Street speak.
The lure for BDC investors is yield. They charged usurious rates.
BDCs pay no corporate income tax and often yield 7 or 8 percent.
Einhorn saw a ruse. Greenlight analysts built a spreadsheet that
tracked Sirrom’s loans and warrant portfolio. Sirrom’s rapid growth
was obscuring the fact that over time, roughly 40 percent of its loans
eventually went bad.
It also seemed to be dragging its feet in marking its portfolio down
to fair value. Einhorn zeroed in on Sirrom’s 1997 lings. The audi-
tor, Arthur Andersen, had omitted a sentence that it had included in
the prior year’s opinion evaluating Sirrom’s portfolio valuations. The
deleted phrase read: “We believe the procedures are reasonable and the
documentation appropriate.”
112 THE MOST DANGEROUS TRADE
It was a smoking gun. Greenlight initiated a short position and
watched as Sirrom shares climbed to $32 a share in May 1998. Then,
following the announcement of two serious loan losses in July, Sirrom
shares collapsed, tumbling to $15 and then $10 when Greenlight
covered its short position. The stock hit $3 in October. Business lender
Finova Group acquired Sirrom in 1999.
Three years later, in early 2002, managers from a rival hedge fund
contacted Einhorn. They asked for his insight into another BDC—
Washington, D.C.–based Allied Capital. They thought the company was
similarly mismarking its portfolio.
Einhorn assigned Greenlight analyst James Lin to construct a
database, tracking as best he could costs and valuations of investments in
Allied’s portfolio over several years, much as Greenlight had done with
Sirrom. Some price data was not available, but the pattern was similar.
Allied was refusing to assign fair values to its myriad debt holdings,
judging by market prices. It was issuing new shares and using proceeds
to help pay out a fat 7 percent “dividend.”
Other issues surfaced. Allied had embarked on a strategy two years
earlier to obtain control of many of its portfolio companies by scooping
up their stock. Then Allied would charge the companies for a variety
of services—accounting, marketing, merger advice—eectively milking
the companies for fees.
Einhorn arranged a conference call with Allied management in April
2002, taping the conversations. Upon questioning, the head of investor
relations, Suzanne Sparrow, told Einhorn that the company did not write
down loans even when warrants it held in the same company cratered.
That, she said, was because the impairment on such a loan was not
deemed “permanent.”
If a loan does decline in value, Sparrow told Einhorn, Allied still
wouldn’t write it down because of the possibility it might rebound.
Then there was this sparkling gem, in which Sparrow explained the
company’s generous valuation policy. “That’s the beautiful thing about a
BDC as a vehicle,” she enthused. “You don’t have, you know, the bank
regulators leaning on you to say you must write o this asset.”
Lastly: Between 2001 and 2002, Arthur Andersen, Allied’s auditor,
had excised exactly the same language it used from its opinion on Allied
as it had from Sirrom’s three years earlier.
Einhorn: Contrarian at the Gates 113
To anyone paying attention it was like a big, ashing neon sign read-
ing: “Danger!”
It was certainly enough for Einhorn. He maneuvered a fat
7.5 percent of Greenlight’s assets into a short position against Allied,
then trading at $26.25. The Ira Sohn Investment Conference was
scheduled for May, and Einhorn had been invited to speak.
Standing behind the podium, visibly nervous and with his name-tag
comically askew, Einhorn joked about how he had put his wife to sleep
rehearsing his presentation the previous night. He then launched into
his fast-paced takedown. “What we have here is a closed-end mezzanine
fund that is trading at two times net asset value,” he declared.
In a speech lasting under 20 minutes, Einhorn went to town on
Allied’s loan portfolio. No, he couldn’t determine the initial costs of
many loans in Allied’s portfolio because they were not disclosed, but Ein-
horn nailed down some choice atrocities. He pointed out that Allied was
carrying bonds of telecom startup Velocita at 40 cents on the dollar while
they were trading at 2 cents in the market. It hadn’t written down its
Startec Global Communications investment at all until the fourth quarter
of 2001. By that point, the company had already led for bankruptcy.
Einhorn waxed incredulous over the implications of Allied’s valua-
tion policies. These allowed the company to avoid writing down the
vast majority of what he was sure were hefty losses. In 2001, Allied
credit losses totaled just 1 percent of its portfolio. The previous year,
by contrast, the default rate on high yield bonds was 12 percent, and
over 5 years, 6 percent. It was crazy. “They must be great underwriters,”
Einhorn scoed.
A 100 percent–owned Allied division, Business Loan Express, or
BLX, which accounted for a big chunk of its prots, was paying Allied
25 percent interest on an $80 million loan. Allied was neither con-
solidating results of BLX nor eliminating the intra-company interest
payments from its income statement. The eect was essentially counting
as income money that merely passed from one of the company’s pockets
into another. BLX’s business would eventually bring the entire Allied
edice crashing down.
First, though, Einhorn was drawn into a Kafkaesque odyssey in
which he and Allied waged a public, at times scorched-earth battle
in courts, with the regulators and the media—each accusing the
114 THE MOST DANGEROUS TRADE
other of disingenuousness, lying and fraud. Einhorn’s recounting of
the tale makes for a sometimes-gripping 426-page narrative, Fooling
Some of the People All of the Time (2011, John Wiley & Sons, Inc.). It’s
worthwhile reading.
The day after the speech, Allied stock dropped almost 20 percent to
$21 a share. Allied held a conference call. CEO Bill Walton and Allied
executives hadn’t heard or read Einhorn’s speech and so skated over the
issues that he had raised. For example, Sweeney said the reason Arthur
Andersen had dropped the sentence endorsing Allied’s valuations of
portfolio securities was due to changes in an accounting industry audit
guide. This proved to be untrue—there had been no such change.
Walton ignored the question of why payments from BLX, a 100 percent-
owned subsidiary, should be counted as income. He did talk about the
value he saw in Velocita senior debt. Allied, in fact, held subordinated
debt, which the company would write down to zero in a matter of
weeks. And Walton opined about his condence in the Startec invest-
ment, including a $10 million “money good” piece of secured paper
that, again, was shortly written down to zero.
Einhorn shouldn’t have been surprised, Allied’s chief operating
ocer, Joan Sweeney, and chief nancial ocer, Penni Roll, had in
February written and later posted on the Internet a white paper entitled
“Valuation of Securities Held by Business Development Companies.”
They claimed that SEC regulations for valuing a security are not appli-
cable to BDCs. And they suggested they followed dierent parameters,
thosesetbytheSBA.
Greenlight, working with another short seller, Jim Carruthers of
Eastbourne Capital Management, began tracking down questionable
loans made by Allied and its BLX subsidiary. Carruthers found court
cases showing senior BLX executives were encouraging applicants to
ll out fraudulent documentation to obtain loans from the SBA.
A key rainmaker for BLX was one Patrick Harrington. Greenlight
hired Kroll Associates, the private investigation rm, to look further into
BLX. Together with Carruthers, Kroll found millions of dollars in loans
made to cheap motels, gas stations, and convenience stores. When busi-
nesses bellied up, BLX would often simply not write down the value of
the defaulted loan. One reason: BLX executives got compensated based
on the value of the loans they made, not on protability or any other
Einhorn: Contrarian at the Gates 115
reasonable metric. BLX loans defaulted at three times the rate of other
SBA-sponsored loans.
Allied didn’t care. As a BDC, the SBA, not Allied, took almost all
of the risk from the loans. Fully 75 percent of the loan was guaran-
teed against loss by the agency. Taxpayers were unwittingly subsidizing
the charade.
More important was Allied’s use of gain-on-sale accounting, which
recognizes most of the income from a loan at the time of its origination.
The likelihood of the loan being repaid was of small consequence from
a prot and loss standpoint.
Some took note of the analysis proered by Greenlight, which
Einhorn posted on the company website. Notably, the indefatigable
Wall Street Journal reporter Jesse Eisinger, now with the nonprot
Pulitzer Prize–winning ProPublica reporting website, bird-dogged parts
of the tortuous saga.
Forces backing Allied stirred. Example: Deutsche Bank analyst Mark
Alpert initiated coverage of Allied with a highly unusual “sell” recom-
mendation in mid-2002. At the behest of Allied, the New York Stock
Exchange launched an investigation into Alpert. By the end of the year,
he no longer worked at Deutsche, which soon was picking up choice
investment banking work from Allied.
The SBA expressed little interest in tackling Allied or BLX and
defended their loan records. The much-criticized agency likely realized
the dubious accounting reected as poorly on its oversight as it did on
Allied and BLX.
In March 2003, Greenlight received a subpoena from the New York
State Attorney General Eliot Spitzer, whose publicity-generating pursuit
of nancial rms would soon propel him into the governorship. Ein-
horn was asked to answer questions about Greenlight’s relationships with
other hedge funds, such as Gotham Partners—run by William Ackman,
another long-short manager.
Within the month, the SEC followed suit with its own probe. With
the attending publicity—Spitzer’s oce leaked its investigation to the
Wall Street Journal—Einhorn’s wife was red from her job as a columnist
at Barron’s, the nancial newsweekly.
Ultimately, after days of back and forth questioning of Einhorn by
an agency lawyer, the SEC did precisely nothing. The lawyer was later
116 THE MOST DANGEROUS TRADE
hired as a consultant by Allied. For its part, Spitzer’s oce, wisely, never
followed up at all.
By the summer of 2004, Einhorn was hearing disturbing stories. The
phones of MarketWatch journalist Herb Greenberg and others linked to
the Allied story were being hacked by someone asking their phone com-
panies to open an online billing account, a ruse known as “pretexting”.
The person had gotten access to all their phone records. When Einhorn
asked AT&T whether someone had done the same thing to him, he was
told they had.
Einhorn, infuriated, sent a March 2005 letter to Allied’s board
demanding an investigation into the pretexting. In a perfunctory
fashion, Allied claimed it had looked into the matter and reported that
the company had discovered no evidence of wrongdoing.
Einhorn continued to badger Allied, writing in a September 2006
letter to the company that “the board clearly has an obligation to
investigate such illegal behavior.” Again, Allied brushed o Einhorn’s
accusations.
Then, in February 2007 the company abruptly about-faced, issuing
a press release stating: “Allied Capital has become aware that an agent of
the Company obtained what were represented to be telephone records
of David Einhorn and which purport to be records of calls from Green-
light Capital during a period of time in 2005.” Einhorn testied before
Congress on the subject of pretexting. It later turned out that Allied
told the SEC that the lawyer it hired as a consultant was responsible for
the pretexting.
It was a victory. But things had already begun to turn against Allied.
In late 2004 the Justice Department had begun a criminal investigation
into Allied and BLX’s loan practices—though the company maintained
it was merely a follow-on to Greenlight’s accusations. In fact, in
September 2005, Einhorn went to Washington, D.C., and presented
federal prosecutors with a 50-page slide show, meeting with assistant
U.S. attorneys and FBI agents.
With the government investigating fraud, Greenlight found a dif-
ferent way to make some money. Under a statute known as the False
Claims Act, a private citizen who uncovers fraud against the govern-
ment is entitled to a portion of the amount recovered, typically one-third
or so. Given the scale of the losses that the SBA was likely to have
Einhorn: Contrarian at the Gates 117
suered as a result of BLX’s loans, this could amount to a sizable chunk
of change.
As Einhorn’s book lays out, Greenlight teamed up with a retired real
estate developer who on his own was turning up dozens of sham transac-
tions at BLX—particulary a raft of suspect loans to shrimp boat owners,
part of an industry reeling from aquafarming and other competition.
They led a False Claims Act suit in Atlanta, in December 2005.
A big break for Greenlight came in late 2006. Allied, in its third quar-
ter earnings statement, revealed that BLX was having trouble making
loans and that the SBA Oce of the Inspector General and the Justice
Department had launched an investigation into the subsidiary and its
Detroit oce, which was soon shuttered. Nobody seemed to notice.
On February 28, 2007, Allied abruptly wrote down its investment in
BLX by $74 million. In October of that year, BLX’s Patrick Harrington,
former head of the Detroit oce, pled guilty to conspiracy and making
a false statement to a federal grand jury. (In November 2008 he was
sentenced to 10 years in prison).
Amazingly, throughout all this time, the share price of Allied Capital
remained robust. Though it had tumbled from more than $25 a share
to less than $17 in the months after Einhorn’s initial speech, it soon
recovered, hitting more than $30 by early 2004. Despite the mounting
questions about the company’s loans, its portfolio valuation, and the BLX
write down, shares kept above the $30 threshold for most of 2006 and
2007. Investors were more interested in the Allied dividend than fraud.
In late 2007, the Oce of the Inspector General of the SBA released
a report on the agency’s handling of the Allied and BLX case. It was so
heavily redacted as to be nearly worthless—data was blacked out as well
as entire passages, all at the request of BLX and the SBA general coun-
sel. Indeed, three of the report’s ve recommendations were redacted
entirely. A nonredacted version, disclosed by the New York Times in
August 2008, showed that these recommendations called for better lend-
ing practices by BLX, a reduction in SBA guarantees until the improved
practices were met and suspension of “preferred status” for BLX until
the improvements were made.
The SBA later argued that it was worried about putting BLX out
of business. By now the credit crunch was pummeling Allied’s shares,
as it could no longer maintain its dividends. In October 2008, BLX,
118 THE MOST DANGEROUS TRADE
which had changed its name to Ciena Capital, led for bankruptcy, forc-
ing Allied to use $320 million to backstop Ciena’s line of credit. From
there, as it slashed dividend payments, Allied’s shares began a precipitous
decline from well over $30 a share to under a dollar at the market low
of March 2009.
In October 2009, the Department of Justice told Greenlight that it
had reached a tentative agreement to settle its False Claims Act suit and
wanted Einhorn to sign o. The case would be settled for $26.4 million,
less than a tenth of the $336 million Einhorn felt appropriate. It was
a disheartening victory: Ares Capital, another BDC, company, agreed
within the week to acquire Allied for cash and stock worth $3.47 a share.
Greenlight’s general partner donated its $6 million in prots from
Allied to charity, including the Project on Government Oversight and
the Center for Public Integrity. In his midtown oces, Einhorn waxes
incredulous when this author asks him whether the end results of his
Allied Capital campaign were worth the eorts he and his colleagues
expended. “Certainly not,” he says, “There’s no investment that’s worth
that amount of grief.”
It was a lesson that was to serve him well in Greenlight’s history-
changing campaign—one that, if it had been successful, might just have
averted catastrophe and spared the world some of the worst aspects of
the 2008–2009 nancial crisis and great recession that followed: Ein-
horn’s very vocal short-selling eort against Lehman Brothers. After all,
if the storied investment bank’s dysfunctional management, the Fed-
eral Reserve System, or the recalcitrant Treasury Department had acted
to shore up Lehman’s overleveraged balance sheet when Einhorn rst
raised his concerns, capital could have been injected in time to avert the
disaster that followed, and an earth-shattering bankruptcy might have
been avoided.
Einhorn pauses in the interview to emphasize a point that he thinks
is sometimes overlooked—and it’s one that he’s not necessarily proud
about. “There were people who thought there was a problem with the
entire housing market early on,” he says, then pausing for emphasis. “I
was not one of those people.”
One of the earliest inklings of the brewing storm came to his atten-
tion on August 9, 2007, when BNP Paribas announced it was suspending
investor redemptions at three of its funds—Parvest Dynamic ABS, BNP
Einhorn: Contrarian at the Gates 119
Paribas ABS Euibor, and BNP Paribas ABS Eonia. Earlier that year,
two Bear Stearns hedge funds invested in mortgage-backed securities
had collapsed spectacularly, creating a ripple of fear that quickly spread
through the credit markets. But these BNP funds were conservative
money market–like oerings and so should have remained unaected.
BNP, after all, itself had negligible exposure to subprime mortgages,
which over the previous decade had been securitized into highly rated
“structured products” such as collateralized debt obligations and their
ilk. But the bank issued a statement explaining its predicament. “The
complete evaporation of liquidity in certain market segments of the U.S.
securitization market has made it impossible to value certain assets fairly
regardless of their quality or credit rating,” the bank said.
The news, from Einhorn’s perspective, was both puzzling and omi-
nous. If a French bank with minimal exposure to the U.S. securitized
mortgage market was having trouble valuing assets, what could that
mean for the hundreds of U.S. nancial institutions whose opaque bal-
ance sheets and portfolios were loaded with all kinds of dicey subprime
securities, not to mention derivatives and related toxic stu?
Einhorn had a feeling that credit markets were about to turn ugly in
a hurry—regardless of whether the CDOs and other securities carried
AAA ratings from agencies like Standard & Poor’s or not. It was, of
course, an area Einhorn was intimately familiar with from his dealings
with New Century—on whose board he had previously served. But
he didn’t have time to have his analysts churn through the customary
mountains of research and documents to nd the companies that were
most at risk for a meltdown.
Einhorn gathered his seven analysts together and announced that
they would temporarily ditch their rigorous and painstaking research
process. Instead, they would work through the weekend to nd the best
list of names that, according to public documents, had the most expo-
sure to the so-called structured nance market—including the kinds of
CDOs and other packages of mortgages and debt that were seizing up.
On Monday, they would begin the process of shorting them as they con-
tinued their research. “I saw the market unraveling,” Einhorn recalls.
“I didn’t think it would be brief—I believed it was structural.”
The initial “credit basket” of short candidates comprised between 15
to 20 stocks. Citigroup was in it, so was Bear Stearns, Morgan Stanley,
120 THE MOST DANGEROUS TRADE
a slew of commercial banks, Moody’s Investor Services, and McGraw-
Hill, which owned Standard & Poor’s. Then, over the weeks, as more
information poured in and analysts gathered more research on compa-
nies’ structured debt exposure, they added new names and covered some
of their shorts.
“Each of the positions was small,” says Einhorn. “As we continued
to do the work, we narrowed the list to those on which we had the most
conviction—Bear Stearns, Lehman, Moody’s, MBIA, Wells Fargo and
maybe some others. That didn’t make us geniuses for covering Citi and
Merrill Lynch, which we did.”
Einhorn became particularly interested in Lehman because of a quar-
terly earnings conference call he listened to on October 18, 2007. Man-
agement suggested that any credit-related problems were behind them.
But Einhorn didn’t like the back and forth between them and Wall Street
analysts. “They weren’t answering reasonable questions from reasonable
analysts,” Einhorn says. “So we dug into our work.”
One particular new accounting rule was especially notable: Finan-
cial Accounting Standard (FAS) 159. When the value of Lehman’s debt
declined, the investment bank would book the decline as revenue. The
thinking was that because Lehman could buy back the debt at the lower
price, it wouldn’t have to pay 100 cents on the dollar to retire the debt. It
could, theoretically, pocket the dierence. That means Lehman or any
other bank could book it as revenue. Other investment banks did the
same thing, but were very explicit about the numbers involved. Bear
Stearns, Merrill Lynch, and Morgan Stanley broke the numbers out.
Lehman did not.
Einhorn gave a presentation at the Value Investing Congress on
November 29 addressing the issue. He wanted to know how much of
Lehman’s $1.2 billion in pretax income was due to FAS 159. He also
pointed out the folly of FAS 159: Taken to its extreme, the worse a
company’s bonds performed, the more revenue it would book. Since
compensation is often based on such revenue, the result is inescapable.
“The most protable and lucrative day in the history of your rm will
be the day you go bankrupt!” Einhorn declared.
Investors didn’t seem to care: Lehman shares rose $5 the next day.
There were, however, other warning signs. In conversations with
Lehman executives, Einhorn got dierent answers when he asked how
Einhorn: Contrarian at the Gates 121
often certain illiquid assets were marked to market. Lehman also insisted
that it hedged its exposure to mortgage-related structured debt. “They
were saying they had seen the crisis coming,” Einhorn says. “We looked
at the balance sheet and asked how they could hedge that much risk?
When you looked at what Lehman would have had to hedge, it was
larger than the whole market.”
When pressed on the details, Lehman executives couldn’t even iden-
tify which instruments they were using to hedge.
In the spring of 2008, Lehman tapped a new chief nancial
ocer—the lithe and photogenic Erin Callan, a protégé of Joe Gre-
gory, chief operations ocer but de-facto right hand man and chief
condante to CEO Richard Fuld. Gregory was a erce loyalist—and
an advocate of psychological paradigm called the Myers-Briggs Type
Indicator, which grouped people into distinct personality categories.
Ability was innate. The fact that Callan was a tax attorney with little
experience in nance matters was of little consequence. Her ability
would be enough carry the day.
Einhorn wasn’t the only person, including some at Lehman, who
thought she was in over her head. Yet Callan, in her short tenure as
chief nancial ocer, had gained a reputation in some circles as being
responsive to investors—dutifully pumping executives for more informa-
tion when analysts requested it. A Wall Street Journal prole of her was
entitled “Lehman’s Straight Shooter.” Einhorn, for one, didn’t buy it.
At Grant’s Spring Investment Conference on April 8, the Greenlight
president told his audience bluntly: “There is good reason to question
Lehman’s fair value calculations.” This was equivalent to calling the rm’s
nancial statements hokum. He estimated that Lehman’s ratio of assets
to tangible common equity was an astonishing 44 times. “The problem
with 44 times leverage is that if your assets fall by only a percent, you lose
almost half your equity,” he said. Lehman, in addition to recently buying
back $750 million in stock as a way to goose its shares, had the week ear-
lier raised $4 billion in new capital from investors. “The regulators seem
willing to turn a blind eye toward eorts to raise capital before recogniz-
ing large losses,” Einhorn said. “Some of the sovereign wealth funds that
made these types of investments last year have come to regret them.”
Lehman CEO Fuld, fulminating, blamed the mounting concerns
about its accounting on short sellers. “I will hurt the shorts and that is
122 THE MOST DANGEROUS TRADE
my goal,” he said in April. When the subject came to raising capital, he
liked the idea of using money to buy back shares to squeeze the shorts
as punishment—instead of shoring up the rm’s balance sheet.
With the May 21, 2008 Ira Sohn Investment Conference approach-
ing, Einhorn decided to try and nail down at least a few of the issues
nagging him about Lehman. He questioned Callan on the discrepancies
in so-called Level 3 assets—those that are particularly illiquid and tough
to value—which had risen by more than $1 billion from the time of the
earnings conference call and the ling of the rm’s nancial statements
just weeks later. Their very illiquidity makes it easy to hide all kinds of
portfolio problems in the category. In an hour-long phone call, Einhorn
asked whether any such assets had been written up. Callan had responded
categorically that they had not.
Most of Einhorn’s Sohn speech was a summation of his Allied Cap-
ital campaign. He then turned to Lehman—and though not terribly
long-winded, the Greenlight president was by no means gentle. Einhorn
cited nancial legerdemain that he attributed to Callan personally. Ein-
horn was especially focused on why an $8.4 billion portfolio of mostly
corporate equities rose $722 million during a period in which the S&P
500 lost 10 percent.
There was also the fact that Lehman had $39 billion of exposure to
commercial mortgages at year-end 2007. An index of such mortgages
that were rated AAA fell 10 percent in the quarter. Lehman’s portfolio
was rated far below AAA and should have fallen more than 10 per-
cent. Instead it dropped less than 3 percentage points. It was a sign
of valuation chicanery. Einhorn called on SEC chairman Christopher
Cox, Federal Reserve chairman Ben Bernanke, and Treasury Secretary
Henry Paulson to act. “My hope is that Mr. Cox and Mr. Bernanke
and Mr. Paulson will pay heed to the risks to the nancial system that
Lehman is creating and they will guide Lehman toward a recapitaliza-
tion and recognition of its losses—hopefully before taxpayer assistance is
required,” Einhorn said.
He continued: “For the capital markets to function, companies
need to provide investors with accurate information rather than
whatever numbers add up to a smooth return. If there is no penalty for
misbehavior—and, in fact, such behavior is rewarded with attering
Einhorn: Contrarian at the Gates 123
stories in the mainstream press about how to handle a crisis—we will all
bear the negative consequences over time.”
Timed to start after the U.S. stock markets had closed, the Sohn
speech sent when shares down less than 3 percent the next day, to $38.50.
But after reporting a preliminary loss of $2.8 billion for the second
quarter on June 9—the rst since the rm went public in 1994—they
plummeted. Three days later, Callan and Gregory both resigned and the
stock slumped to $22.70.
In congressional testimony, Fuld said: “The n---d shorts and rumor
mongers succeeded in bringing down Bear Stearns. And I believe that
unsubstantiated rumors in the marketplace caused signicant harm to
Lehman Brothers.” He claimed the alleged short campaign to be the
work of a cabal. Some journalists backed up his claim, including Matt
Taibbi of Rolling Stone. Surely, of course, a leverage ratio of 44 to 1 had
something to do with Lehman’s demise.
Lehman desperately searched for additional outside capital. With-
out backup or assistance from the U.S. government, which Treasury
Secretary Paulson was adamant in not providing, nothing panned out.
Bank of America opted to purchase Merrill Lynch instead, talks with
Korea Development Bank never got serious, and ultimately British bank
Barclays—the most serious contender—was overruled by U.K. regula-
tors and eventually picked up Lehman’s remaining post-bankruptcy assets
for a song. The 158-year-old investment bank led for bankruptcy on
1:45 a.m. on September 15, the largest in U.S. history, with more than
$600 billion in assets.
It’s certainly fair to say that Einhorn made nancial history, although
to lay blame for the disastrous outcome at his feet would be grossly
unfair. Einhorn was the messenger—leverage and management hubris
the culprits.
The crisis turned Einhorn into a keen Fed watcher, and he
continued incorporate macroeconomic outlooks into his world view.
He began a veritable campaign in 2012 to argue that the expansionary
impact of former Federal Reserve chairman Bernanke’s quantitative
easing had dissipated, making it useless as a tool to goose growth. In an
article in the Hungton Post, he then described a hypothetical episode
of The Simpsons animated TV show mocking Bernanke’s reasoning,
124 THE MOST DANGEROUS TRADE
with the evil nuclear power plant owner/operator Montgomery Burns
standing in for Bernanke, bantering with his none-too-bright sycophant
assistant, Smithers.
Burns: Don’t you get it? A rising stock market allows people to
feel wealthy. And a seemingly wealthy person is a proigate
person.
Smithers: Proigate, sir?
Burns: Proigate. It means they spend money they don’t have on
things they don’t need.
Smithers: So instead of enabling people to actually have more
disposable income, we’ll get them to spend more money by
simply making them feel rich?
Burns: Exactly! Now how can we do that?
Smithers: Well, we can always encourage them to sell their bonds and
buy stocks.
Burns: Now, how would we ever convince them to do something
as foolish as that?
Smithers: Just set interest rates at zero indenitely. Then no one can
aord not to invest in the market.
Burns: Why Smithers, that’s brilliant! This is exactly the kind of
counterintuitive thinking we’ve been needing around here.
The imagined dialogue is classic Einhorn—logical, a bit hokey with
more than a dash of wit and sarcasm. Even if you don’t agree with this
outlook, you ignore Einhorn’s observations at your own risk. Market
history has shown that time and again.
Chapter 5
Block: Playing the
China Hand
T
he white van careened along a narrow, two-lane road deep in the
snow-covered He Bei province, 150 miles southwest of Beijing.
In the back, Carson Block, attorney, entrepreneur, and capitalist
adventurer, bumped along at 35 miles an hour on his way to visit Orient
Paper and its upgraded factory, which, the company claimed, would
allow it to sharply increase production of high-quality cardboard and
other paper product lines. Beside him sat Sean Regan, a manufacturing
expert and Asia hand with a specialty in supply chain management and
quality control.
Both Block and Regan lived in Shanghai, graduates of the University
of Southern California who had become close friends after bonding over
USC football. On this blustery day in January 2010, they were on their
way to visit a small, New York Stock Exchange–listed company, Orient
Paper, at the behest of Block’s father, William Block, who ran his own
Los Angeles investment rm, WAB Capital. The older Block analyzed
125
126 THE MOST DANGEROUS TRADE
microcap companies and, if he liked them, published bullish research
reports for a clientele of hedge funds and other money managers. The
rub was that WAB got paid by the company—not investors—with war-
rants or restricted stock for the research and for introducing management
to his investor clients. Some called him a stock promoter.
The previous night, the pair had scoured Orient Paper’s U.S. Secu-
rities & Exchange Commission (SEC) lings—and grew skeptical of
the company’s claims to inventory turnover that was more than dou-
ble that of rivals. There were also improbably high production gures,
what looked like inated asset values, a revolving door of top customers,
and a list of suspect suppliers—at least one controlled by Orient Paper’s
own chairman.
Now, as the van approached the factory, something else caught their
eyes—pavement. The road was not suitable for the volume of output
Orient Paper claimed. “We gured they had to ship 100 trucks a day at
maximum capacity,” says Block. “Sean noticed that the road didn’t have
the kind of wear and tear you would expect.”
Entering through a pair of battered gates, Block noted the paucity of
workers or activity. There was a 20-foot-high pile of used paper outside,
wet,whichthecompanyhaddescribedinanSEClingasexpensive
feedstock for its operations—worth $4.7 million. Regan climbed the
mound of scrap paper and shouted down to Block.
“If this is worth $4.7 million, the world is a lot richer than I
thought,” he said.
Inside the factory, the rolling machinery was antiquated. Water
dripped onto a table where paper was to be folded. The air was thick
with steam—a prescription for disaster in a plant that was supposed to
produce high-quality paper.
Zhenyong Liu, Orient Paper’s chairman and chief executive ocer,
greeted Block and Regan in his oce and led them on a tour through
the factory and workshops.
“How many tons do you ship?” Block recalls asking. Liu didn’t know.
“Well, how do you dene a good day?”Again, Liu demurred.
“What kind of metrics are you using, then?” Liu shook his head.
In fact, Liu was unable to answer even basic questions. Rather than
the diamond in the rough that Block’s father was hoping for, Orient
Paper seemed a fraud. Liu rushed Block and Regan through the rest of
Block: Playing the China Hand 127
the tour. “This is amazing,” Block recalls thinking. “This is a zero. This
is a sure thing.”
Block himself at the time was bleeding cash—he was majority
owner and manager of a struggling self-storage company in Shanghai
and could ill aord the time and expense of this trip to He Bei. WAB
obviously wouldn’t be publishing anything bullish on Orient Paper. But
on the ight back to Shanghai, Block and Regan discussed publishing
a negative report via e-mail. Perhaps they could short the stock ahead
of time and at least defray some of the cost of the research—$10,000
to $15,000.
Back in Shanghai, the two delved into their due diligence, calling
Orient Paper’s suppliers, customers, and competitors. Few of the num-
bers they turned up backed anything the company claimed. They com-
pared the SEC lings meant for U.S. investors to information deposited
with China’s the State Administration for Industry and Commerce, or
SAIC. The Chinese numbers were drastically less impressive. Total 2008
net assets, as disclosed to the SAIC, were less than half those in the
SEC lings. Block determined that scal 2009 revenue was overstated
by about 40 times.
Block and Regan admit to turning paranoid. They worried that the
Chinese maa—rumored to be entangled with fraudulent companies—
was on to them. “I’m looking out for black sedans,” Block says. “We
started talking in code.” He began carrying a heavy polycom phone
handset with which he could defend himself.
The research report Block and Regan drafted would eventually total
30 pages—lled with every item they considered suspicious. They stated
that Orient Paper had misappropriated $30 million in capital raised via
private placements on machinery that did not meet the specications
the company claimed. The report detailed inated revenue, turnover,
and asset gures. “We are condent ONP is a fraud,” the report stated. It
included more than a dozen photographs illustrating the decrepit physical
plant, and linked to videos of the tour they had taken.
Block waited for an alarm system to be installed in his Shanghai
apartment before publishing. There were other delays: He needed a good
name for his nascent rm to lend it some credibility. Block recalled a
Chinese proverb. “Muddy waters make it easy to catch sh.” He incor-
porated Muddy Waters LLC in Las Vegas, Nevada.
128 THE MOST DANGEROUS TRADE
Then, through an online brokerage, Block and Regan located some
$4,000 worth of put options, most with August expiration dates, that
gave them the right to sell Orient Paper stock at a strike price of $7.50
versus the $8.50 or so the stock was trading at. It was hardly a pre-
cisely calibrated strategy. “I had no idea what the f--k I was doing,”
admits Block.
Block released the Muddy Waters report at 1:15 a.m. Shanghai time
on June 28, 2010 via an e-mail blast to 75 investors, mostly people he
had met in his earlier days on Wall Street. There were less than three
hours before trading closed in New York, and Block remained awake
long enough to watch the share price tick down at the end of the
day, closing o 10 cents at $8.35. “I wonder if I did that,” he said to
his wife, a Vietnamese-American who had spent days formatting and
paginating the report. (Block asked that her name not be divulged for
security reasons.)
The next day, Orient Paper traded at $7.23, down 11 percent. The
research report had gone viral overnight, and the stock price would fall
below $5 before the company responded.
Orient Paper at rst denied it was the company Carson had visited
and accused him of lying and extortion. But the report gathered atten-
tion: The 21st Century Business Herald, two weeks later, published an
investigative report on the Muddy Waters research, an article that was
later posted on Sinanance.com, a popular website. Carson sold most of
the options in mid-July for a prot of about $6,000, then went into the
market a few days later to buy more—a move that backred, wiping out
his prot and then some.
Nevertheless, the Orient Paper trade catapulted Muddy Waters to
the forefront of a small and contentious short-selling movement that has
racked up a formidable record of unmasking fraud at United States–
and Canada-listed Chinese companies—proting as the shares of target
companies crumble. Other research rms trolling the same pond include
Citron Research LLC, founded by Andrew Left, and Alfredlittle.com, a
website run by a long-time China investor named Jon Carnes.
They are not the only ones who have bet against the East’s rising tide.
Short sellers like Kynikos Associates’ Jim Chanos have focused on China’s
bubble economy, awash in empty real estate and manufacturing capac-
ity. That has left it to Block and his ilk to probe the underbelly of the
Block: Playing the China Hand 129
dicey small-cap markets, where dubious accounting and outright scams
flourish. The explosion in China-based fraud isn’t dicult to explain:
U.S. and other foreign investors face restrictions on buying A-shares
listed in Shanghai and Shenzhen and so have scrambled to sink their
money into Chinese growth story stocks, even those of dubious quality.
Chinese operators are happy to furnish them. “So many people are being
paid to manage China money right now,” says Block.
The preferred medium for the dicey promotions are reverse takeover
companies (RTOs in industry argot)—United States– and Canada-listed
shell companies with no operating businesses that are bought by China
corporations for the purpose of accessing North American capital. After
the acquisition, the shell company typically changes its name to reect
that of its new owners and then proceeds to raise money, often via public
equity or debt oerings. Orient Paper t the description.
The benets to RTOs are twofold. It’s an inexpensive process, since
listed shell companies can be purchased for a pittance—often in exchange
for equity in the merged company. More importantly, for shady opera-
tors, reverse takeovers make it easier to avoid scrutiny by stock exchanges,
the SEC, and other regulators, compared to a traditional IPO.
The number of United States–listed, China-based RTOs have
climbed since 2007, according to DealFlow Media LLC. Most are
traded on the New York Stock Exchange, NASDAQ and other mar-
ketplaces. Though most are legitimate or have only minor accounting
problems, the area makes for fertile hunting ground for Block and his
short-selling rivals.
The promotions have relied on an ecosystem of enablers. RTOs his-
torically worked with a clutch of boutique investment banks, including
Rodman & Renshaw Capital Group, Roth Capital Markets, and Global
Hunter Capital Markets. These often underwrote stock oerings. Law
rms providing legal advice to China-based RTO companies over the
years include Loeb & Loeb and Pillsbury Winthrop. Accounting rms
have included Frazer Frost LLP, Davis Accounting Group PC, and
MaloneBailey LLP. “Everybody has a lot to lose—investment bankers,
investor relations, the accounting rms, the law rms in the RTO
world,” says Block. “There is serious money at stake.”
The degree to which such companies are entwined with China’s
political and economic elite is uncertain. Block suspects the worst.
130 THE MOST DANGEROUS TRADE
“I think it goes to high levels,” he says. “I believe local and national
ocials and their families have been involved with the U.S. listed frauds.”
Block believes an organized network originates the frauds, taking
the dubious companies and dressing them up for reverse takeovers and
eventual listing. He cites an article by Today’s Fortune, an economics
newspaper, that alleges a sophisticated “Fraud School” matches sham
enterprises with shady auditors who provide expertise on faking
nancial documents, tax receipts and bank accounts. For the occasional
investor performing due diligence, the school furnishes the companies
with phone numbers of fake customers who are given scripted answers
to likely questions. If a factory visit is demanded, teams of “workers”
are hired for the day and brought to empty factories where production
equipment and bogus inventory has been shipped in the day before.
The ill-gotten prots are generated by selling shares to the public
and then using those proceeds not channeled directly to management to
buy machinery or properties at wildly inated prices, with the kickbacks
being distributed to scam artists.
Certainly, the risk of corporate fraud to investors outside of China’s
blue-chip, state-run enterprises is high. In 2011, Moody’s Investors
Service issued a report that looked for “red ags” that would signal
possible problems at companies issuing high-yield debt in China. The
ags identied problematic corporate governance issues like related
party transactions, opaque business models, negative free cash ow, poor
earnings quality, and suspect nancial reporting. Of the 23 non-property
related high yield issuers Moody’s looked at, the average number of
red ags tripped for each company was 7.5. Hong Kong’s Securities &
Futures Commission charged Moody’s with fraud over this report in
December 2014.
Accountants signing o on the nancial statements are part of the
problem. The SEC has sued Chinese-based aliates of the United
States’ Big Four accounting rms for withholding documents as it
investigates fraud cases at nine China-based companies that trade in the
United States. The four—Deloitte Touche Tohmasu CPA Ltd., Ernst
& Young Hua Mong LLP, KPMG Huazhen, and PricewaterhouseC-
oopers Zhong Tian CPAs Ltd—along with BDO China Dahua Co.
all deny wrongdoing and say they are only complying with Chinese
accounting rules that prevent them from turning over documents to
foreign regulators.
Block: Playing the China Hand 131
With the audits suspect, investment banks co-opted, and the Chinese
government often supportive of fraudulent companies, uncovering cor-
ruption has fallen to the likes of Muddy Waters, Citron, Alfredlittle.com
and GeoInvesting LLC, a Skippack, Pennsylvania, rm that pursues both
short and long investment ideas.
The business is increasingly nasty, litigious and dangerous. Citron
has been sued for defamation at least three times by Chinese companies,
including Qihoo 360 Technology Company, a software manufacturer
that it accused of accounting irregularities. Kai-Fu Lee, founder
of Google China and Internet gady, began the website Citron-
fraud.com challenging Left’s research. A lawyer for Alfredlittle.com was
pistol-whipped in August 2011 by police from the Ministry of State
Security as the rm conducted research on China New Borun, a New
York-listed alcohol maker. After the website questioned production
gures of Silvercorp Metals, a Toronto Stock Exchange–listed mining
company with operations in China, police from the same organization
arrested Alfredlittle.com analyst Huang Kun, who served prison time
on charges of “criminal” defamation.
And Alfredlittle.com founder Jon Carnes himself was investigated
for, among other things, publishing inaccurate information in a Sil-
vercorp research report, not by Chinese authorities, but by the British
Columbia Securities Commission, which accused him of fraud. A com-
mission panel cleared him in May 2015.
Block himself receives periodic death threats via e-mail, and Muddy
Waters’ website is regularly hacked. “The campaign against the shorts is
at a fever pitch,” says Dan David, vice president of GeoInvesting. “Some-
body’s going to get killed.”
Regan, for one, decided the pressure was not for him. Married to
a Chinese citizen and with ongoing business interests that bring him
to China, he asked Block to not include his name on research reports
following Orient Paper, and left Muddy Waters altogether in early 2012.
Regan cites another Chinese proverb for his decision, one that bluntly
advocates making an example of one person to intimidate another: Kill
the chicken to scare the monkey. “I gured I would be the chicken,”
Regan says.
Block too, though publicly deant, packed up and moved his base
to San Francisco. Muddy Waters’ sta, 30-somethings who pool their
capital, are spread between the United States and Asia. Block will not
132 THE MOST DANGEROUS TRADE
disclose their names or any oce locations and won’t divulge personal
information like travel plans.
Nevertheless, Block polishes a kiss-o bravado. Despite a wardrobe
of bespoke suits, he has a penchant for gangster rap and peppers conver-
sations with choice profanity. Muddy Waters’ earlier website showed two
dapper models posing under the letterhead for a ctional brokerage rm,
“Churnham & Burnham.” Research reports—enlivened with quotes
from hip-hop stars like Notorious B.I.G.—tend toward the incendiary.
One title: “Is ‘Independent’ Verication in China Better Than Toi-
let Paper?”
Despite e-mail threats, Block vows not to be pushed around by what
he describes as a “thugocracy” of China’s business and political elite.
Born into a family of renegades, Block’s contrarian tendencies trace back
to childhood. One key role model: his father, William A. Block, a polio
survivor who still has issues with the establishment. “I hate authority,”
says William Block. “So does Carson.”
The elder Block’s Wall Street career is a worthy tale in its own right.
Shortly after graduating from USC in 1966, he landed a job as a junior
analyst at Tri-Continental Corp., a venerable closed-end stock fund run
by J.W. Seligman & Co. It was terrible t. “The investment committee
was made up of stodgy, blue-blooded a------s,” the older Block says.
Block had a penchant for picking small-cap winners—and getting
his ideas shot down. His rst year on the job, Block recommended
McDonald’s—the great growth stock story of the decade. “Who would
want to buy this company?” one committee member demanded. “All
they do is sell hamburgers!” Other picks included Health Corporation of
America, H&R Block, and what became Tenet Healthcare. The com-
mittee usually ignored him. “I didn’t think they knew s--t,” he says.
“They didn’t like me either.”
In 1971, Block quit. An avid athlete, he started a squash club in
Chatham, New Jersey. In the late 1960s, he met his future wife and mar-
ried her in 1974. Carson was born two years later. The family moved
from New York City to Summit, one of New Jersey’s wealthiest sub-
urbs, where luxury cars, swimming pools, and country club member-
ships determined the social pecking order. Among its famous residents
was former Goldman Sachs Group CEO Jon Corzine, who went on to
become a New Jersey senator and then governor.
Block: Playing the China Hand 133
The Blocks denitely did not t in. William Block drove a bat-
tered grayish Chevrolet Nova with a cracked window shield, its bumper
secured with duct tape. The Blocks separated when Carson was six, his
father taking a townhouse in the adjacent town of Chatham. Over the
years, as their interests became more aligned, Carson gravitated more
and more towards his father.
The separation was tough on Carson—and both parents compen-
sated. An only child, Carson pined for a dog, so his mother bought
him an African Basenji named Wysches, which tore apart Carson’s
mother’s house.
Disillusionment fed into an early rebelliousness. In elementary
school, Carson was suspended and banned from eld trips for his
backtalk. Along with his best friend, Daniel Devroye, Carson began
a campaign to undermine the school “safety patrol,” which was what
the well-behaved children joined. “Carson and I thought there was
something fascistic about it,” says Devroye. “The kids were being
co-opted.”
By 1982, the older Block returned to Wall Street, this time as
analyst for a progression of sell-side brokerage rms specializing in dicey
small caps—Rosenkrantz Lyon & Ross, Triad Securities, Buckingham
Research Group, and M.H. Meyerson & Co. Carson, always interested
in his father’s work, constantly peppered him with questions about
the markets.
Amidst his campaign of hit-and-run rebellion, Carson by middle
school had moved in mostly full time with his father. He would binge
on junk food, engage in petty shoplifting, and have pizzas delivered to
classrooms at school. Once, the police detained Carson and Devroye
for loitering at the local mall. “I was terried,” recall’s Block’s friend.
“Carson just played it cool.”
William Block tried his hand at discipline, but his heart wasn’t in
it—something Carson picked up on. Their relationship was more like
that of siblings than father and son—competitive, bickering, yet intensely
close. Secretly, William admired Carson’s nerve, condence and growing
poise. “He is what I’d like to have been,” he says. “He was always very
savvy. He’s always been attractive to women.”
For years, the fathers running the local Little League blackballed the
crusty, Chevrolet-driving William Block from managing a team. When a
134 THE MOST DANGEROUS TRADE
manager dropped out, they relented. The Lions’ uniforms were mis-
matched, the players spontaneously changed positions in the eld, and
the team nished dead last. The kids loved it.
Carson was of two minds about the Summit social scene. On the
one hand, he felt it extremely provincial. “The parents felt they were
raising their kids in this safe environment,” Block says. Instead, it was
the kind of highly pressurized social scene that often results from living
in a bubble. For teenagers, including Block, booze was one escape. “It
was party at my place, party at your place,” Block recalls. “It wasn’t really
a party. It was more or less the same people sitting around getting drunk.”
A so-called “funnel club” included members who used a funnel to pour
straight vodka down each other’s throats. Block was not a member.
Summit High School ran a sister city exchange program with
Toyomashi, Japan. Fullling a boyhood dream, Block took a horizon-
expanding trip there, in the summer between his freshman and
sophomore years. The experience got Block thinking about global
markets as they toured metal workshops and factories. “I’d say, ‘Imagine
you’re the guy selling Pepsi in China,’” Block says.
His father bought him a copy of Security Analysis, the denitional
tome on value investing by Benjamin Graham and David Dodd.
“Unlike Warren Buett, I didn’t read the whole thing,” Carson says.
Still, his interest in markets grew. He accompanied his father to Wall
Street, where he learned how to build spreadsheets, with columns for
revenues, expenses, and prots. “He was curious, he was intrigued,”
says William Block. “He liked the idea of making money and the
lifestyle Wall Street oered.”
Block passed his Series 7 securities broker exam at age 18. Ever pre-
cocious, Carson even called clients about stocks, once convincing a fund
manager to buy 100,000 shares of Anchor Gaming.
Applying for college, Block steered clear of Ivy League and other
highly competitive options, targeting party schools like Tulane Univer-
sity, Notre Dame, and USC. His essay for USC was a personal one: How
much he admired his father.
Envisioning a career in Asia, Block headed west to USC with its
Pacic Rim campus and big Asian-American student body. He was soon
immersed in the culture and languages of the Far East. With its bright
sunshine, Mediterranean-style architecture, and palm trees, it was a wel-
come change from New Jersey.
Block: Playing the China Hand 135
His rst roommate was Jason Tsai, a native of Taiwan, with whom
he shared his aspirations. “He said China would be the next big thing,”
says Tsai, who helped Block with his Mandarin and got him hooked on
ma la kuo, a spicy Chinese stew.
At Tsai’s suggestion, Block joined the Asian students’ association.
Later, after Block returned from summer school in Beijing, Tsai recalls
his business idea to introduce Chinese companies to U.S. mutual funds.
Block had promised his parents he wouldn’t pledge to a fraternity.
But he pointed out that the business fraternity, Alpha Kappa Psi, was a
great way to further his commercial contacts. Adding to the fraternity’s
interest: It was nicknamed Asia Kappa Psi, as a majority of the mem-
bers were of Asian heritage. Block won an election as pledge class party
planner, campaigning on his credentials as a licensed bartender.
In junior year, he was a member of the Alpha Kappa Psi team com-
peting in USC Business School’s inaugural business case study compe-
tition. Most of the rest of the team blew the project o, leaving it to
Block and a friend, Arvind Mishra, to keep the fraternity from looking
bad in front of the school, and the team from looking bad in the eyes of
the fraternity.
The case study involved a struggling laundromat, which was pre-
sented with three business opportunities from which participants had to
select one. Based on the nancials furnished, all the alternatives were
terrible. “We knew all three options sucked,” says Block.
At the presentation, Block and Mishra explained as much to the
judges, walking them through the poor economics of the options. They
then presented a list of better ways to employ the capital. First—buy an
army of penguins and put on a show.
“That will make money because everybody loves penguins,”
Block said.
Second—buy O.J. Simpson’s Heisman trophy.
“That will certainly increase in value,” Block deadpanned.
Block continued through eight more alternatives, like a late night
TV comedian.
The judges were silent for a minute before bursting into applause.
The Alpha Kappa Psi fraternity won the competition—and one judge
oered Block and Mishra jobs.
In his senior year, Block wrote a letter to Jon Corzine, then at
Goldman Sachs. He was interested in investment banking and though
136 THE MOST DANGEROUS TRADE
he had slim hopes of landing a job at the rm, he had been friendly in
high school with Corzine’s son, Josh, and could use some insights into
the business.
Corzine, who with his neatly trimmed beard and wire-rimmed
glasses had a professorial look about him, graciously welcomed Block
to the rm’s gray granite monolith headquarters at 85 Wall Street.
They talked about the investment banker career path. Typically, a new
hire with an undergraduate degree would join as an analyst in the
investment-banking department and, after two years, leave for business
school. After earning an MBA, a dierent bank would typically hire
him or her as an associate. Yet a few of the analysts would become
associates without leaving to get their MBA. Block’s question was why
Goldman insisted analysts return to business school for their MBAs and
whether that could be avoided.
“If we don’t feed the business schools, we will lose our recruiting
privileges,” Corzine responded. “Merrill Lynch and Salomon Brothers
would keep theirs.” It was a lesson in the riptides of hidden interests that
churned beneath the surface of the business world. “That was an ‘a-ha’
moment,” Block says.
Ultimately, Block realized his goal was to head east—with the
cushion of cash he built helping his father, he booked a ight to
Shanghai to nd his fortune.
Block settled in, planning to follow through on his plan to write
research reports about Chinese companies for foreign investors. He net-
worked with expatriates, hanging out at a watering hole on Mao Ming
Road called The Stock Bar.
There was a gold rush mentality to the city. To Block’s amazement, a
local operator gave lectures at the Stock Bar on how to manipulate stocks,
which he explained was part of company policy. The idea was to invest
on Monday morning and wait until promoters hyped the stock over the
next two days, then dump shares late Wednesday. Companies not only
approved, they participated—buying alongside the manipulators. With
the prots companies reaped they could report earnings surprises and
goose the stock further.
“I came to the conclusion there were no companies that were
investable,” says Block. “The stock market was really a policy tool—it
gave people the ability to dream about becoming rich. It kept them
Block: Playing the China Hand 137
from protesting in the street.” In fact, the government wouldn’t list
good companies at the time, because doing so would throw a light on
how poorly the public ones actually were.
In 1998, Block headed back to Los Angeles to take a position
at CIBC World Markets as an investment banking analyst. It was a
small oce of seven bankers; the work was uninspiring and the hours
grueling. He nevertheless learned skills. Analysts were required to create
all the pitch books, including graphics. Block also became procient in
building nancial models with balance sheets, cash ow, and income
statements. All this would come in handy when he turned to researching
and publishing on his own.
The next year, Block announced to his father that he wanted to work
at WAB Capital. William Block hated the idea, but when Carson told
him he had already quit CIBC, there was not much to debate.
WAB’s dicey business model—being paid by small companies to gen-
erate research in exchange for stock or warrants—worried Carson. It
was an era when institutions were slashing commissions, and plenty of
analysts were casting about for new ways to make money. “We felt we
were managing the conicts,” Carson says, pointing out that if a com-
pany didn’t pass muster, WAB simply wouldn’t publish.
WAB took a hit with Rent-Way Inc., a company it covered that
leased electronics and computers to a low-income clientele. It turned
out the chief nancial ocer was understating expenses in order to
inate prots. The stock plummeted and WAB was left awash in losses.
“I said ‘F--k this,’” Carson recalls. “I don’t want to be in equity research
anymore.”
Block decided it was time to get serious about starting his own
business and resolved that a law degree would provide him the tools
he needed. He enrolled in Chicago-Kent College of Law, expecting
to suer. “I’m here to learn what I need to become a business per-
son,” he recalls thinking. Instead, he found himself fascinated by the
law, and not just the corporate-related subjects. “Lo and behold, I really
enjoyed law—criminal law, torts, constitutional law,” he says. In addition
to making law review, he was named to the moot court honor society
and became president of a law school honor fraternity, Phi Delta Phi.
Block also married his wife, who he had met at USC. He asked that her
name not be published for security reasons.
138 THE MOST DANGEROUS TRADE
Block was suddenly hot law rm property. “Because I enjoyed law,
I thought I will practice law,” he says. He soon jetted o to Hong Kong
and Shanghai, upon arrival cold-calling managing partners at major law
rms. Jones Day, the global rm with headquarters in Cleveland, Ohio,
hired him in the summer of 2005.
It was interesting work for 15 months—Block’s business background
helping him work on the proposed leveraged buyout of construction
giant Xugong Group Construction Machinery, at the time China’s
biggest—although his client ultimately lost. Then, the businessman in
Block began to get the upper hand. “I was getting the itch to be a
nancial entrepreneur,” he says. “I gured to help the Chinese manage
their wealth outside China.”
Block registered his new wealth management company in
Singapore—Yi Bao Sheng Ptl Ltd, or YBS, which means “easy to attain
treasures.” The plan for YBS was to focus on the burgeoning capitalist
class that was growing up in China’s so-called third- and fourth-tier
cities, places like Wenzhou and Nanking with growing economies that
bigger players like Goldman Sachs and UBS had yet to target.
As he began laying plans to get YBS o the ground, two other
projects presented themselves. He and a businessman with a China
background collaborated to co-author an installment to the wildly
successful For Dummies series, Doing Business in China for Dummies
(John Wiley & Sons, Inc., 2007). The book, a primer for prospective
entrepreneurs, belies its low-brow title, humorously dispensing smart
advice on the protocols of declining duck tongues at business banquets,
the proper way to behave when addressing high government ocials,
and the etiquette of business meetings. It also carries sharp guidance
on hiring and terminating employees, negotiating contracts, and
interacting with the Communist Party, local government, and People’s
Liberation Army.
An acquaintance named Zhao roped Block into a new venture
bankrolling China’s rst self-storage facility. Block intended to be a
passive investor, but he could see the opportunity: With the growth of
Shanghai’s wealth and increasingly expensive real estate, the business
made sense on a number of levels. An uncle of Block’s had run a
self-storage business in the United States and regaled Block with tales
of the 50 percent cash on cash returns it generated, not including
Block: Playing the China Hand 139
real estate. As a kicker, Zhao agreed to let Block use oce space at the
new self-storage company for YBS.
The venture was a slow-motion disaster. From his original passive
stance, Block soon agreed to help build the company with Zhao and
then retreat into the background. He put his plans for YBS on hold, and
then abandoned them altogether. With Zhao, he named the company
Love Box Self Storage, and leased a 14,000-square-foot space near central
Shanghai. The plan was to build top-line growth as a way to generate
investment interest and then move the storage business into ever more
economical locations. Zhao soon lost interest and Block bought him
out, bringing his investment to nearly $400,000.
Building the physical facility, though, was a nightmare. “Nothing
they said would be done was done,” says Block. “Construction quality
wasn’t there.”
The build-out was as tortuous as it was time consuming. “We had a
45-minute conversation about what kind of screws we would use in our
partitions,” says Block. “It was an epiphany. Companies are not driven by
nancial models. It gave me an appreciation of what went into running
a company.” Ultimately, the steel container units were ordered from and
manufactured in the United States.
By early 2010, Block was being hit up routinely for bribes by
contractors—which he wouldn’t pay, not just on principle, but because
it would jeopardize his standing as a United States–qualied lawyer.
While the contractors were a problem, the landlord was worse. It turned
out the holder of the property was not precisely who the lease suggested
it was. His landlord had presented itself as a subsidiary of a state-owned
enterprise. Instead it was privately owned, and Block discovered it owed
millions of dollars to the local government and private contractors.
That rendered his lease problematic, so Block withheld rent until his
landlord resolved its government problems. “They threatened to shut
down utilities and ban us from the premises,” Block says. “It was going
to be an extinction-level event.”
Block rented a generator, installed gates on the windows, and
brought in air mattresses and provisions. He lobbied the local gov-
ernment. “We were prepared to hang banners out the window,” he
says. At the 11th hour, following a call from a local Communist Party’s
secretary’s oce, the landlord relented. Nevertheless, Love Box was
140 THE MOST DANGEROUS TRADE
a costly lesson. “We sold it for $125,000 net in August 2012. It cost
me $600,000,”says Block. “It was payment for my Ph.D. in Chinese
business.” The tribulations of Love Box also steeled him for his new
career as a short seller.
It also fomented Block’s go-for-broke attitude. “Having nothing to
lose: there’s a real power in that,” he says.
Indeed, Orient Paper responded to Muddy Waters’ report two days
after it was published by atly denying virtually every negative assertion.
It claimed that that Block and Regan had researched the operating sub-
sidiary of an entirely dierent company. Five weeks later Orient Paper
published a more comprehensive rebuttal, 11 pages long—essentially
reiterating its claims concerning production, capital spending, feedstock,
and nancials. On November 29, Orient Paper presented the ndings of
an independent committee comprised of Loeb & Loeb LLP, Deloitte &
Touche Financial Advisory Services Ltd., and TransAsia Lawyers, exon-
erating the company on all counts.
The market didn’t buy it. The stock hit a low in August 2010 of
$4.08, before rallying to close out the year at $6.36. By late 2012, it was
trading at under $2.00. In early March 2015, Orient Paper traded for
95 cents.
The days and weeks after the Orient Paper research report were
a urry of activity. Muddy Waters issued follow-up reports, and the
often-somnolent Chinese news media began to investigate Orient Paper.
Meanwhile, Block found himself in demand. “I learned this was the
tip of the iceberg,” Block says. “People are e-mailing, calling, Skyping.
This company is a fraud, that company is a fraud. It was investors, funds,
short sellers.”
Some communications were less welcome. “Bullets to the brain
can be quite painless,” read one anonymous e-mail message. A blogger
posted his father’s address in Los Angeles—suggesting a group visit by
Orient Paper investors.
Though Block ultimately lost money on the deal, he knew he had
stumbled on a business opportunity, but needed to decide how to pro-
ceed. Should he sell his bearish research by subscription? Or publish
it for free on the web? Should he perform contract research for U.S.
investors? “I was discussing it with friends and family, talking to fund
Block: Playing the China Hand 141
managers,” Block says, “It was an exciting time. I was on the cusp of a
new career.”
One burning question was whether his new career would let him
remain in China. To Block’s thinking, he was protected to some degree
after Orient Paper in that if anything should befall him, the police would
have a single and obvious prime subject to pursue. Anybody thinking of
harming him would be keenly aware of that. If Muddy Waters began pub-
lishing multiple reports, the pool of motivated suspects would grow, pro-
viding some safety to a potential predator. Regardless, Block began pulling
together a team of researchers and analysts. “We always look for particu-
lar skill sets,” says Block, who declines to identify any of his colleagues.
“They have to be true believers. We are punishing the wrong-doers.”
Among the ood of tips proered was one concerning RINO Inter-
national Corp., a manufacturer of ue gas desulphurization equipment,
which scrubbed pollutants from steel plant emissions. Based in Dalian,
China, and listed on the NASDAQ Stock Market, there were a series
of warning ags in its presentations and SEC and SAIC lings. As was
the case with Orient Paper, no single line item in the compendium of
evidence proved decisive. Instead, Block says the accumulation of ques-
tionable income and balance sheet items combined with kick-the-tire
research convinced him the company’s credentials didn’t pass muster.
The balance sheet, for example, showed a preponderance of paper
assets: As of June 30, 2010, the company reported tangible operating
assets of $17.4 million, just 8.3 percent of total operating assets of $209
million. This was particularly strange for a manufacturing company like
RINO. Industry rivals reported tangible operating assets of more than
60 percent of the total. “Document forgery is so prevalent,” says Block.
“We thought so much of this could be faked.”
Next, Muddy Waters analysts zeroed in on raw materials in rela-
tion to revenues. Sales, earnings, and cash ow gures are relatively easy
to massage and sneak by inattentive auditors; raw material balances, by
contrast, are more dicult to fake and remain one of the best ways to
measure a manufacturer’s production. From 2007 through 2009, contract
revenues at RINO grew more than fourfold, to $187.5 million. Yet raw
material balances had risen little more than 33 percent, to $246,798. That
pointed to another suspicious ratio: Contract revenues totaled more than
142 THE MOST DANGEROUS TRADE
750 times raw material balances at the end of 2009. At competitors, that
gure was in the low to mid teens. Either RINO was astonishingly more
ecient than its rivals or something wasn’t right.
Again comparison to rivals turned up questions—if no smoking
guns. The company told Muddy Waters Research that gross margins on
desulphurization gear, which accounted for 70 percent of RINO’s total
revenue, were 35 percent or more. Two larger competitors, by contrast,
reported margins of 20 percent and 11 percent. That made no sense.
Block consulted an engineer at the in-house research institute of one
of China’s biggest steel companies, Baosteel Group, to evaluate RINO’s
technology. The expert—who requested anonymity—told him RINO’s
system had a relatively low sulfur reduction rate and had higher operating
costs because it took longer, used pricier chemical additives, and had
a bigger physical footprint than its competitors’ equipment, amongst
other things.
A Muddy Waters analyst, claiming to represent a steel mill in the
market for a ue desulphurization system, surveyed nine steelmakers that
RINO executives listed as customers in an investor presentation it gave in
March 2010. Five of them outright denied having bought RINO gear
while at a sixth steelmaker the executive in charge of such purchases
claimed to have never heard of RINO.
RINO, like many RTO companies, was structured using something
called a variable interest entity, or VIE. This complicated structure was
designed to allow management to tap oshore capital while retaining
technical ownership, as required under Chinese law in many restricted
industries, like the Internet and, in this case, steel. The VIE, controlled
by management, ran and technically owned the operating business.
But through a series of legal contracts, all prots, liabilities, and legal
powers, like the power of attorney, are supposed to be channeled to the
foreign-owned entity, which is typically domiciled in the Caribbean
and traded on a North American stock exchange—in this case,
RINO. To Block’s amazement the money was owing in the opposite
direction—from the operating company, RINO, to the VIE, controlled
by RINO CEO Dejun Zou and his wife, chairwoman Jianping Qiu.
The most vexing issue in dissecting RINO was its tax situation.
The company in its SEC ling reported paying no income taxes in
2008 or 2009—though it should have been paying at least 15 percent,
Block: Playing the China Hand 143
according to Muddy Waters calculations. Then there was the Value
Added Tax (VAT) reported by RINO. Virtually all companies in the
Peoples Republic of China pay a VAT of 17 percent. However, the
amount reported by RINO over the course of several years implied
that RINO was underreporting its revenues by large amounts—62
percent for 2009. In fact, they were reporting real revenues to the tax
authorities and false ones to investors. Block did notice that RINO had
been through four chief nancial ocers in three years.
RINO traded at $15.52 on November 10, 2010. Block had no
problem borrowing shares to short. He won’t disclose how many shares
he shorted, nor whether he bought any put options. Block does say he
entered some limit orders to lock in prots if the stock tanked.
The truth was that RINO shares were already under pressure, as
several analysts had downgraded shares citing rising competition in the
ue desulphurization market: The stock had fallen from a high of $31.25
in early January to $15.52 the day before the Muddy Waters research
report was released on November 10. Shares began to tumble, closing
the day at $13.18, and RINO’s chief nancial ocer was quoted saying
the company was considering legal action. The company scheduled a
conference call to address the Muddy Waters report for a week later.
(Block later admitted in a 2014 Wall Street Journal article that he had
sold a copy of his RINO report in advance to an investment rm before
releasing it).
Block decided he wasn’t going to wait around to hear what manage-
ment had to say. Breathing a sigh of relief, he settled back into a hired
minivan and headed out to Shanghai Pudong International Airport with
a one-way ticket, an assortment of bags, and his two cats, leaving behind
Love Box and his dreams of a life as a Chinese businessman. “I had to get
the f--k out of China, especially with that report out,” he says. Block
still grouses about the $1,500 in excess baggage fees he coughed up to
United Airlines. Upon arriving in Los Angeles, he called his broker-
age rm to nd out where the stock closed. All the limit orders had
been triggered.
The next week, at 7 p.m. New York time on November 16, the
RINO call was set to begin. Shares had closed at $7.15. The confer-
ence moderator announced a delay of 10 minutes—and then abruptly
cancelled the call altogether. The next day, shares fell to $6.07, and the
144 THE MOST DANGEROUS TRADE
company led a statement with the SEC quoting CEO Dejun Zou say-
ing that two of the six ue desulphurization contracts pegged as likely
shams by Muddy Waters were “problematic.” On November 18, RINO
led a second statement saying its three previous quarters’ nancial state-
ments should not be relied upon—insofar as they included data from
2008 and 2009. Its stock was suspended and reopened on the pink sheets
on December 8, declining to $3.15. By year-end, shares RINO traded
at $4.04 and in March 2015 for under a penny.
From the safety of San Francisco, Carson Block directed the
campaign against his next target, China Media Express Holdings, a
company that sold advertising over video monitors installed in intercity
buses traveling between major Chinese cities like Shanghai, Shenzhen,
and Beijing. Investors began badgering Block to investigate China
Media Express Holdings shortly after Muddy Waters published the
Orient Paper reports. The years building nancial models and analyzing
balance sheets had instilled in him a sensitivity to the kinds of business
characteristics that signaled problems. “I read the numbers, read the
story,” Block says. “It just smelled.”
The premise for the China Media Express business model was indeed
on the surface somewhat questionable. The demographics of intercity
bus riders in China are unattractive. With an impressive air route sys-
tem, world-class high-speed trains, and a fast-improving highway system,
intercity buses are typically lled with farmers and low-paid factory
workers. Not a choice customer base—and one that Block doubted
could generate the $290 million in annual revenues the company claimed
for 2009.
Nevertheless, China Media Express’s biggest shareholder was C.V.
Starr & Co., the insurance agency overseen by former American Inter-
national Group. CEO Maurice “Hank” Greenberg, a seasoned China
hand. A Starr executive sat on its board. China Media Express’s audi-
tor was no second string bean counter, either, but the China aliate of
Deloitte Touche LLP, the Big Four juggernaut.
In its investor presentations and SEC lings, China Media Express
cited copious data and analysis it commissioned from CTR Media
Intelligence, a Chinese market research rm, to back up its claims
regarding its network, viewership, and demographics. If Muddy Waters
could establish that the information CTR was generating wasn’t
Block: Playing the China Hand 145
accurate, Block would have a powerful basis for questioning China
Media’s fundamentals.
Block instructed one of Muddy Waters’ analysts to approach the
China Media Express sales department and describe himself as a clothing
designer looking to buy advertising time. That’s legal, but ethically
debatable. In business parlance, misrepresenting one’s identity to gain
information is referred to by a benign-sounding term, pre texting,which
certainly sounds better than, say, lying.
Block makes no apologies. “Pre texting is entirely justied because
we are investigating criminal activities,” he says. “You have to use mea-
sures that go beyond walking in the front door.” With a certain disdain
he adds: “That’s what sell-side analysts do.”
Regardless, the Muddy Waters analyst, whom Block declines to
identify, turned up incriminating information by scrutinizing the China
Media Express advertising kit he was e-mailed. For example, China
Media Express’s press releases claimed that over 27,200 buses plied its
intercity network of routes. The ad kit it furnished to Muddy Waters
claimed the company had less than half that amount, only 12,565 buses.
A China Media Express salesperson conrmed the doctored num-
bers in a taped phone conversation with the analyst. “When we reported
the details to the stock market regulator, we didn’t report the number
of vehicles we quoted you. The number we reported is times two, or
doubled,” she said.
The largest client mentioned in the CTR report, Shanghai Ba-Shi
(Group) Industrial Co. Ltd, upon questioning by Muddy Waters, said it
did not have a business relationship with China Media Express. Among
the buses purportedly in the China Media Express network equipped
with the proper gear, fewer than half were actually airing the advertis-
ing. Block dispatched an analyst to Shanghai’s central bus terminal and
showed that mostly they were airing DVDs of current movies provided
by travelers themselves or commercials produced by the local govern-
ment to drum up interest in local events.
Muddy Waters analysts surveyed six major buyers of outdoor digital
media in China: None had heard of China Media Express. The company
claimed that three of its top ten advertisers were China Mobile, Master
Kong, and Coca-Cola—all of which were represented by media buyers
who claimed they had never heard of China Media Express.
146 THE MOST DANGEROUS TRADE
Lastly, in December 2010 China Media Express had launched what
it described as an online shopping platform and had claimed that Apple
Inc. or its distributor were among the companies that had signed on
as participants. Upon questioning by Muddy Waters, Apple denied that
was the case.
Block points out that Muddy Waters’ research didn’t show China
Media Express was a total fraud, only that it was vastly overstating its
business and revenues. For example, Block pegged 2009 revenues at no
more than $17 million versus the $95.9 million China Media Express
reported. And if the nancial statements were to be believed, there was
a fair amount of cash on China Media Express’s balance sheet: about
$170 million. All told, Muddy Waters’ report valued the stock, trading
at $16.61, at $5.28. Block thought the value would be much lower if the
cash wasn’t there.
As Block and his colleagues wrapped up their research, it became
apparent that other shorts had taken an interest in the company. Andrew
Left of Citron Research, for example, was growing increasingly skeptical
about the scale of China Media Express’s business. On January 30, he
published a scathing note about the company—observing in particular
how major advertising surveys in the country failed to make mention
of what he called “the phantom company.” Another short seller, John
Hempton of Bronte Capital, had also posted negative comments about
China Media Express. Block began borrowing shares in the last week of
February—as apparently did other investors. Short interest as a percent
of China Media’s free oat had risen to nearly 25 percent from 10.2
percent three months earlier.
When Block released his report, the eect was devastating. Shares
fell 33 percent in a day, tumbling to $11.01 from $16.61 a share.
Unlike RINO, which essentially folded in the face of Muddy Waters’
accusations, China Media struck back—for starters castigating Muddy
Waters for releasing the report at the outset of the Chinese New Year. In
a press release a week later, the company quoted its CEO, Zheng Cheng,
denying any inaccuracies in its numbers, pointing out that Deloitte had
audited them.
Others facilitators fell in line. On February 17, Ping Luo, an analyst
at Global Hunter Securities issued a report on China Media Express say-
ing that she had reviewed contracts, tax lings, and bank statements and
Block: Playing the China Hand 147
found nothing remiss. Luo claimed to have met with bus company exec-
utives and conrmed the number of buses under contract with China
Media Express. She also met with advertising clients who, once again,
conrmed their relationship with China Media Express. Luo reiterated
her $26 price target.
Bloggers disparaged Block. One website posting claimed to be filing
a class action suit against him. China Media Express shares seesawed
between $11 and $14. Block again declines to reveal specics of his
short position.
On March 14, China Media Express announced that Deloitte
Touche Tomatsu had resigned. So too had the company’s chief nancial
ocer. At Muddy Waters’ oces, it was st bumps all around. “It
had been a really bitter battle, with numerous nasty things put on the
Internet about me,” says Block. “It felt absolutely great.” NASDAQ
halted trading in the company’s stock. When they opened 35 days
later on May 19, they fell to $2.16. Block won’t say what Muddy
Waters’ prot was on the trade except to say that it exceeded the prot
for RINO.
Muddy Waters was making a name for itself—challenging the nan-
cials of not just Orient Paper, RINO, and China Media Express but
with varying degrees of success a smattering of other dubious prospects
too: It accused Duoyan Global Water, Inc. of forging audit documents;
Spreadtrum Communications of aggressive accounting; and New Ori-
ental Education and Technology Group of claiming to own its entire
network of schools while, in fact, it franchised some of them.
Newspapers in the United States, Canada, and even China itself had
begun portraying Block as the “go-to” guy for RTO fraud. Investors,
including rival short sellers, would call in regularly with tips. And in
mid-2011, Block picked up the phone and began talking with an investor
who was skeptical about Sino-Forest Corp., a timber company based in
Hong Kong and Missewea, Ontario, whose shares were traded on the
Toronto Stock Exchange.
Sino-Forest was no run-of-the-mill penny stock. It purported to
be a major harvester of timber, which it turned into a variety of prod-
ucts, including plywood, veneer, and wood chips for China’s burgeoning
construction industry. Over ve years, earnings had surged 28 percent
annualized on sales growth of 41 percent.
148 THE MOST DANGEROUS TRADE
With a market cap of $4.2 billion dollars, it was worth four times
Orient Paper, RINO and China Media Express combined—and it
had some $2 billion in debt outstanding. While Sino-Forest went
public via a reverse takeover in 1994, since then Morgan Stanley had
underwritten shares in 2004, giving it a respectable imprimatur. Credit
Suisse and Dundee Capital Markets had also sold shares. And unlike
other RTOs, whose auditors were China-based, Sino-Forest relied on
Ernst & Young Canada.
Adding luster to the Sino-Forest story, three of the biggest
shareholders had gilded reputations: John Paulson of Paulson & Co., the
hedge fund rm that had made $4 billion wagering against the housing
market in 2008; Fidelity Investments; the giant mutual fund rm; and
Singaporean sovereign wealth fund Temasek Holdings.
Muddy Waters’s research was extensive—one requiring more than
two months of work by ten analysts, who panned out to ve dierent
cities. Muddy Waters retained four dierent law rms as outside
counsel. The analysts plowed through tens of thousands of pages of
SAIC documents—noting dozens of red-ags, accounting discrepancies
and questionable transactions on numerous whiteboards in their Hong
Kong oces. Every couple of days, an analyst would come across
an incriminating piece of evidence. “Oh my God!” he would shout.
“I found another one!” They found more than a dozen serious issues.
It was an exhilarating paper chase. “The smoking guns were all in
the SAIC les,” says Block. “We ran out of whiteboards.”
The problems lay in Sino-Forest’s byzantine corporate structure. It
relied on six so-called “Authorized Intermediaries” to handle essentially
all of its forestry business. The shadowy A.I.s, as they were known, would
buy the timber, process the wood, and sell it. In so doing, they were
acting as both suppliers and customers to Sino-Forest.
Sino-Forest itself, however, would book the revenue and prot,
reimbursing the A.I. for expenses. The critical point was that the A.I.s
were responsible for all tax payments, including the VAT, the invoices
for which in China are key to tracking down fraud. The country has
controls in place to prevent money laundering, and a massive tax bureau
is actively engaged in doing so. The identities of the A.I.s, with the
single exception of one headed by a Sino-Forest executive, were secret,
allegedly for competitive reasons.
Block: Playing the China Hand 149
Without VAT invoices, there was no paper trail to verify Sino-
Forest’s revenues or prots. The company could claim what it wanted.
Muddy Waters calculated that the company was booking several
times more timber from Yunnan province than was allowable under
government quota limits for the entire province. Even if Sino-Forest
could produce the kind of timber product volumes it was claiming, the
road network in the remote region was far too primitive to support it.
In sum, by Muddy Waters’s estimates, timber assets in the region were
overstated by about $900 million.
There were moments of levity. Muddy Waters analysts found what
they believed was an obviously forged bank reference letter from HSBC
Holdings with fractured English that was a dead giveaway. Overall,
though, the scale and hubris of the operation were shocking. “They
didn’t have to forge VAT documents, they had the A.I.s deal with
that,” he says. “It was stunning.” Block says that ultimately, the vast
majority of gross prot simply never passed through the company’s
bank accounts.
Block met with a Sino-Forest executive at an investment confer-
ence in Hong Kong, pre texting, in this case, that he was a slow-witted
mutual fund analyst, brushing his hair forward to make himself look like
a rube. “I tried to appear disheveled, ‘Dumb & Dumber’ kind of look.
I asked dumb questions and then a leading one, say, on how they dealt
with currencies.”
The high trading volume of Sino-Forest shares kept the cost of the
borrow low, initially. Muddy Waters by this time had its own dedicated
trader—Block won’t disclose where.
Once again, Block worked late into the night before pushing the
button on the 39-page research report, laying out Muddy Waters’
findings.
The stock was trading at $18.21 when the report was released. Block
had set some limit orders to begin covering positions if the stock began
to fall. He got into a cab and called his trader—only to discover that the
shares had plunged below the limit order prices on their way to closing
out the day at $14.46.
The company responded in 24 hours. “The allegations contained
in this report are inaccurate and unfounded,” CEO Allen Chan said
in a press release, and soon promised a full-throttle investigation to be
150 THE MOST DANGEROUS TRADE
completed in two to three months. That was later postponed to the end
of 2011. Shares fell to $5.23.
On a June 13 conference call, Chan cut o an analyst asking pointed
questions about Sino-Forest’s cash balance. A high-pitched feedback
sound drowned out another query and the analyst was disconnected
from the call. Shares tumbled to $3.36 from $4.98. “It seemed as though
because we had lifted the veil, investors were now listening to the
company and thinking, ‘These guys don’t sound like business geniuses
who created billions of dollars of investor value,’” Block says.
On June 18, 2011, the Toronto Globe & Mail published a lengthy
article that among other things questioned Sino-Forest’s ownership of
swaths of Yunnan province forestry property. “They corroborated our
conclusion about the overstatement of timber purchased in Yunnan
province,” says Block. “That’s when I breathed a large sigh of relief.”
As with RINO, some brokerages rallied around the timber purveyor.
One Dundee Capital Markets analyst accused Block of shopping the
research report to hedge funds in the weeks leading up to the release.
And some investors piled in, seeking to prot from an expected rebound.
Wellington Management LLC snapped up beaten-down shares, buying a
7 percent position. Paulson, notably, did not, dumping his entire position
for a peak to trough paper loss of nearly half a billion dollars, with the
actual hit a fraction of that.
Within a week, the Ontario Securities Commission (OSC) opened
an investigation, and in late August it accused Sino-Forest executives
of inating revenues and misrepresenting timber holdings. The OSC
suspended trading in Sino-Forest shares and later referred the case to the
Royal Canadian Mounted Police for criminal prosecution.
Chan resigned that month. When Sino-Forest released its own
report in mid-November, the company’s independent directors said
that they had veried the company’s cash balances and conrmed its
rights to timber assets whose book value it also vouched for. “We can
categorically say Sino-Forest is not the ‘near total fraud’ and ‘Ponzi
scheme’ as alleged by Muddy Waters,” the report said.
Nevertheless, the company defaulted on a convertible bond debt
payment later that month. The Toronto Stock Exchange de-listed
Sino-Forest on May 9, 2012. Block declines to disclose Muddy Waters’
prot on Sino-Forest.
Block: Playing the China Hand 151
By then, however, the window for betting against China-based
U.S.-listed companies was closing fast in the wake of the negative short
seller reports. As their share prices dived en masse, China Development
Bank Corp. began nancing management buyouts of companies like
Harbin Electric, Focus Media Holdings, Fushi Copperweld, and China
Security and Surveillance Technology. All told, the state-run bank
committed more than $1.5 billion in nancing to pull them o the U.S.
exchanges. Roth Capital estimated 27 Chinese companies with U.S.
listings announced plans to go private through management buyouts in
2012, up from 16 in 2011. About 50 mostly small Chinese companies
“went dark” or deregistered with the SEC, meaning they needn’t le
public disclosures.
On the other hand, local Chinese authorities revved up their
repression of short sellers—or anyone else getting curious about
corporate nancials. Local city oces stopped furnishing the SAIC and
other lings so helpful in identifying frauds. Those requesting them
face harassment—or worse. “China has gotten harder in the sense that
the government has really taken the side of the fraud,” Block says. “The
government is working with a number of these companies to try to
conceal records that are public. That is one of the reasons we’re not that
interested in China anymore.”
(The apogee of government manipulation was in 2015. Chinese
A-shares more than doubled over 12 months until mid-June. Then, as
stocks reversed sharply, authorities panicked, curbing short sales, sus-
pending some stock trading, and using a state-owned fund to buy ETFs).
In November 2012, Carson Block—at the inaugural Sohn Confer-
ence Foundation investment forum in London—launched into a new
campaign, this time alleging the target company, a trading rm backed
by blue chip Asian institutions, had embarked on a capital expenditure
and asset purchasing “binge” that threatened its very solvency. Block
detailed a series of accounting missteps. Before the packed audience
of hedge fund managers in Grosvenor Square, he compared the rm
to Enron and said the company should be valued on a liquidation
basis, since it was unlikely to survive. Particularly notable was that
the company—commodities juggernaut Olam International—was
based not in China, but Singapore. (Temasek back stopped Olan and
152 THE MOST DANGEROUS TRADE
eventually purchased a majority stake in May 2014.) “We are done with
companies that operate in China,” Block declared.
Easier said than done for the China hand. Less than a year later,
on October 24, 2013, Muddy Waters released a research report on NQ
Mobile, a maker of mobile Internet services, including security, search
and games as well as enterprise-focused products. It alleged 72 percent
of the company’s security revenue was ctitious, that its antivirus soft-
ware was unsafe, and its cash balances were unlikely to be real. American
Depositary Receipts of the company, based in Beijing and Dallas, fell to
$10.63 from $20.10 before the report. NQ Mobile called the allegations
false and threatened legal action. ADRs traded in May 2015 at $3.81. For
Block, apparently, shing in the murky tidal pools of one of the world’s
fastest growing economies is to hard to resist.
Chapter 6
Fleckenstein: Strategies
and Tactics
B
ill Fleckenstein slammed the door to his black BMW 740i and
rode the elevator to the 4th-oor oces of his most famous
client, Paul Allen’s Vulcan Capital, the private rm that oversaw
the Microsoft co-founder’s $5 billion fortune. Fleckenstein, whom
friends call Fleck, was there to see Vulcan president Bill Savoy. In late
1999, the end-of-millennium Internet bubble was inating at mach
speed, generating billions for technology stock investors like Vulcan. By
contrast, it was open season on Fleckenstein’s eponymous bearish rm,
which had nearly been wiped out over the previous two years as wagers
against market darlings like Micron Technology, Compaq Computer,
and Gateway hemorrhaged cash.
Intel was trading at a price-earnings multiple of 80. An analyst had
just hung a $450 price target on a money-losing online retailer called
Amazon.com. And the stocks of personal computer makers were spik-
ing, even as the price of desktops fell below $1,000. The very name of
153
154 THE MOST DANGEROUS TRADE
Fleckenstein’s own hedge fund mocked him—RTM, for Reversion To
the Mean.
There was no reversion—only surging stock prices as investors
bet their life savings on something called the new economy.Now,in
Savoy’s oce, which looked out onto shimmering Lake Washington,
Fleckenstein told his favorite client he was ready to quit.
“I’m thinking about throwing in the towel,” he said. “I need to
maintain my sanity.”
Savoy held a Louisville Slugger baseball bat, taking practice swings
as they talked. He looked Fleckenstein in the eye and told him to hang
tough—that the hedge his fund RTM provided was critical for rms like
his. Fleckenstein’s insights were invaluable. The market would turn.
“You’ve got to stay in there,” Savoy said.
“But I can’t keep losing money for people,” Fleckenstein said. “I’ve
got to stop doing this.”
“No, you’ve got to keep on, Bill, you’re our insurance policy,” Savoy
said. The two discussed strategy changes for RTM, anything to relieve
the unrelenting pressure. “Do what you have to do,” Savoy concluded.
“But closing the fund is not any option.”
Savoy kicked in an additional $15 million—a lifesaver for his
beaten-down fellow investor.
Fleckenstein needed it. The next quarter, as he worked to revamp his
trading methodology, the NASDAQ Composite Index surged another
24 percent to its all-time peak of 5,048 on March 10, 2000. Staunch bears
packed it in: Loews Corp’s Larry Tisch covered the last of the company’s
short positions on the Standard & Poor’s (S&P) 500, locking in a stunning
loss of $2 billion. Julian Robertson’s vaunted Tiger Management hedge
funds, which had bet heavily against tech stocks, packed it in.
RTM turned in a stomach-churning rst quarter loss of more than
30 percent for the quarter. Without Vulcan’s capital injection, it likely
would not have survived.
Then, as they always do, the markets turned. The NASDAQ index
began a vertigo-inducing fall that would eventually vaporize 75 percent
of its value, equal to $5 trillion of market capitalization. RTM cashed
in as its bearish bets began to pay o, scoring a 58.1 percent gain for
the last three quarters of 2000, versus an 11.9 percent decline for the
S&P 500.
Fleckenstein: Strategies and Tactics 155
The next year, RTM notched a 33.1 percent gain as the index
tumbled another 11.9 percent, and in 2002, RTM posted a further
17.3 percent prot while the S&P 500 dropped 22.1 percent.
Fleckenstein’s resolute stance during the Internet bubble made him
a legend among short sellers—and sealed his reputation as a steel-nerved
contrarian seer. “It was strength and conviction,” declares Fred Hickey,
editor of Nashua, New Hampshire newsletter Hi-Tech Strategist,andan
outspoken bear at the time. “It takes condence, but not so much that
you’re arrogant.”
From there, triumph just followed triumph. By late 2003,
Fleckenstein was already warning of galloping speculation in the
housing market. “The Fed and government have attempted to bail out
the aftermath of our giant stock bubble with a leveraged real estate
bubble,” he wrote. “This will end in disaster.”
Fleckenstein, spot on, wagered against subprime lenders and mort-
gage insurers—including IndyMac, Countrywide Financial, and MGIC.
But as the bubble deated in 2008, he began to target economically
sensitive technology companies, a favorite being what was then called
Research in Motion, the Canadian maker of the BlackBerry mobile
phone, as well as banks and brokers such as Washington Mutual and
Lehman Brothers.
Though the market declined during that period, the Federal
Reserve’s eorts to manage the crisis, as well as other government
intervention, such as bailout legislation and the ban on short selling
nancial stocks, provoked violent rallies, making the lives of short sellers
like Fleckenstein dicult. The ban on shorting nancial stocks, absurdly
broad, included International Business Machines Corp. and Winnebago
Industries, two stocks RTM was short.
Nevertheless, in 2008, as the mortgage-fueled credit bubble deated,
bringing the world nancial system to the brink of collapse, the fund
gained 41 percent versus 28.4 percent for the average short-biased hedge
fund and the 37 percent drop in the S&P 500.
He nailed it again in March 2009, shuttering RTM within weeks
of the stock market low. A student of the crash of 1929, Fleckenstein
reasoned that in the kind of deep recession he foresaw, Federal Reserve
chairman Ben Bernanke would ood the economy with money, pump-
ing liquidity into the stock market. That would generate a gale force
156 THE MOST DANGEROUS TRADE
headwind for any dedicated short fund. “There was no way I was going
to ght that battle,” says Fleckenstein.
Today, short sellers are on the run—and not just because of the cen-
tral bank’s loose monetary policy, though that of course remains the most
important factor. Far too many investors are sifting the same fundamen-
tal data to identify protable short sale candidates. The signs they look
for are well known—compressed corporate prot margins, increased
account receivables versus sales, and high “days sales outstanding,” the
average number of days a company takes to collect revenue after a sale
has been made. All are bearish signals and all can be sussed and sorted
out with a click or two of a computer mouse.
“There are just a lot of guys looking at the same predictive indi-
cators,” says Claudio Chiuchiarelli, a partner at Banyan Securities of
Greenbrae, California, which caters to short sellers. “There’s too much
money chasing too few poor-quality companies, especially when you
include the short books of the long-short managers.”
The competition has inated the cost of borrowing shares. The rate,
known as the “borrow” in short-selling argot, tops 40 percent annualized
for hard-to-locate shares like Sears Holdings or Netix, double what it
was before the nancial crisis.
Macro funds managed by rms like Bridgewater Associates and
Brevan Howard Asset Management have surged in popularity, partly
because their returns do not track those of stock markets, though their
performance has turned lackluster of late. Such funds use currency,
bond, and commodity futures to wager on global economic trends. Of
course, with less skin in the equity markets, investors are less interested
in hedging their stock positions.
With the exception of 2011, when they eked out a 0.35 percent
gain, short-selling hedge funds have bled money every year since 2008,
according to Hedge Fund Research. The number of such funds tracked
by the rm has fallen to just 17 at year-end 2014 from 50 in 2009.
Assets under management are just $5.8 billion, down from $7.8 billion
in 2008.
“Practicing short sellers are an endangered species,” says Harold
“Fritz” Garrecht, former president of East Shore Partners, a brokerage
in Hauppauge, New York that was known for generating short-selling
ideas. “There are as many of them as pandas bred in captivity.”
Fleckenstein: Strategies and Tactics 157
As for Fleckenstein, today he manages a $70 million “go-anywhere”
fund, Fleckenstein Partners LP, that he invests as he sees t—longs,
shorts, or anything else. “I run it for friends, family, and a few like-
minded souls,” he says. In 2012, for example, it was heavily invested
in precious metals, both the raw commodities and mining stocks, both
of which should benet as the world turns away from the dollar as its
reserve currency. “I’m not expected to do anything specic,” he says.
“And I don’t have to explain what I’m doing.”
Fleckenstein, who has shoulder-length gray hair and favors brightly
colored shirts, has always charted an independent course—and kissed o
convention as he does. He advocates a return to the gold standard, dis-
misses reexive bulls as “U4ians,” and refers to CNBC, the business news
channel, as “Bubblevision” for its relentless stock market cheerleading.
When Mad Money T.V. host James Cramer before the 2008-2009
crisis began recommending Apple, Google, Amazon.com, and Research
in Motion to viewers, dubbing them the “four horseman” of the tech-
nology sector, Fleckenstein rechristened them the “four horseies” for
their high risk and high valuations. For Fleckenstein, sell-side analysts
are mostly “dead sh” who unthinkingly issue buy recommendations
on stocks they don’t know particularly well.
One Fleckenstein proposal—renaming the U.S. dollar the “Xera,”
a word he invented by combining Xerox, the copying machine brand,
with lira, Italy’s former, notoriously hyperinated currency. “‘Xera’
sounds like ‘zero,’ which is ultimately where the dollar is heading,”
Fleckenstein wrote.
Fleckenstein churns out contrarian opinions on his website, eck-
ensteincapital.com, and wrote a weekly column for MSN Moneyfor
10yearsaswell.His4,000websitesubscribersandMSNreadershave
helped bolster his position as an informal spokesman for what might
be called Bear America, a cadre who believes the Fed’s bouts of quan-
titative easing—buying back mountains of Treasuries and other bonds
to keep interest rates low—combined with a willingness to print money
are undermining the dollar, pumping up stock prices to dangerous levels,
and fueling a global, debt-fueled super bubble that will end in disaster.
Aable and self-deprecating, Fleckenstein turns scathing on the
subject of the Federal Reserve, especially its former chairman, Alan
Greenspan. “People don’t understand what a completely reckless and
158 THE MOST DANGEROUS TRADE
incompetent fool Greenspan was, even to this day,” he snaps. “In
addition to a nancially corrupt two-party political system, the biggest
problem we have is the Fed.”
In an act of catharsis, Fleckenstein wrote a best-selling book on
the topic: Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve
(McGraw-Hill, 2008). In it, Fleckenstein trawls through transcripts of
the Federal Open Market Committee from 1996–2002 (these are kept
secret for ve years) and compares them to the public statements of Alan
Greenspan at the time. “I remember seething as I read through the tran-
scripts,” he says. The book details contradictions, mistakes, and what
Fleckenstein sees as Greenspan’s utter indierence to the rampant spec-
ulation of the era.
Fleckenstein blames the Federal Reserve chairman’s loose money
policy for the Internet and housing bubbles. He slams Greenspan for
not tightening margin requirements, for ignoring evidence of a housing
bubble, and for lax regulatory oversight, including the abolition of the
Glass-Steagall Act, which until 1997 separated commercial lending from
riskier investment banking activities. “There is no debate: Greenspan
was no ‘Maestro;’ he was the master of the United States’ descent into
nancial turmoil,” Fleckenstein’s book concludes. “The evidence speaks
for itself.”
Whether you agree with Fleckenstein’s arguments or not, Greenspan’s
Bubbles was an act of market-timing genius, published at the cusp of
the credit crisis. It has been translated into a dozen languages, including
Russian, Chinese, Bulgarian, and Thai.
“Bill made the case as bluntly as anybody that this Fed chairman
was doing enormous harm to the economy,” says James Grant, editor of
Grant’s Interest Rate Observer. “It was a work of great passion and great
power in terms of its impact on Wall Street.”
In early 2015 Fleckenstein says that the Federal Reserve has “done it
again but only bigger” and produced not only another bubble in stocks
but also one in bonds. Current equity valuations as measured by market
capitalization to gross domestic product have only been exceeded in a
couple of quarters at the zenith of the subprime-fueled bubble. “When
these markets exhaust themselves and nally begin to decline, the ensu-
ing nancial disaster will be worse than in 2008,” he says, though it will
also be dierent. So Fleckenstein has readied plans to launch RTM 2.0,
Fleckenstein: Strategies and Tactics 159
a new fund, and will return to the short side once again as soon as he
feels the time is right.
For all his focus on the U.S. central bank, the public track record
speaks equally to Fleckenstein’s acumen as a bottom-up accounting
sleuth—making him one of those relatively uncommon investors who
can claim both great micro- and macroeconomic expertise. What he
unearths in SEC lings, balance sheets, and footnotes informs his short
positions, since he seldom bets against broad market indexes.
In 1998, Fleckenstein began shorting Gateway, a maker of budget
personal computers that he felt would suer as prices fell through the
oor. “I had a jihad for that company,” he admits. “It was just a com-
modity.”
In October 2000, Fleckenstein dug into new SEC lings, zero-
ing in on the sharp growth in the balance sheet item called “other
assets.” Fleckenstein was sure this reected the increased nancing Gate-
way was providing customers to bolster computer sales—a bright red
ag that the business was in trouble. Four weeks after his post on the
subject—“Fudgement Day”—the company announced it would miss
estimates and its shares lost nearly a third of their value. “It was a com-
plete bottoms-up detective case,” Fleckenstein says.
Another perennial Fleckenstein short was Dell. In July 2004, the
company raised earnings guidance by two cents, to enthusiastic market
response. Fleckenstein, who trained as an actuary, crunched the numbers
and found a rounding error in the company’s calculations. The mis-
take, it turns out, permitted Dell to trumpet improving protability. In
fact, a lower tax rate was largely responsible for the bump in earnings.
The Securities & Exchange Commission (SEC) subsequently investi-
gated Dell’s accounting. Its results have not been made public. Dell went
private in a management-led leveraged buyout in 2013.
All in all, Fleckenstein’s successes have made for a heady redemption
since the overwrought days of the Internet bubble. Even as the markets
pushed him to the brink of nancial ruin, he was under near constant
attack for his contrarian outlook—and for his readiness to talk publicly
about it.
E-mails and anonymous phone calls were vitriolic, message boards
sometimes worse: “total loser,” “pinhead,” “complete Bozo,” and “the
village idiot of the technology sector” are some examples. One accused
160 THE MOST DANGEROUS TRADE
him of making up numbers. Another compared him to cult leaders Jim
Jones and David Koresh.
“I even had subscribers to my website sending me hate mail,” says
Fleckenstein.
On television, anchors mocked Fleckenstein for questioning stock
valuations and advocating that investors avoid companies like Compaq,
Hewlett-Packard, Dell, and Gateway. “If I had followed your advice and
sold this market short at any point in the past three to ve years, I would
have lost my shirt, and you sir, I believe, lost money last year,” sniped
Stuart Varney on CNN Moneyline in February 2000. “What do you have
to say to that?”
Characteristically unappable, Fleckenstein responded that so-called
new economy valuations seemed to have no relation to prots. “I’m no
technophobe, but we’ve lost all sense of reality,” he said.
Like a lot of short sellers, Fleckenstein says an ethical impulse was
underpinning his advocacy at the time. “In the 1990s, I could see that
people were being led like lambs to the slaughter,” he says. “I wanted to
warn people.”
Says Fleckenstein’s younger sister, Mary Fleckenstein Simpson: “He
just wants to be right. I asked why he sat there and took it and he just
said, ‘I’m going to be right and they’ll remember.’”
That didn’t make it easy. “To see one’s neighbors getting rich by
doing the wrong thing is unbearable,” says Grant. “His interrogators
were pounding shivs of bamboo under his ngernails.”
Today, Fleckenstein works from a Mediterranean-style home in
the Madison Park district of Seattle; his spacious oce faces east,
toward Mercer Island, from which direction light oods in on a bright
September morning. Unlike most successful hedge fund managers
who buy lavish apartments or estates, Fleckenstein rents, in keeping
with his bearish outlook when he moved in. “I said, ‘I’m not going to
buy a house in the middle of a bubble,” he chuckles.
The room is dominated by a ve-foot-ten-inch-tall stued upright
black bear—a gift from a fellow short seller, now retired. The bear—who
has no name—wears a baseball cap emblazoned with what became a sort
of a mantra in the early years of the Internet bubble: “Dow 10,000.”
Initially, it was a sign of the euphoria overtaking the nancial system,
since the Dow Industrials traded at around 8,000 in 1996. When the
Fleckenstein: Strategies and Tactics 161
index surged past the 10,000 milestone in 1998, it became a slogan for
bears who foresaw a day of reckoning. The Dow peaked at 14,000 in
2007, and hit its nadir on March 2009, at 7,400. In March 2015 it traded
at 18,000 again.
Facing the big picture windows is a wall of Bloomberg terminals and
other computer screens. The decor speaks to the occupant’s relentless
Fed-watching. On the walls are caricatures of Greenspan—a bit obses-
sive, you might say. In a rst oor bathroom hangs a signed copy of a
Statement to Congress from October 17, 1979, by former Fed chair-
man Paul Volker, who Fleckenstein admires for his campaign to rein in
galloping 18-percent ination during his tenure. At their leisure, visitors
can ponder Volker’s handwritten missive: “Monetary policy can only be
part of the overall framework.”
Despite his dark economic worldview, Fleckenstein is upbeat. He
talks quickly, zipping from subject to subject. Fleckenstein will make
near-instantaneous connections between, say a balance sheet footnote in
a 10-K ling and a Financial Accounting Standards Board (FASB) regu-
lation that would take a normal investor half an hour to gure out. On
occasion, that will result in a lightening quick trade. “It’s surprising how
quickly he goes from premise to thesis to action,” says Grant. “That’s
Bill—decisive.”
At ve feet, ten inches and 165 pounds, Fleckenstein looks 10 years
younger than his 60 years. He has been married to the same ex-Wall
Street analyst for 30 years; the couple has two daughters.
Fleckenstein plays national tennis tournaments, does CrossFit, and
helicopter skis. He collects white Burgundies, which he ages, one
favorite being Corton-Charlemagne. From the bouquet alone he can
identify a wine’s varietal blend, maker, and vintage. Fleckenstein is an
enthused audiophile, and a high-end stereo system is in the corner. He
prefers vinyl LPs to digital alternatives, has two turntables, and keeps
CNBC anchor Maria Bartiromo on mute as he blasts British 1970s-era
rock, including the Rolling Stones, David Bowie, and the Who. “Bill is
all-in on anything he does,” says one high school friend. “He is never
half-hearted.”
One morning in late summer, Fleckenstein sprawls on his oce
sofa, dressed in a long-sleeved green T-shirt and worn gray sweatpants.
He’s scheduled to play tennis later that day, and friends say his athletic
162 THE MOST DANGEROUS TRADE
disposition helped him endure the pressures of short selling. Fleckenstein
and most of his ilk describe the short business as a more taxing investment
discipline than other varieties, especially when managing other people’s
money. “You have to be even more willing to stand against the crowd,”
he says. “You’ve got to be disciplined and exible at the same time.”
Finessing that contradiction has been key to Fleckenstein’s success.
The discipline is embodied in the rigorous fundamental analysis he does
when valuing a security. However, market dynamics require that today’s
short seller cover positions quickly or nd ways to cut risk when a trade
doesn’t pan out or goes awry—hence the requirement for exibility. “My
rm belief is that research is not enough,” says Fleckenstein. “It’s tactics.”
It was Fleckenstein’s meeting with Savoy that emboldened him to
reassess his trading methodology—and go in a very dierent direction.
A truism of the business is that short sales generate most of their prots
in only relatively brief periods. “You make money in a small amount of
time,” he says. “Stocks fall much, much more quickly than they rise.”
Hence the Wall Street adage: escalator up, elevator down.
Fleckenstein’s research pinpointed when those sudden downdrafts
are most likely to occur—for example, when the Federal Open Market
Committee is meeting, because that is generally when interest rates
are raised or lowered. Or during the mid-quarter “pre-announcement
period,” when companies signal to analysts whether their earnings
estimates were too high or too low. Or during earnings season itself.
“It didn’t take catalysts to get people to buy stocks,” Fleckenstein says.
“It sure took catalysts to get them to sell.”
Fleckenstein worked with a technical portfolio manager, Dave
Davidson, to sort through volume and price patterns to identify the best
times to initiate a trade. Fleckenstein calls the strategy “tactical short.”
“My thinking was, ‘I’m not going to be short all the time,’”
Fleckenstein says. “I was going to be short when it made sense.”
Fleckenstein abandoned his strategy of maintaining near-constant
shorts on April 1, 2000—a fortnight after the stock market turned. It
was in fact superb timing. Though in retrospect, many people recall a
freefalling stock market from the peak, in reality there were several vio-
lent bear market rallies, like the three-week period in September 2000
when the NASDAQ Composite surged 20 percent. Fleckenstein’s tacti-
cal short strategy largely sidestepped those surges.
Fleckenstein: Strategies and Tactics 163
When stocks began to rebound from their nadir in late 2002,
Fleckenstein was again able to avoid steep losses, even turning a prot
in 2005, when the S&P 500 rose 5 percent. “If you were a jihad short
seller you would have gotten your face ripped in 2003 and 2004 and
2005,” says Chiuchiarelli. “Fleckenstein’s strategy will lose you less
when the market is going against you and make you more when the
market is going down.”
Tactical short selling is proving transformational for some in the
industry, allowing select short sellers to ourish even during an era of
continual central bank easing—which is now happening in Europe as
well. Fleckenstein, characteristically, is sanguine about his achievement.
“I’m proud of the fact that after getting beat up in the market mania, I
was able to revamp my strategy,” he says.
William Alan Fleckenstein was born in 1955, the youngest of
four siblings, in what is today the capital of value investing—Omaha,
Nebraska. His mother, Shirley, kept house; his father, William Russell
Fleckenstein, served in the National Guard with Warren Buett before
landing a job at Mutual of Omaha, the insurance company, where he
rose to assistant controller.
Both of his parents were Depression-era babies, born in 1926, and
a frequent topic of conversation was the Crash of 1929 and the Great
Depression that followed. It helped inculcate the notion in the boy’s
mind that things do go wrong. “My Mom said there was just no money,”
Fleckenstein says. “I asked, ‘How could there be no money?’”
In 1967, the elder Fleckenstein quit the insurer after it refused to
address what he considered a conict of interest. The family decamped
for the Seattle area, where the older William took a job at what is now
Milliman Inc., a consulting rm, rising to chief nancial ocer.
The young Fleckenstein excelled at sports—especially skiing—and
showed an innate propensity for mathematics. At the all-boy Seattle
Preparatory School, Jesuit fathers taught him the meaning of
discipline—or at least tried to. There was frequent back and forth, for
example, about his rebellious demeanor. “I kept trying to grow my hair
longer than I was supposed to,” says Fleckenstein.
Nor did the fathers appreciate his unorthodox opinions. “He was a
dissenter back then,” says a high school friend. “He knew more than was
presented by the fathers and therefore came to dierent conclusions.”
164 THE MOST DANGEROUS TRADE
By his sophomore year, Fleckenstein was chang under the Jesuit
fathers’ discipline and lobbied to transfer to a high school closer to
home—one with a broader curriculum. The fathers made the decision
easier by expelling him. He graduated from Newport High School, in
Bellevue, after acing a class in accounting—a rare subject for a U.S. sec-
ondary school. Fleckenstein hoped to follow in his father’s footsteps.
From there it was o to the University of Washington—and
what became his beloved fraternity, Theta Chi. “Everybody says
their fraternity was like ‘Animal House,’ but ours really was,” says
Fleckenstein. Expulsions, suspensions, and dropouts had reduced the
number of students in the frat house to 15 from 90 two years earlier.
Among his extracurricular activities: beer, namely four-person pony
keg drinking contests.
Fleckenstein’s unlikely passion (at least for a partier) remained
accounting, which put his intuitive math skills to practical use. “It
was all about how the pieces t together,” he recalls. “It was fasci-
nating.” Fleckenstein helped work his way through school, hawking
subscriptions to the Seattle Times, doing underwater construction in
the Puget Sound, and—mostly—crunching numbers in the accounting
department of Milliman.
Rolling into his senior year, he found another practical outlet for his
mathematical skill sets: computer programming. In particular he mas-
tered the high-level ALGOL programming language used by Burroughs
Corporation in its popular mainframe computers. “I thought, ‘This is
really cool,’” says Fleckenstein. “This is better than math.”
Fleckenstein picked up his B.A. in mathematics from the University
of Washington and persevered toward his ultimate goal—to follow in
his father’s footsteps. Actuaries are business professionals certied in
the techniques for modeling and managing risk—crucial to insurers,
accountancies, and some money managers. To become an associate
actuary, Fleckenstein needed to pass ten tortuous, math-heavy tests
administered by the Society of Actuaries covering subjects such as
probability, nancial mathematics, and corporate nance.
Perhaps the Theta Chi kegs tripped him up. “You needed a six to
pass,” Fleckenstein recalls. “I got a ve, twice.”
Dejected, Fleckenstein went hunting for his rst full-time work. The
local Burroughs oce was looking for a salesman. “The branch manager
Fleckenstein: Strategies and Tactics 165
was blown away that I knew ALGOL,” he recalls. Fleckenstein joined
and basked in his newfound independence. “I was getting paid well,
$800 a month,” Fleckenstein says. “I remember thinking, ‘If I could get
$1000 a month, I’ll be set for life.’”
Fleckenstein picked up a book: Psychology in the Stock Market by the
now acclaimed value money manager David Dreman. It was his intro-
duction to investing. The takeaway changed Fleckenstein’s life. “You
didn’t have to be an expert in any industry to be a successful investor,”
he says. “You just had to recognize that unanimity in the markets pushed
prices to extremes. My ‘a-ha’ moment was that in any price is embedded
risks and fears.”
Fleckenstein was soon devouring other investing works—Benjamin
Graham and David Dodd’s Security Analysis, John Train’s The Money Mas-
ters, and the annual reports of Berkshire Hathaway.
Investing might have remained a hobby had it not been for a way-
laid jet at Los Angeles International Airport in 1980, when Fleckenstein
found himself sitting next to George Froley, a bond fund manager with
Pacic Investment Advisors. Froley recalls being impressed by his seat-
mate’s Wall Street savvy. “I said, ‘You’re ready to go into the stock
business,’” Froley says. He referred Fleckenstein to Kidder Peabody’s
Seattle oce where a friend was branch manager.
Kidder Peabody, an innovative rm at the time, seldom hired rook-
ies, but the branch manager took a ier on Fleckenstein—and was soon
glad he did. “He brought in more accounts and did more business than
anybody they’d ever seen,” says Froley.
It was the maw of the 1977–1982 bear market, during which time
the S&P 500 lost 48 percent. “If you had survived that drought you had
to be pretty savvy,” Fleckenstein says, recalling that the predominant
product of the day was neither equities nor bonds but certicates of
deposit. “Nobody wanted stocks. It was all about CDs.”
The Kidder Peabody greybeards fostered a collegial environment and
looked after their longhaired rookie broker. “I was always bombarding
them with questions,” Fleckenstein says. “They always had time for me.”
After running the New York City Marathon in 1981, Fleckenstein
developed a passionate interest in something aside from the markets—
Melody Miller Johnson, a blonde Kidder Peabody stock analyst in New
York who covered copier companies Xerox and Savin. “She was a tech
166 THE MOST DANGEROUS TRADE
person who believed in rapid growth,” Fleckenstein says. “I was a value
guy. We butted heads.”
Though Kidder Peabody policy forbade analysts from taking phone
calls from brokers, she accepted his. It owered into an enduring
romance. The two were married in 1984.
At Kidder Peabody, Fleckenstein showed entrepreneurial air.
While keeping a roster of retail clients, he also tried his hand, unof-
cially, at research, penning a white paper on an Apple disc drive
clone maker called Standun Controls. Condent as always, he sent it
to Warren Buett, mentioning his father’s connection to the Oracle of
Omaha. Buett wrote back that he remembered Fleckenstein’s father
but didn’t comment on individual stocks.
Fleckenstein also developed a distinctive line of business. Using his
mathematical background, he measured the risk, volatility, beta and
Sharpe ratios of dierent institutional portfolio managers, positioning
himself as matchmaker for pensions and directing them to the managers
best suited to them. “I thought, somebody has to evaluate the money
managers,” he says. “If I can hook them up, maybe I can get a piece of
the action.”
One of the rms on Fleckenstein’s roster was three-year-old
Olympic Capital Management, a value-oriented shop in Seattle.
“When he asked questions, you could just see he knew his stu,” says
Olympic founder John Crowl. “He had a good analytical mind.” When
Crowl asked Fleckenstein to join him in 1982, he jumped at the chance
to get into the money management business.
By that time, Olympic Capital had $2 billion under management
and Crowl decided to cull its client roster, limiting it to those with
$5 million or more to invest. Fleckenstein would run an internal
fund—Fleckenstein Capital—that would handle smaller accounts with
a minimum of just $250,000. “It was a way to help me out, keep
the number of clients low, and stave o competition,” he says. When
Crowl merged Olympic into Sirach Capital Management in 1996,
Fleckenstein set o on his own.
The former head of the investment division of New York–based
Bankers Trust Corp, Crowl became a mentor to the still-green investor.
“He just understood how the world worked,” says Fleckenstein. “He
would synthesize things.”
Fleckenstein: Strategies and Tactics 167
Crowl constantly drove home to Fleckenstein how the changing
market dynamics determined the catalysts driving stock prices. “There
are times when macro doesn’t matter. There are times when it’s all that
matters,” says Fleckenstein. “John taught me you had to know both
bottoms-up stock picking as well as the macro view.”
As the bull market began to gather steam in the mid-1980s,
Fleckenstein plowed ahead with a voracious reading schedule: 10-Ks,
Barron’s, Forbes, Fortune,andFinancial World. He was particularly
fascinated by the stock market crash of 1929 and the subsequent Great
Depression, and his favorite books included Only Yesterday by Frederick
Lewis Allen, Economics and the Public Welfare by Benjamin Anderson,
Modern Times by Paul Johnson, and The Crash and Its Aftermath by
Barry Wigmore.
By mid-1987, Fleckenstein saw stock markets getting frothy. The
U.S. dollar was under pressure, and bond markets were weakening.
Equities were spiking upward, rising 27 percent in the rst half of
the year. Ominously, investors were throwing money at a newfangled
product called portfolio insurance—an invention of the Berkeley,
California rm of Leland O’Brien Rubenstein Associates. The idea
behind portfolio insurance was simple: For a fee, Leland O’Brien would
hedge an investor’s stock market exposure in the event of a crash by
furiously selling stock index futures as a way to limit losses. The rm’s
book of business covered portfolios worth an estimated $60 billion, a
lot of money at the time.
“I knew that would be a disaster,” Fleckenstein says. “Everybody
can’t get out at the same time.” More importantly, portfolio insurance
meant pension funds, foundations, and endowments felt inured to the
risks they were taking on as stock prices rose. They weren’t shifting
money into cash as they normally would in a surging market. Why
should they? Portfolio insurance would protect them.
Olympic Capital built a 30 percent cash position by October
1987, sidestepping a big part of the 24 percent one-day sell o. While
Fleckenstein believed the meltdown would trigger a recession, Crowl
thought not. He argued, correctly it turned out, that since there hadn’t
been a major misallocation of capital, the economy would shrug it
o. “I didn’t understand that at the time,” Fleckenstein says. He was
learning to think big macro thoughts.
168 THE MOST DANGEROUS TRADE
The next year Fleckenstein turned his attention to Japan, where,
in addition to galloping real estate prices, stocks like Sony Corp., Japan
Air Lines, and Toshiba Corp. were trading at multiples of 80 times
trailing earnings or more. “They were insanely priced,” Fleckenstein
says. One key problem for a bear was that it was virtually impossible
to borrow shares on Japanese markets to sell short, and the American
Depositary Receipts of Japanese companies that traded on the New
York Stock Exchange were suciently illiquid as to be vulnerable to
short squeezes.
Fleckenstein found an arcane yet useful instrument to help him bet
against the Japanese market—a series of three put warrants on the Nikkei
Stock Index issued by Salomon Brothers beginning in June 1988. The
warrants gave the holder the right to sell the benchmark index to a
counterparty at strike prices of around 28,000, 31,000, and 33,000,
respectively, and expired between August 1990 and April 1992. The
cost? As little as $4.50. When the Nikkei, which was trading at 35,000
as Fleckenstein began buying the warrants, tumbled to 20,000 by April
1991, he was able to garner a twelvefold payo on his investment. “It’s
not the analysis that will get you to the Promised Land, it’s the tactics
you employ,” says Fleckenstein.
Fleckenstein was less interested in size—the biggest his fund ever
got was $170 million—and more focused on being right. “I think $50
to $100 million is a good size; you can move in and out quickly. I don’t
have trouble nding options, which is part of my strategy,” he says. “I
don’t want to be the richest man in the cemetery.”
By 1996, however, Fleckenstein was growing increasingly skeptical
of Greenspan’s easy money policies. In 1994, with GDP growth acceler-
ating to 6.5 percent, the Fed acted to dampen inationary worries, rais-
ing its target rate six times over 12 months to 6 percent. Growth throttled
back to 3.2 percent by early 1995. Wall Street, the media and politicians
lauded the chairman for navigating this economic “soft-landing” that
forestalled a recession. Greenspan would later call the maneuver “one of
the Fed’s proudest accomplishments during my tenure.”
Fleckenstein took a dimmer view. To his mind, following the soft
landing, the Fed chairman ignored the speculative bubble building
in stocks, especially the technology-heavy NASDAQ Composite,
which rose 22 percent in 1995. Worse, he began cutting rates again in
July of that year, just six months after his last rate hike, and repeated
Fleckenstein: Strategies and Tactics 169
cuts twice more over the next eight months. The NASDAQ index
spiked 22 percent in 1996. “He was serving more punch to the party,”
Fleckenstein wrote. “Greenspan thought of the stock market as one
giant applause meter.”
In Greenspan’s book, The Age of Turbulence: Adventures i n a New World
(Penguin Press, 2007), the Fed chairman writes that he held o tighten-
ing because of his suspicion at the time that technological changes were
in fact fueling productivity growth in an unprecedented fashion. “What
if this wasn’t a normal business cycle?” he wrote. “What if the technol-
ogy revolution had, temporarily at least, increased the economy’s ability
to expand?”
In other words, despite his famous 1996 admonishment warning of
“irrational exuberance,” Greenspan was himself buying into the fantasy
about an Internet-enabled new economy—and persuading the Federal
Open Market Committee (FOMC) as well.
Needless to say, Fleckenstein thought that was claptrap. And he par-
ried the prevalent notion that technology was increasing productivity
growth, when even Greenspan conceded there was no evidence to sug-
gest that it was.
While Fleckenstein blames Greenspan for starting the bubble, human
nature played its own role. One early example: the 74 percent one-day
rise in Netscape Communications shares at its initial public oering in
April 1995.
The Federal Reserve, combined with crowd psychology and a con-
uence of factors set the stage for disaster. An aging baby boomer popu-
lation approaching retirement with insucient savings; the introduction
of the Microsoft Windows 95 operating system, which greatly increased
the ease of communications—and red up the public’s imagination as to
the power of the Internet; the advent of cable channel CNBC, a relent-
less cheerleader for the bull market; and companies themselves, who,
enabled by Wall Street analysts and bankers, hawked dubious “account-
ing” measures of protability—price per eyeballs, clicks and so on—if
not promulgating outright fraud.
Set against Greenspan’s backdrop of loose money, this cauldron
of indomitable forces led Fleckenstein to think a traditional Dodd
& Graham approach to picking beaten-down, out-of-favor stocks
would be a hopeless slog. “I knew the value business was going to be
impossible going forward,” he says. From 1995 through March 2000,
170 THE MOST DANGEROUS TRADE
growth stocks more than doubled the gains of value stocks, returning
32.7 percent annualized versus 14.9 percent.
Fleckenstein kicked o RTM in 1996, marketing it as a short
fund—one that would bet continuously against the expanding bubble.
One of his rst investments as an independent rm, however, was a
long investment in silver. At $3 to $4 an ounce, the metal was priced at
the cost of production or lower. “I knew silver was going to have a big
move,” he says.
The best way to prot from rising precious metal prices is often
through beaten-down mining company stocks, which because of their
xed costs are leveraged to the price of the commodity. Among the
cheapest was Pan American Silver Corp., a Vancouver-based producer
with a mine in Peru and an appetite for acquisitions. Shares were trad-
ing at $4.50, and Fleckenstein gured they would quadruple on even a
modest rise in silver prices. He held the position until 2007, when silver
hit $12.75 an ounce—and Pan American shares $44.
“It was something that took a long time to evolve,” he says. “With
value investing you’re combating apathy. With a short sale there is no
apathy. It doesn’t matter if you’re right, it only matters when the market
agrees with you.”
Although by 1996 rampant speculation was inating sectors ranging
from telecommunications to banks, Fleckenstein focused on a shifting
portfolio of 15 to 30 computer hardware stocks. That’s largely because
of their interconnectedness: Computer sales drive chip sales, which in
turn drive sales of semiconductor equipment. “They are all suppliers and
customers of each other,” he says. “You get a pretty good idea of what’s
going on in the whole mosaic.”
Micron Technology, America’s largest maker of DRAM chips,
was a perennial on Fleckenstein’s short list. The stock in December
1997 traded at some 30 times trailing earnings. The prevalent view
was that as the Internet continued to make over the world economy,
there would be a shortage of DRAMs that Micron would benet from.
Fleckenstein thought Micron’s chips were commodities, looked at the
DRAM manufacturing capacity that was slated to come on line and
predicted a glut. Moreover, Micron’s principal competitors, Samsung
and Taiwan Semiconductor, were subsidized by their governments.
Fleckenstein: Strategies and Tactics 171
Computer makers Hewlett-Packard, Compaq, Dell, and Gateway,
also made the list. At year-end 1997, their price earnings multiples were
at what Fleckenstein considered to be nosebleed levels, too. Conven-
tional wisdom was that the Internet would foster year-over-year unit
sales growth as buyers annually traded in their old models for new, faster
ones. Fleckenstein argued that computers had plenty of power already.
Plummeting PC prices would pressure margins no matter how many
they sold anyway.
Intel was a case in and of itself. It traded at 80 times earnings and,
together with Microsoft, constituted the half of the Wintel cartel that
provided the brains of the personal computer. Intel, however, with
rare consistency failed to meet its own earnings projections. Midway
through the quarter it would hold a conference call for analysts to
pre-announce, in the argot of Wall Street. That meant guiding earnings
and sales targets lower. “They were terrible at knowing their own
company,” says Fleckenstein. RTM would be short Intel before the
pre-announcements—and made money 70 percent of the time.
“With bubbles, people believe a false set of assumptions,” says
one former Fleckenstein Capital investor. “Bill basically looks at those
assumptions and says they’re wrong.”
Indeed, Fleckenstein in August 1999 had a new and bully pulpit from
which to voice those opinions. Fleckenstein began writing a column
for Seattle-based Go2Net Inc., sounding o on stocks he was buying or
shorting and commenting on the markets and economy in general. “I felt
strongly that Greenspan’s policies were going to have terrible repercus-
sions,” Fleckenstein says. “I wanted to warn people.”
Beyond that, Fleckenstein admits to enlightened self-interest. “In my
own selsh way, I wanted to be in the camp of those who saw problems
coming,” he says. “I thought the investment world would be sorted into
two piles—those who saw the problems and those that didn’t.”
In 1998, Fleckenstein moved his column to Jim Grant’s investing
website, www.grantsinvestor.com. When that folded in 2001, he moved
to what was then called TheStreet.com, and later to MSN Money,owned
by Microsoft.
“Bill has never been shy about giving people his opinion. I don’t
think it’s an ego thing,” says Hickey. “He wants to educate them.”
172 THE MOST DANGEROUS TRADE
The NASDAQ rose 22 percent in 1997, yet Fleckenstein Capi-
tal’s RTM Fund managed to turn a prot. The next year would prove
far tougher.
In August 1998, Russia unexpectedly defaulted on its sovereign debt,
triggering a global rout of hedge funds that had been betting that spreads
between emerging markets, like Russia, and developed ones, like the
United States and Germany, would narrow. Instead, they exploded.
The biggest casualty was Long-Term Capital Management LP,
a $4.7 billion fund run by former Salomon Brothers trader John
Meriwether. In addition to employing two Nobel Prize–winning
economists, the Greenwich, Connecticut–based LTCM was distin-
guished by the more than 25-to-1 leverage it employed in making
its myriad bets worth over $125 billion. LCTM’s derivatives exposure
reportedly topped $1 trillion. Much of the borrowed money was
imprudently furnished by Wall Street’s biggest banks, including Gold-
man Sachs, Merrill Lynch, Morgan Stanley, and UBS, many of which
were also investors in the ill-fated fund.
As word of LTCM’s collapse spread in August, world equity markets
began to unravel. The S&P 500 dropped 19 percent peak to trough.
Greenspan rushed to cut rates, slashing three times in the space of
two months to 4.75, once in an emergency meeting on the Friday before
options expiration. “I went absolutely apoplectic,” Fleckenstein says.
“That was the moment they really got drunk. They had no concept of
the damage they were doing with a monetary policy that was drastically
too loose.”
The markets, as Fleckenstein puts it, “got the wink-wink”—and
began their relentless rocket to the moon. Over an 18-month period,
the NASDAQ Composite would more than triple to 5,048 from 1,428.
RTM, which had been up more than 30 percent going into September
1998, nished the year with a loss. Fleckenstein, already suering, was
entering a new world of pain.
Each morning, he would wake up at 4:30, read the papers, and drive
to his 33rd-oor oce in downtown Seattle. There, in the predawn
darkness, the markets would open on the East Coast, and soon his com-
puter screens would begin to glow green—signaling another up day for
technology stocks. “The lights would start up and we would scramble
to play defense,” Fleckenstein says.
Fleckenstein: Strategies and Tactics 173
It was a lonely profession. Fleckenstein for most of the time
worked only with a receptionist and a trader. The oce had two direct
lines—one to Furman Selz for trading options, the other to Banyan
Securities which would help cover positions. “It was take o here, take
o there,” Fleckenstein says.
Making matters worse was knowing that everybody else was
making money. “The less you knew, the more you were making,”
says Fleckenstein, whose thoughts turned to the words of existential
philosopher Frederich Nietszche. “The quote ‘Whatever doesn’t kill
me makes me stronger.’ I remember thinking that.”
Fridays, for some reason, seemed to be the worst days, with tech-
nology stocks making their biggest gains. There was really no respite
over the weekend—Sundays became a day of dread, because Monday
the beatings would begin all over again. Fleckenstein developed a sup-
port group of like-minded bears—Jim Grant, Fred Hickey, and Marc
Faber, publisher of the Gloom, Boom & Doom Repor t .
“Misery loves the phone,” says Grant. They would discuss the latest
market surge or rare dip, economic data, and Federal Reserve outlook.
“We were the last of the Mohicans,” says Hickey. “We almost held each
other’s hands.”
The painful culmination of the tech bubble ultimately served as
handmaiden to Fleckenstein’s tactical shorting strategy. The tools he har-
nessed, then as now, have a common goal—reduce the risk of putting
on and maintaining a short position.
All short sellers face an incontrovertible truth. Even leaving aside the
fact that equities as a whole generally rise over time, market mathematics
that work to benet a long investor redound savagely in a process that
undermines those betting against a stock. Most obviously: The down-
side of a long buyer—assuming the investor shuns leverage—is the total
amount invested. That is, a stock bought at $10 can fall no further than
zero. By contrast, an investor shorting the same stock has virtually unlim-
ited downside, since the stock, on a tear, can keep rising indenitely,
theoretically speaking.
That, however, is only the start. A long investor holding a winning
stock is automatically expanding the bet by simply letting the position
run. That is, all else being constant, a $10 stock that rises to $20 will dou-
ble the dollar value of its position and increase its weight in the portfolio.
174 THE MOST DANGEROUS TRADE
The manager may want to sell some shares to lighten up and lock in
prots—hardlyadauntingprospectinaliquidmarket.
By contrast, a short seller betting against a stock that falls from $10
to $5 watches his dollar exposure to the winning trade cut in half. That
means a short seller is often set scrambling to nd more shares to borrow
and sell when a successful short kicks in, just to maintain a constant dollar
exposure.
That phenomenon makes for extraordinarily unhappy market
dynamics. An investor who shorts 100,000 shares at $10 will be required
to short an additional 100,000 shares if the stock falls to $5 and the
short seller wants to maintain the same dollar position in that security.
If the stock falls to $3, the bearish investor will need to boost the short
position to a total of 333,000 shares to do that. The investor may hold
its short position at an average cost of, say, $5.70.
The practical implications are savage. If the stock bounces back from
$3 to $5.75—barely a bump on a long-term price graph—the investor
will be losing money on a position that was initiated at $10—not includ-
ing costs and regardless of the fact that the stock is down more than 40
percent from the initial short. Such “reex rallies” frequently wipe short
sellers out, even when their directional bets are correct over the long
term. “That’s just part of the process,” says Chiuchiarelli. “All the good
managers know how to construct a portfolio with this in mind and nd
a way to navigate through it.”
Fleckenstein’s tactical short strategy addresses these dynamics by
reducing risk. Fleckenstein had long steered clear of a short if the
“borrow”—or interest charged—was high. In addition to the costs of a
high borrow, it often signals that a particular trade is crowded (i.e., there
were too many shorts betting against the same stock). That increases the
likelihood of a short squeeze—when bulls collude to drive shares higher
by quickly snapping up shares, sending prices higher and thus forcing
short sellers to cover their positions by buying more shares, reinforcing
the upward spike.
Fleckenstein became more vigilant, sticking to the most liquid shares
whose borrow was relatively low—Cisco Systems, IBM Corp., and
Intel Corp.
Fleckenstein would only preemptively initiate a short position
during windows when catalysts were likely to kick in—during the
Fleckenstein: Strategies and Tactics 175
preannouncement periods, earnings season, and when the FOMC
was meeting. More recently, he has looked for other periods where
government or corporate actions are likely to send stocks lower, for
example when the European Central Bank, International Monetary
Fund, or European Commission were likely to address the Greek
nancial crisis. “I manage my exposure from one catalyst to the next,”
he says.
Outside those windows, Fleckenstein generally initiates a short only
when a stock is already falling. “Nothing is ironclad, but what I’m not
trying to do is pick a market top.” And he’ll move lightning-quick to
cover if the trend reverses. “Taking o your position is part of the ex-
ibility,” Fleckenstein says. “The question when you are a short seller
today is ‘How are you going to control the risk?’”
One technique is to use options more frequently and more
creatively. If a stock was trading at $25, and he expected it to fall to
$15, Fleckenstein would initiate his usual short position. Concurrently,
however, he could also buy put options, giving him the right to sell the
stock at $20. Because these are so far below the current trading price,
he could buy them cheaply, as little as $1 each. If the stock fell below
$20, he would cover his short positions, eliminating the borrow and
reducing the risk of a reex rally wiping out his gain, while holding on
to his put options. That way he could continue to prot as the stock
declines without the undue worry of the stock rebounding.
Perhaps most of all, Fleckenstein has sworn o the role that gained
him so much attention—and admiration: That of the stalwart contrar-
ian, resolutely betting against the madness of the crowd. “Cutting and
running is part of the strategy,” Fleckenstein says. “Part of this is manag-
ing your own psychology.” However steadfast, in the world of shorting
a surfeit of willfulness is the road to losses and ruin.
Chapter 7
Kass: Nader’s Raider
Hits the Street
D
oug Kass’s journey into short selling began at a harness-racing
track at the Lycoming County Fair in in Williamsport, Pennsyl-
vania. Going into the home stretch he was in the lead, driving
a three-year old standardbred horse, Bacon, under sunny skies. Kass, a
New York money manager, describes himself as obsessed with the sport
of kings, hooked on the speed, excitement, and of course, the magnif-
icent horses themselves. “I owned them, I bred them, I raced them,”
Kass says.
That July morning in 1990, danger lurked. The leather collar that
held up Bacon’s head, called a martingale, had worn thin. As the two
neared the nish line, it snapped and Bacon stumbled, overturning the
sulky and spilling Kass, then 44 years old, onto the track into the path
of trailing horses and their drivers.
Bacon escaped injury. Kass did not. The tumble and trampling col-
lapsed Kass’s liver. It shattered his left bula and tibia and broke seven
ribs and nine vertebrae.
177
178 THE MOST DANGEROUS TRADE
Kass was airlifted to New York and Mount Sinai Medical Center
in Manhattan, the start of a two-year convalescence in a full body cast.
His agonizing recovery gave him time to ruminate about life as well as
investment ideas—more to stave o boredom than to turn a prot. “I
had to do something because I was going crazy,” he says.
By early 1992, still in a cast, Kass had turned his attention to a
white-hot market darling—newly public Marvel Entertainment, the
comic book publisher whose characters included Captain America,
Spider-Man, the Incredible Hulk, and the Silver Surfer. It was the age of
the hostile takeover, and Ronald Perelman, serial raider and corporate
acquirer, had snatched up Marvel three years earlier for a pittance: $82.5
million from New World Entertainment. The previous July, Perelman’s
holding company, MacAndrews & Forbes Holdings, sold 4.2 million
shares to the public at $16.50 each—the stock shot up, tripling by the
time Kass began to research it.
Here’s what he saw: Marvel shares were trading at 46 times trail-
ing earnings, 6.4 times revenues, and 17 times shareholder equity. In
fact, its $786 million market capitalization was almost twice the entire
comic book industry’s annual sales. Could that possibly make sense?
Although the IPO proceeds were to have been used to pay down debt,
MacAndrews & Forbes had instead helped itself to a $37.2 million special
cash dividend, on top of a $10 million one-year dividend note.
That left Marvel leveraged, with $57 million in debt and other lia-
bilities and just $43 million in equity.
As Kass dug into Marvel’s quarterly reports, he realized the stock was
at nosebleed levels—the question was what would cause it to tumble.
Conned to a wheelchair, Kass cold-called comic book stores around
the country, talking to dealers who told him that Marvel was repeatedly
raising prices, to as high as $2.95 an issue. Customers were starting to
balk. Together with his caregiver, he hired a van to take him to retail-
ers, where he saw for himself how boxes of X-Men and X-Force issues
were stacked high. “This was the top of the comic book cycle,” Kass
recalls thinking.
Marvel’s promotional eorts, Kass felt, smacked of desperation: The
company printed its third quarter annual report in comic book format.
That seemed gimmicky. Marvel hired celebrity sports anchor Frank
Giord for its board. Kass didn’t see what he added. Kass learned that
many of Marvel’s best writers and artists were leaving, sometimes to
Kass: Nader’s Raider Hits the Street 179
upstart rivals like Malibu, Viz, Innovation, and Valiant, which were
generating buzz.
Kass wrote a draft research report and resolved to personally show
it to his favorite business writer, Alan Abelson of Barron’s, the nancial
news weekly. Though the two had never met, the acerbic columnist was
required reading for Wall Street cognoscenti, especially those with a bear-
ish disposition, since he exulted in debunking market shibboleths—blue
chips as well as red-hot trend stocks. “I had like a man crush on Alan
Abelson,” says Kass. “I thought he was a journalistic treasure. I just loved
his skepticism, his cynicism.”
Kass’s aide wheeled him to Abelson’s oce on the 16th oor of the
Dow Jones & Co. headquarters at the World Financial Center. His leg
was full of rods, making him look like an Erector Set. The receptionist
told him he needed an appointment. Just then, Abelson returned from
the men’s room.
“What the f--k do you want?” he asked.
“Well Mr. Abelson, I love your journalism,” Kass gushed, by way of
introduction.
“Get to the chase, kid,” Abelson replied. “I’ll give you four
minutes.”
Wheeling himself into Abelson’s oce, Kass handed him his analysis
of Marvel Entertainment. Abelson raised an eyebrow.
“Look over there,” he told Kass, gestured to his conference table.
There was a Marvel prospectus on it.
“I f--king hate Ronald Perelman,” Abelson declared. “Why don’t
you leave this with me and give me a number where I can reach you?”
That Saturday, Barron’s ran Kass’s research report as a bylined story.
“High-Flying Marvel Comics May Be Headed for a Fall,” the deck ran.
Kass playfully sprinkled the terms “Pow!” “Smash!” and “Ker-plash!”
throughout the piece. Come Monday, Marvel shares crashed.
Perelman sued Kass for $20 million for his “inammatory”
research—though he was later forced to reimburse Kass for legal fees.
Kass and Abelson went on to write ve follow-up items for Barron’s.
Just 18 months after the initial article, Marvel Entertainment led for
bankruptcy.
Thus Kass says he found a métier as a professional bear. “My reputa-
tion as a short seller and as a kind of protégé of Alan Abelson was made,”
he chuckles. Abelson died in May 2013.
180 THE MOST DANGEROUS TRADE
Investors took note of Kass’s penchant for sning out losers. The
stock research department he took over at First Albany Corp. earned
some credibility for incisive, sometimes bearish calls. Kass soon ed the
chilly Northeast and signed on as head of sales research and trading at J.W.
Charles Securities, a Florida brokerage rm. Though Kass ogged plenty
of small-capitalization stocks, many of which amed out, the rm was
soon known for its sell recommendations. He was dubbed the “Bear of
Boca”—a sobriquet Kass relished. He later worked a stint at Leon Coop-
erman’s Omega Advisors hedge fund, ultimately launching Seabreeze
Partners Short LP in 2005.
The dedicated short fund notched an impressive record over a
ve-year history: According to investors, it gained 11 percent in its rst
year versus a return of 4.9 percent in the Standard & Poor’s (S&P) 500.
In 2006, the fund lost 5 percent when the index surged 15.8 percent
and mustered a 7 percent gain in 2007 versus a 5.5 percent rise in the
S&P 500. In the cataclysm of 2008, it surged 18 percent versus a 37
percent loss for the benchmark. And amidst a rebounding S&P 500
in 2009, during which the index jumped 26.5 percent, the Seabreeze
Short LP lost just 6 percent.
Kass continued to manage the $300 million Seabreeze Long-Short
Fund LP until a bout with cancer prompted him to close the fund and
focus on managed accounts. He remains Mr. Media. The hyperkinetic
money manager’s experience at Barron’s fed into a passion for broadcast-
ing his views across the spectrum—television, the Internet and print.
After Marvel Entertainment, Kass kept Abelson abreast of his fund’s
picks and pans, maintaining an almost worshipful aection for the man
he calls his mentor. In 1998, Kass began writing for what was then
called TheStreet.com, becoming friendly with its fast-talking, ebullient,
and bullish founder Jim Cramer, who is now a TV show host on cable
news channel CNBC.
Distinguished by home-styled argot—pricey stocks are “Snapp-
lesque” and beaten-down companies are “schmeissed”—Kass is also a
regular on the channel, counterbalancing relentless boosterism from
many of its contributors with regular cold-water dousings on the
prospects for the stock market and economy, always delivered in his
Kass: Nader’s Raider Hits the Street 181
Long Island accent. Kass calls his outspokenness a public service,
especially when it comes to his bearish outlook.
Privately, some friends say his penchant for punditry undercuts his
ability to gather assets, as investors prefer their money managers to keep
their views to themselves, especially when they are so relentlessly bear-
ish. “Being publicly acclaimed means more to him than the wealth that
comes with managing more money,” says one. “He has a yen to be
known as a great nancial prognosticator.”
For the record, he’s done okay on that count, calling the market
bottom in 2009 and sporting an impressive record in his annual list of
likely surprises for the coming year. Kass comes from a potent intellectual
milieu, the son of a multi-instrumentalist jazz musician who, according
to Kass, jammed with the likes of Benny Goodman and Billy Holiday.
One of Kass’s sisters, Deborah, is an celebrated conceptual artist. The
other, Barbara, is a psychologist. His cousin, Sandy Koufax, is the great
former Brooklyn Dodgers southpaw, the youngest player ever elected to
the Baseball Hall of Fame. Kass’s older son, Noah, is a psychotherapist
and contributor to TheStreet, as it is now called, and MSNBC, while his
younger son, Ethan, is an award-winning playwright.
Hooked on stocks from his early teens, Kass nevertheless can claim a
distinctly antiestablishment track record. He’s prone to reminisce about
Jimi Hendrix’s legendary rendition of “Hey Joe” at the 1969 Woodstock
Music Festival. In 1970, Kass helped organize the student anti-Vietnam
War march on Washington. Later, he worked with consumer activist
Ralph Nader to take on Wall Street cronyism, co-authoring an exposé
of what was then known as Citibank. He was toiling on a Ph.D. in
philosophy at Princeton University before suddenly switching gears to
earn an M.B.A. from the Wharton School and pursue a life on Wall
Street. A lifelong Democrat, he repeatedly interjects in any discussion of
politics to emphasize that he’s “to the left of Obama.”
Sitting on a sofa in his den in East Hampton, New York, Kass is
dressed in jeans, a T-shirt, and a dark blue cardigan. He is ve feet nine
inches tall and weighs 205 pounds, having shaved o 10 pounds after a
recent operation for prostate cancer. Though little over a month out of
surgery, Kass bubbles with energy, rst leading a visitor into the basement
182 THE MOST DANGEROUS TRADE
to see a poster-size photograph of him from his harness-racing days,
jumping up to print out a stock chart or a bottle of water, or rolling up
a trouser leg to show o his scars.
Kass has a full head of salt-and-pepper hair and a beard to match. He
dotes on his wife, Nanette, as well as their four dachsunds—Bella, Oliver,
Cousette, and Sebastian, who at age 16 is deaf, blind, and dumb and
sleeps soundly beside Kass throughout a two-and-a-half-hour interview
on a cold winter evening. Unlike a lot of bears, Kass projects relentless
optimism, sprinkling his conversation with jokes, asides, and humorous
anecdotes. “I’m not miserable the way some short sellers are,” he says.
“I’m not downbeat about the secular world. I don’t think the world is
coming to an end—I just think some companies are coming to an end.”
The investment discipline Kass hones is based on an independent
outlook and sometimes tacks sharply against common short-selling wis-
dom. “The real function of a short seller is to develop a variant view,”
Kass declares. “You try to nd companies whose business models are
changing for the worse and then develop a projection of earnings that’s
far lower than the consensus estimates.”
The approach is rooted in common sense. The kind of business-
disrupting change to which Kass is attuned is often related to technology
and in particular the Internet. A classic example is the destruction of
the newspaper industry, which Kass bet heavily against beginning in the
2000s. Later in the decade, Sea Breeze successfully wagered against Regal
Entertainment Group, the movie theater chain undermined by streaming
video; American Greetings Corp., whose birthday and other cards were
upended by the growth of free e-cards; and coupon publisher Vallassis
Communications, undercut by the likes of Groupon. Kass bet against
them all and won.
Where Kass begins to dier from some other investors is that he
won’t wager against a stock based on its valuation, as measured by such
common metrics as a high price-to-book value, earnings, or earnings
growth ratios. “It is not a catalyst for a short, because an inated stock
often moves even higher,” says Kass. “It’s arrogant to believe that one
can determine whether something is fully priced on a valuation.”
That stance redounded to Seabreeze’s benet most obviously dur-
ing the technology bubble of the late 1990s. Shares of companies like
Cisco Systems, Oracle, and EMC were trading at outrageous levels, yet
Kass: Nader’s Raider Hits the Street 183
continued to rise higher, some topping out at more than 150 times trail-
ing earnings in early 2000, by which time they had wiped out an entire
generation of short sellers who had bet against them.
By contrast, Kass steered away of such companies, as well as the sea of
protless dot-com ephemera of the era like Pets.com and theglobe.com.
“There was no way of evaluating the intrinsic value of these companies,”
says Kass. “It was totally a function of emotion, and the best thing was
to stay clear.”
Unlike rival shorts like Bill Fleckenstein and David Tice, Kass
eschews gold as a hedge or alternative to a weakening dollar. That’s
partly because while bullion prices tend to rise in low-interest-rate
environments, the attraction dissipates as rates begin to rise. “It has no
intrinsic value,” Kass says. “So being totally a function of demand and
supply, that means that if gold goes from 1800 to 900, I wouldn’t be
able to assess what that really means.”
Kass admits to a streak of paranoia, living in fear of a short
squeeze—in which opposing bullish traders buy shares of a company
targeted by shorts with the aim of pushing its share price higher. As they
do so, the short sellers are forced to cover, buying shares to pay back
those they’ve borrowed, goosing prices further. It’s the short sellers’
worst nightmare.
He keeps an eye on two simple ratios. First, Kass won’t make a bear-
ish bet if the short interest in the stock—that is, the total shares being
shorted, divided by the average daily trading volume—exceeds 7 days.
Likewise he’ll steer clear if the total number of shares being shorted,
divided by a company’s share oat, exceeds 8 percent. Both metrics warn
of the danger that too many shares have been shorted, leaving a short
seller vulnerable. “I simply don’t want to get caught in a short squeeze,”
says Kass.
There are other ways to limit downside—specically by creating
so-called synthetic puts. If a stock seems susceptible to a positive surprise,
Kass is likely to construct a trade that caps possible losses if the market
turns against him, by purchasing call options, which give the holder the
right to buy a set number of shares at a given price by a particular date.
So, when shorting 10,000 shares of, say, Herbalife, at $40, he will simul-
taneously purchase 100 call options for $2 apiece, giving him the right
to buy 100 shares of Herbalife for, say, $45. Kass will still make money if
184 THE MOST DANGEROUS TRADE
the stock falls, but his loss is capped at $7 a share, since if the stock rises
past $45 he’ll be able to exercise his $45 options at $2.
The synthetic put neutralizes one of the most of daunting of chal-
lenges for a short seller—the prospect of unlimited losses when a bet goes
awry. “What that does for me is it denes my risk,” says Kass. “That’s
kept me alive.”
Nevertheless, Kass’s market success is rooted in a deep aversion to
the bullish mass psychology that overwhelms otherwise sober investors.
“Doug is very smart,” says Jerry Jordan, chairman of Hellman, Jordan
Management Company, Inc., an investment rm and a former colleague
of Kass’s from Putnam Investments. “He has a very, very strong bearish
bias, which lets him make money shorting stocks when others can’t.”
Cocky and precocious, even as a child Kass had a way of impressing
those around him, including fellow elementary school students who
dubbed him “the professor” when growing up on the South Shore of
Long Island in New York. That’s where Douglas Allen Kass was born
in 1948, just in time to catch the early post-World War II wave of New
Yorkers eeing the city for the bucolic suburbs, among them Rockville
Centre, a comfortable, multiethnic town 20 miles east of Manhattan.
It was a prime destination point for beneciaries of the G.I. Bill,
which amongst other things provided cheap mortgage nancing for
ex-servicemen.
His mother, Selma Koufax, taught elementary school. His father,
Saul Kass, worked by day as a dentist, but was known as Dr. Hip in
New York’s illustrious jazz community for his ability to play virtually
every instrument likely to nd its way into a combo—clarinet, alto
saxophone, piano, trombone. Radio station disc jockeys knew it was
Dr. Hip calling in during “Name That Tune” contests because he would
often nail the song after just two or three notes. Arriving home from
school, his father would be in the den drinking Johnny Walker scotch
with jazz greats like Benny Goodman, Gerry Mulligan, Illinois Jacquet,
and Billie Holiday. Saul Kass taped high-quality recordings of jazz perfor-
mances on a Wollensak reel-to-reel machine—color coding, rating, and
writing reviews on the cardboard boxes. Columbia University oered
$15,000 for the collection in the 1960s.
“Dougie,” as he was known, tried his hand at various instruments—
saxophone and clarinet among them—but eventually stopped playing
Kass: Nader’s Raider Hits the Street 185
in high school as his tastes turned to 1960s era rock ’n’ roll, the lyrics
from which he still sprinkles throughout his market commentaries.
Besides, Kass was more interested in collecting baseball cards, following
the Brooklyn Dodgers, which his Cousin Sandy would soon join, and
studying, at which he excelled.
In 1958, Kass appeared on the junior version of the television game
show Tic-Tac-Dough, in which host Jack Barry quizzed contestants on a
variety of subjects.
“Name two of the New York daily newspapers,” Barry asked.
“Daily News and New York Times,” the young Kass responded.
“Tell me the name of Popeye the Sailor’s girlfriend.”
“Olive Oyl.”
Kass was on for ve consecutive shows, winning a color television
set. The eight-year-old amed out on the subject of holidays.
“The Sunday before Easter is given the name of a tree. What is this
Sunday called?”
“Dogwood? Redwood?”
Barry teased the fourth grader about it. “But Mr. Barry, I’m Jewish,”
Kass wailed.
Kass’s maternal grandmother, Jeanne Koufax, was an avid stock
market enthusiast and instructed him to use a notebook to keep track
of what products he was interested in and then track the share prices
of the companies that made them in the newspapers. “We would talk
about stocks,” he recalls. Among the names he remembers tracking
were Arkansas Gas & Electric, Harvey Hubble, IBM Corp., and various
airline stocks. A local Merrill Lynch branch in Merrick, Long Island,
had a real-time ticker and Kass would go over to watch the changing
prices, like other kids watch movies. Classmates thought he was weird.
At South Side High School, Kass earned mostly As. “I was smart—I
excelled in math, history, everything,” Kass says. “I was an over
achiever.” From there, it was o to Alfred University in the rolling hills
of western New York State, a school known for its liberal politics—it
was one of America’s rst racially integrated schools—and home to a
world-famous ceramics program.
Money was tight. One semester, Kass slept in his car to save on room
and board. His grandmother, who ran a successful chain of children’s
clothing stores in the Bronx called Koufax Youth Center, helped with
186 THE MOST DANGEROUS TRADE
tuition. “Thank you very much for the clothes,” Kass wrote her. “I’m
having a fantastic time at Alfred. Everything is great.”
The focus at Alfred was on learning, not class rank or competi-
tiveness. “It was bucolic, serene, and low pressure,” he says. Kass was
enthralled by existentialists like Friedrich Nietzsche, who pioneered the
concept of the overman and rejected contemporary Christian values as
life-defeating, and embraced the concept of the Dionysian man. He
loved Søren Kierkegaard, who in books Fear and Trembling and The Sick-
ness unto Death, argued for a personal interaction between the individual
and God. An even greater inuence was Martin Buber, a quasimystic
philosopher and author of the denitional text, I and Thou.Heposited
two kinds of relationships between humans and indeed between the indi-
vidual and God himself—an authentic comprehensive embrace known
as the “I–Thou” and the pedestrian, cursory “I–It.”
Kass was denitely of his times. He teased his hair into a “Jew-Fro,”
a bushy style reminiscent of an Afro that was popular with leftist Jewish
Americans. He wore denim overalls, attended the Woodstock music
festival in Bethel, New York, and protested the war in Vietnam. “We
were galvanized in an important theme to stop the war,” he says. “It
wasn’t about being a partner at Goldman.” Yet Kass kept his inter-
est in the markets. He used some of his bar mitzvah money to wager
$1,000 on the conglomerate Teledyne, which initiated a series of buy-
backs and earned some $2,000, which he used to purchase a Triumph T4
convertible.
Kass graduated Alfred with a double major in philosophy and eco-
nomics, earning his degree in three years rather than the typical four in
order to save on money. His father, at age 47 died of a stroke in 1971,
likely brought on by his late-night jazz gigs and fairly heavy partying.
Money became even tighter.
Kass headed to Princeton University with plans to earn a Ph.D. in
philosophy. The subject of his thesis would be a Buber quotation: “As
I become I, I say I–Thou.” It referred to the personal journey to an
authentic existence and relationship to God and the world. Kass already
had his future mapped out after earning his Ph.D. “I could teach phi-
losophy in a small girl’s school and trade stocks on the side and make
millions of dollars,” he chuckles. “It would be a great life.”
Kass: Nader’s Raider Hits the Street 187
His advisor at Princeton was noted for his work on the philosophy
of science: Thomas Kuhn, author of The Structures of Scientic Revolutions
which argued that technological progress did not occur in a steady linear
fashion but in sudden and sporadic leaps and bounds. Kuhn coined the
term “paradigm shift” to describe the process.
The cold breath of economic necessity was breathing down Kass’s
neck, however. A Time magazine story on job prospects for Ph.D.s put
a chill on his plan for a career teaching philosophy. Among all subjects,
it ranked dead last.
Kass about-faced and applied to the Wharton School of the Univer-
sity of Pennsylvania and Harvard Business School in Boston, choosing
the former not just because of the economic aid it oered but because
it allowed him to start in the January semester. He was eager to get out
in the real world. His favorite professor was Dan Rei, who dressed like
a Hell’s Angel and often digressed into conversations about extrasen-
sory perception.
Like thousands of college graduates at the time, Kass sent his resume
in to the Center for Responsive Law, the consumer advocacy group
established by Ralph Nader with money he won in a suit he brought
against General Motors Corp. The carmaker had hired a group of pros-
titutes to discredit Nader after he published Unsafe at Any Speed,an
exposé of safety problems with the Chevrolet Corvair sports car. Kass
heard nothing for six months, until his phone rang at 5:45 a.m. one
Saturday morning.
“Mr. Kass, this is Ralph Nader,” the voice said.
Kass thought a friend was ribbing him.
“Ralph, you can call me Doug.”
Kass went to work for Nader, commuting every Thursday by Metro-
liner to Washington, where his ocemates included Mark Green, the
future New York City public advocate and mayoral candidate, as well as
a cherubic lm bu named Michael Moore, who went on to direct such
documentaries as the scathing anti-General Motors broadside Roger &
Me and the anti-gun diatribe Bowling for Columbine.
“Anybody who worked on these projects got a huge dose of self con-
dence,” says Nader. Other former Nader’s Raiders included columnist
Michael Kinsley and talk show host Jimmy Fallon.
188 THE MOST DANGEROUS TRADE
Kass ultimately contributed three chapters to a book-length
exposé—Citibank: Ralph Nader’s Study Group Report on First National
City Bank—focusing on the conicts between the money management
side of Citibank’s business and the lending side, particularly about the
lack of a Chinese wall between the two. He tackled the conicted
nature of interlocking directorates and the lack of investment in poor
neighborhoods from which Citibank drew deposits. “We were 40 years
ahead of our time,” chuckles Kass.
Citibank CEO Walter Wriston was not happy, and summoned
Nader to New York. “They were nervous,” says Nader. “They had
never had a book length exposé on them.” The bank launched a
response: an 80,000-word report entitled “Citibank, Nader, and the
Facts,” seeking to rebut Nader’s claims.
Nader keeps in touch with Kass and views his short selling as a public
service. “In the Pollyanna-ish world of gung-ho investment promot-
ers, he basically recast the function of the short seller in the manner of
‘This is a critical appraisal,’” says Nader, “He said the short sellers in
this situation are realists. He has an antenna into the speculative side of
Wall Street.”
Ultimately, the Citibank report allowed Kass to kill two birds with
one stone: His three chapters formed the basis for his MBA thesis and
he was able to graduate Wharton in just 13 months, saving big-time on
the $3,000-per-semester tuition.
Upon graduation, the Wall Street job oers rolled in. Kass’s heart
was set on Goldman Sachs. “The job I wanted was in arbitrage,” he
says, but after seven interviews he was eventually passed over by risk
arbitrage co-head L. J. Tenenbaum for another candidate. In 1972, Kid-
der Peabody was rebuilding its equity research department under a new
director, Johann Gouws, an alumnus of H. C. Wainwright & Co. who
had gained some notoriety for his 70-plus page research ticklers.
Gouws was looking for new, uncorrupted thinkers and says he
took an instant liking to Kass. “He would look at a situation and see
things other people wouldn’t,” says Gouws. Hired as Kidder Peabody’s
housing analyst, Kass plunged into an in-depth analysis of the mobile
home industry, the hottest part of the market that brokers loved to
pitch. Kass issued a deeply negative report on the sector—and Gouws
backed him up.
Kass: Nader’s Raider Hits the Street 189
Like a lot of analysts, though, Kass really wanted to manage
money. An opening for an analyst’s position at Boston-based Putnam
Investments—a prestigious yet tradition bound money management
rm—oered a foot in the door to the buy side.
Research director Lawrence Lasser hired him as part of a campaign to
transform the sleepy mutual fund giant into an aggressive, risk-oriented
competitor to up-and-comers like crosstown rival Fidelity Investments.
“It had been a savings-oriented industry,” says Lasser. “There was a
change in the business. Doug exemplied that.”
Lasser rode Kass hard, he says, partly because portfolio managers,
superior to analysts in the rigid Putnam pecking order, were sometimes
put o by Kass’s cocky self-condence. He would send o scathing,
typewritten criticisms to employees; Kass dubbed them “Lassergrams.”
One constant was Lasser’s laser-like focus on communication—the best
research is useless if the portfolio managers don’t understand its value.
“The job of an analyst is to engender condence in the portfolio man-
ager,” Lasser says.
Kass excelled at that. In 1978, Argonaut, a property and casualty
insurance subsidiary of Los Angeles-based conglomerate Teledyne Inc.,
posted a surprise loss. “Everybody wanted to sell,” says Kass. He per-
suaded them not to, and the stock rose twentyfold over the next 10
years. Kass calls Lasser a key mentor. “He was a perfectionist,” Kass says.
“I copied him.”
In 1979, top Putnam management issued strict new personal invest-
ing limits on traders and analysts—curtailing their freedom to manage
their own accounts. However noble, the new guidelines were a deal
breaker for investment talent, who loved buying and selling stocks. Soon,
Kass and a bevy of other investing professionals, including Jerey Tabak,
Larry Laverty, and Jerry Jordan, left Putnam, either for other rms, as
in the case of Kass, or to start new ventures, in the case of Tabak, who
launched the options powerhouse Miller + Tab ak + Hirsch Inc., and
Jordan, who built an investment rm with former Lehman Brothers
chairman Warren Hellman.
Kass was eager to head back to New York. After talking to San-
ford C. Bernstein and Oppenheimer & Co. in 1978, he opted for a
tiny, family-owned business called Glickenhaus & Co., specializing in
municipal bonds with just $5 million or so in assets. It was run by family
190 THE MOST DANGEROUS TRADE
patriarch Seth Glickenhaus. Kass helped rack up an impressive record
investing in deep value stocks, and assets under management rose to $500
million as institutional investors like the State of Oregon, Xerox Corp.,
and Blue Cross Blue Shield became clients.
By 1983 Kass was ready for a new challenge. He hooked up with
partner John Jakobson to start a hedge fund, which closed within a year
following poor performance. Kass then struck out on his own, found-
ing his own rm, DAK Securities, managing a pool of money from
First Executive Corporation, the Los Angeles-based insurance rm run
by Fred Carr. Kass had been introduced to Carr by Drexel Burnham
Lambert junk bond pioneer Michael Milken. First Executive, a huge
buyer of Drexel Burnham Lambert–underwritten junk bonds, would
le for bankruptcy in 1991 amidst the collapse of the high-yield bond
market that year.
Kass wound down DAK while convalescing from his horse-racing
accident. In 1991, with money running low, he took a call from CEO
Allen Goldberg of First Albany, a well-regarded regional brokerage rm
in upstate New York that was looking for someone to run its equity
research and asset management divisions. Kass, his leg still held together
by external metal rods, liked the idea of not enduring painful commutes
to midtown in bumpy taxis. He lived during the week in Albany
and commuted back to Manhattan on weekends. Over two years,
he built the rm’s research department and asset management group
in conjunction with the ubiquitous Hugh Johnson, the company’s
equity strategist.
The weekly Amtrak commute eventually weighed on Kass and
he quit in 1994. The next year, he got a call from Marshall Leeds,
the CEO of J.W. Charles Securities, a scrappy brokerage rm in Boca
Raton, Florida. He was looking for someone to head sales, trading, and
research. Kass jumped at the chance: He loved the Florida weather and
lifestyle and relished the chance to run a research department the way he
saw t.
With just ve analysts, Kass kept a tight rein and made sure that
sell and buy recommendations were balanced 50/50. Most brokerages,
then as now, overwhelmingly tilt toward buy recommendations. Kass
also banned the wishy-washy “hold” recommendation, to which ana-
lysts default when they don’t want to oend the management of the
Kass: Nader’s Raider Hits the Street 191
companies they cover. “We had a hard-hitting research department,”
he says.
Kass was building his public persona. With his witty quotes and con-
trarian market views, journalists loved him. After J.W. Charles slapped a
sell recommendation on virtually the entire brokerage industry, a writer
for the Wall Street Journal’s inuential “Heard on the Street” column in
late 1993 dubbed Kass “The Bear of Boca.” The next year, brokerage
stocks turned in a terrible performance, pummeled by a series of interest
rate increases by Fed chairman Alan Greenspan.
A lot of J.W. Charles’s recommendations were cited by USA Today
columnist Dan Dorfman, a friend of Kass’s who was later tied to a dicey
stock promoter named Donald Kessler, who plead guilty to securities
fraud. A 1996 BusinessWeek article eviscerated Kass, highlighting some
of his rm’s bad calls. Kass says it comes with the territory. “One of the
risks of being a person in the media is you become a target,” he says.
By that time, however, Kass had moved on to work on Omega Advi-
sors, the famed long-short hedge fund run by former Goldman Sachs
Asset Management chairman Leon Cooperman, who had recruited him
to work as a senior portfolio manager. Cantankerous and demanding,
Cooperman parceled out the dierent names in the portfolio at Omega
among portfolio managers, with each keeping track of a group of posi-
tions and on call to endure Cooperman’s withering interrogations. “It
was a tough job for two years,” Kass laughs. “He basically red me.”
That was okay, though. Kass, who remains friendly with Cooper-
man, was eager to return to Florida, where he had bought a house, and
start up his own investment rm, with money from an insurance rm.
He ran Kass Partners until 2003.
Kass launched a hedge fund under the Seabreeze Partners moniker
in 2001, eventually allocating capital between Seabreeze Partners
Long-Short LP and, from January 2005 to August 2009, to the short
fund called Seabreeze Partners Short LP, which he shuttered after the
Federal Reserve got its quantitative easing program underway.
In early 2003, Kass oversaw short positions for 12 months at a mar-
ket neutral fund for Circle T Partners LP, a New York hedge fund run
by Seth Tobias, a fellow CNBC talking head who had a house in nearby
Jupiter, Florida. Circle T later imploded. Tobias was found dead in mys-
terious circumstances in September 2007.
192 THE MOST DANGEROUS TRADE
Today, bueted by the warm Caribbean tradewinds, Kass runs
Seabreeze from posh Palm Beach. The fund is housed in a red terra
cotta–roofed guesthouse that overlooks Kass’s swimming pool. The
walls are festooned with laminated press clippings, and sunlight pours
into the oces. Aside from Kass, there are a head trader, three analysts,
and an administrator.
The typical Seabreeze research initiative is informed by what Kass
learned from Johann Gouws at Kidder Peabody and Putnam research
director Larry Lasser—exhaustively enumerate every issue, large or small,
that may bear on a company’s share price. Kass is often prone to warm
over plenty of well-known observations, almost burying the new insights
that he brings to the analysis. “I’m old school,” says Kass. “I don’t shoot
from the hip.”
In early October 2001, though, Kass did what most any introductory
book on investing will advise: He simply read the footnotes to AOL
Time Warner’s 10-Q led with the Securities & Exchange Commission
(SEC) and traded on it.
To be sure, Kass was a long-time skeptic toward AOL’s business
model well before it had purchased Time Warner in a $180 billion
all-stock deal in January 2000, having protably shorted it on several
occasions. The previous May, for example, as the economy headed into
a tailspin, Kass bet against the merged company’s shares based upon,
among other things, decelerating ad sales growth. Second quarter earn-
ings results proved him right, and the stock fell 9.7 percent.
More fundamentally, by late 2001, Kass was worried that AOL
Timer Warner’s market was increasingly saturated. Subscriber growth,
by his calculation, was on track for its third straight year of decline.
While Wall Street analysts were forecasting 25 percent long-term
earnings per share growth, Kass pegged the number at half that amount,
give or take. It would be Kass’s “variant view” versus the consensus.
Plowing through AOL Time Warner’s lings, Kass stumbled upon
a surprising footnote in the 10-Q. It had to do with AOL Europe, the
company’s 50.5 percent–owned subsidiary, which was struggling against
such rivals as Tiscali and T-OnLine—a sideline to the bigger issues, but
involving a potentially huge amount of money. What had escaped much
notice at the time was that AOL, shortly after agreeing to buy Time
Kass: Nader’s Raider Hits the Street 193
Warner, had entered into a put-call arrangement with Bertelsmann, the
German publishing giant that owned the other 49.5 percent of AOL
Europe. As the footnote spelled out, the agreement valued AOL Europe
at between $13.5 billion and $16.5 billion.
AOL Europe was in fact hemorrhaging. Kass estimated it would lose
$300 million on $700 million in sales for the year and pegged the value of
the subsidiary, in what was now a post -technology bubble market, at just
$2 billion. The key was that the put-call agreement gave Bertlesmann the
right to sell 80 percent of its stake to AOL-Time Warner for $5.3 billion
by January 31 of 2002, and the remaining 20 percent for $1.45 billion
the following June. At least $2 billion of the payment had to be in cash,
of which AOL Time Warner had just $1.3 billion on its balance sheet.
“That was a ‘what the f--k’ moment,” says Kass. “I couldn’t believe what
Isaw.”
He called Abelson, and told him about the put-call agreement that
everybody seemed to have overlooked.
“It can’t be right,” Abelson erupted.
“Alan, would you like me to fax you the report?” Kass responded.
Abelson wrote up Kass’s analysis in the “Up & Dow Wall Street” col-
umn. Kass began shorting the shares at $70, which is about where they
traded before the article appeared. Shares fell to $65.54 the rst day after
Barron’s published. As the footnote stated, AOL Time Warner was forced
to buy the balance of AOL Europe for $6.85 billion and issued billions of
debt to nance it. By June 30, 2002, AOL Time Warner shares had tum-
bled to little more than $30, the price at which Kass covered. Though
he won’t give a dollar amount for the prot Seabreeze notched, the gain
on the position was more than 50 percent. “It was one of the great nds
ever,” Kass says of the footnote. “The company was symptomatic of the
avarice of the time.”
Kass concedes that no matter how thorough his research, sometimes
markets don’t cooperate. “Doug remembers when he is wrong,” says
Herb Greenberg, of Pacic Square Research. “He makes bold calls and
’fesses up when he doesn’t get it right.”
His history with Washington, D.C.-based Danaher Corp., a man-
ufacturer of auto parts, power tools, and medical equipment, stretched
back decades. In the early 1980s he had purchased a 10 percent
194 THE MOST DANGEROUS TRADE
stake in its predecessor company, Diversied Mortgage Investors,
a money-losing real estate investment trust (REIT) with a market
capitalization of $15 million, on behalf of Glickenhaus and some of
its clients.
The REIT owned a motley assortment of assets, ranging from a
motor home park in upstate New York to an underground refrigeration
facility in Kansas City. Its lure was $125 million in tax loss carry
forwards. “I thought, this thing is worth more dead than alive,” recalls
Kass. His plan was to take control of the rm, sell o its holdings and
merge protable businesses into the REIT to take advantage of the
tax losses.
Kass got as far as ousting management, but was impatient to leave
Glickenhaus. With no one to oversee the REIT investment, he agreed
to sell it to brothers Steven and Mitchell Rales, who eventually changed
the name to Danaher Corp. The Rales executed Kass’s strategic plan,
building sales to $4.6 billion by year-end 2002 by rolling up manufac-
turers across a range of markets—including test tools, electronic motors,
and dental equipment.
It was this last segment that interested Kass in mid-2003, as he sifted
through the market looking for short candidates in the dental equipment
sector. Familiar as he was with his late father’s line of work, Kass knew
dentists in tough economic times postpone buying equipment. Some 25
percent of Danaher’s revenues derived from the sector.
As Kass dug down into Danaher’s SEC lings, evidence began to
mount that the company would make a good target on a number of
counts. Like a lot of short sellers, he was suspicious of serial acquir-
ers, such as Tyco International, because of the ease with which they
can engage in accounting obfuscation. “They set up reserves,” Kass says.
“There are all kinds of accounting gimmickry.” More than other com-
panies, roll-ups are dependent on the vagaries of external market forces,
which may pump up prices of target companies or, alternatively, reduce
their access to nancing.
Right o the top, Danaher’s stock was expensive for a conglomerate,
trading at 22.5 times trailing earnings, the upper range of its historical
price-to-earnings ratio (P-E) and well above industry bellwether General
Electric, which traded at 19 times trailing earnings. Danaher used its high
market valuation to good eect. It bought mid-sized companies at prices
Kass: Nader’s Raider Hits the Street 195
equivalent to about one times their annual sales while Danaher shares
themselves traded for 2.4 times sales. This meant paying $100 million for
a company with a like amount of sales would generate a $240 million
rise in Danaher’s market capitalization—the dynamic is seductive yet is
also a classic warning sign for investors.
That’s because the high P-E multiple was based on the investor
assumption that the company could wring all kinds of synergies
out of its acquisitions and integrate them smoothly. The Seabreeze
analysis showed this wasn’t happening. Internal sales—that is, excluding
acquisitions—had shrunk 4.5 percent in 2002. Kass was forecasting a
further 3 percent decline for 2003. That suggested Danaher was having
trouble making its purchases work, the very reason for its high P-E in
the rst place. Kass gured that once investors were convinced of his
variant forecast, the premium would revert to that of the overall market,
and shares would decline 25 to 30 percent.
For the t-crossing, i-dotting Kass, that wasn’t good enough: He drew
up a list of 18 reasons why the stock was overpriced and likely to post dis-
appointing earnings going forward. These ranged from its low dividend
payout of 10 cents per share to brisk competition and high production
costs. Two accounting analysts, he noted, were also critical of the quality
of its earnings, which beneted from nonrecurring gains, a sliding tax
rate, and special restructuring charges.
Seabreeze began accumulating a short position in Danaher in May
2003. Shares were trading at $17.35 the day Kass published the anal-
ysis in his column on TheStreet.com.CriticaltoKass’sgameplan,he
gured Danaher management itself would provide a catalyst for a sell-
o when it would be forced to lower 2003 earnings guidance in the
next few months. The consensus analyst estimate was $3.20 earnings per
share—Kass thought $3 seemed more reasonable.
Things didn’t work out. Five weeks later, during its second quarter
earnings call, the company conrmed that it expected to post 2003
prots of between $3.25 and $3.15 per share, essentially on target.
Danaher stock, which had traded down to $16.55, the previous day,
closed at $16.93, nishing o the week at $17.40. At year-end the stock
closed at $22.94.
Seabreeze was suciently deft to close out its Danaher position with
a loss of just 5 percent or so, but Kass says there are lessons to be learned.
196 THE MOST DANGEROUS TRADE
What he did not pay sucient attention to were the problems besetting
two far larger diversied manufacturers. Tyco was still digging itself out
from ex-CEO Dennis Kozlowski’s wide-ranging accounting fraud, and
General Electric was being hammered by a portfolio of souring small
business and real estate loans. Institutional investors were looking toward
Danaher as the remaining market leader—and were prepared to stand by
the stock.
“Psychology is often as important as fundamentals,” says Kass. “One
lesson in short selling is that you have to leave your dog at the doorstep.
You’ve got to be exible and when the market ignores, you move on.”
The stumble on Danaher did not prevent Kass from shorting
conglomerates. He bet against it again in 2007 with similar results.
And in early 2008, he turned his attention to Berkshire Hathaway, the
Omaha-based juggernaut lorded over by Warren Buett. For decades
Berkshire Hathaway investors rested easy in the knowledge that its
fortress balance sheet and AAA credit rating made it a bear market
tank—as safe a place as any in collapsing markets. There was condence
to be derived from its varied business mix, with subsidiaries focused
on power generation, homebuilding materials, machine tools, and ice
cream, to name a few. The company’s massive insurance portfolio was
comprised of huge stakes in some rock-solid blue chips, including
Coca-Cola, Johnson & Johnson, and Procter & Gamble. Berkshire
Hathaway’s balance sheet coers swelled with $37.7 billion in cash—part
of an almost unfathomable war chest under the command of the world’s
undisputed master of asset allocation.
The key for Kass, once again, was developing that “variant view.”
What was the consensus missing that could be the basis for a negative
take on Berkshire Hathaway?
It started with valuation: The $134,000 price on those shares as of
March 2008 seemed rich. Kass crunched a sum-of-the-parts valuation
comparing Berkshire’s various businesses to their peers and assumed a
P-E multiple of 12 times on projected 2008 earnings of $9,750. That
resulted in a fair value of $121,000. For Kass, that represented a mean-
ingful gap. Using a variation on that methodology, Kass calculated a price
that melded a 1.6 times price-to-book value ratio on Berkshire’s insur-
ance and other businesses and a 1.25 times book ratio on nance and
nancial products. That resulted in a projected price of $125,000 a share.
Kass: Nader’s Raider Hits the Street 197
Again, though only modestly below the market price, the discrepancy
was sucient to explore further.
More dramatic was Berkshire Hathaway’s recent sizzling relative
stock price performance. The class A shares by March 2008 had risen
12 percent over the previous six months versus an 11 percent decline in
the S&P 500. Over 12 months, the stock was up 26 percent versus an
8 percent drop in the broader index. That huge performance gap was
not logical given the driving forces behind the broader market sello.
Housing prices were falling, defaults on the rise, and the subprime con-
tagion spreading to the general nancial industry. Yet Berkshire derived
most of its revenues from the nancial sector in the form of insurance
businesses, and it had a big exposure to the housing market through
its Clayton Homes, Nebraska Furniture Mart, and building materials
subsidiaries like Acme bricks, Shaw carpets and Benjamin Moore paints.
It only took a glance a Berkshire’s annual report to see that its stock
portfolio was bloated with nancial companies, many of them good
ones, but still at risk in the impending meltdown—Wells Fargo, Amer-
ican Express, Moody’s Investors Services, Swiss Re, and U.S. Bancorp.
Kass was also sensitive to perennial concerns, like Buett’s advancing
age of 78 at the time. “I gured with his age, you had to gure in a 15
percent discount the way you do a closed end fund on the New York
Stock Exchange,” says Kass. He also averred that growth prospects for
Berkshire Hathaway’s industrial businesses should likewise be discounted
because it wasn’t likely that Buett would be able to make the kind
of large transformative acquisitions that would allow it to boost future
earnings.
In his methodically comprehensive fashion, Kass also noted Berk-
shire Hathaway’s slowing earnings growth in recent years, somewhat
opaque nancial disclosure, and the likely headwinds in the property
and casualty insurance industry. There was also the overhang of Buett’s
38 percent stake in the company, which was to be turned over to Bill &
Melinda Gates Foundation and likely to weigh on the market for years.
Because Berkshire Hathaway’s class A shares, at well over $130,000
each, often traded fewer than 1,000 shares a day, Kass began building
a short position in the class B shares beginning in March 2008 at a
split-adjusted $92 a share. Class A shares at the time were the economic
equivalent of 30 class B shares, although the latter had only 1/200 of the
198 THE MOST DANGEROUS TRADE
voting rights of the pricier class. (In January 2010, Berkshire split the
class B shares 50 to 1, giving them an economic value equal to 1/1,500
of a class A share).
“Of all the stocks on the New York Stock Exchange, few have a
cadre of more loyal long-term investors than Berkshire. Warren Buett
has been so successful that this cadre is more than willing to endure
extreme pain,” says Kass. “They tend to be hostile to naysayers. Criticism
is not taken well.”
The reaction was incredulity. “There are certain things in life you
just don’t do,” wrote one Motley Fool columnist. “You don’t spit into
the wind. You don’t pull the mask o that ol’ Lone Ranger, and you
denitely don’t short Warren Buett. Apparently, that’s a lesson Doug
Kass is determined to learn the hard way.”
The trade made for a rollercoaster ride. Berkshire class B shares stock
initially ratcheted down from Kass’s initial shorting position of $92 a
share, adjusted retroactively, in March 2008 to the mid-70s in July. A
collapsing Bear Stearns Cos. had been snapped up by JPMorgan Chase
& Co. in June, and concerns were growing about the solvency of Fan-
nie Mae and Freddie Mac. Kass was short those stocks by this point in
addition to Citigroup, MBIA, and Washington Mutual. By the end of
September, the two government-sponsored mortgage machines were in
conservatorship and Lehman Brothers in bankruptcy. American Inter-
national Group, would soon become a ward of the state, after the federal
government bailed it out of a $62.1 billion portfolio of imploding CDOs
it had insured in a rescue package that left U.S. taxpayers on the hook
for more $182 billion.
As terror gripped the world nancial markets, though, it soon looked
as if Kass had badly miscalculated. Berkshire shares rallied in the last
two weeks of September as panicked investors stampeded into the stock,
handing Kass a paper loss as shares hit $93. In October, Buett showed
how well he could play a nancial crisis by purchasing $5 billion of
preferred stock in Goldman Sachs Group and General Electric. The
preferred stocks each paid a 10 percent dividend and were redeemable
at advantageous prices just 10 percent above where they were trading.
Kass, though, didn’t cover a share.
Then it got worse. As worries that the world nancial cataclysm
would suck down the entirety of the Western nancial system increased,
Kass: Nader’s Raider Hits the Street 199
the Chicago Board Options Exchange VIX index, which measures the
volatility of the S&P 500, pierced 80, versus little more than 20 at the
beginning of the year. The S&P 500 itself lost a quarter of its value in
November peak to trough, and Berkshire cratered along with it to a 2008
low of $52.40 on November 20.
Of course it wasn’t over. The Treasury Department under Secretary
Henry Paulson was rolling out massive rescue initiatives like the Troubled
Asset Relief Program (TARP), and Bernanke’s Federal Reserve ooded
the system to keep markets from freezing, cutting its target rate to 1
percent. Berkshire class B shares rallied to $64 at year-end.
The rst two months of 2009 were characterized by capitulation
across the nancial markets. The S&P 500 tumbled to 676, down 56
percent from its peak in 2007 and o 31 percent from the previous year’s
close. Berkshire shares bottomed at $46. Seabreeze ultimately closed out
its short position below $50 in March, as it did with the remainder of
its nancial shorts. Kass gured the rm’s gain on the Berkshire trade
was 30 percent. “I was early,” says Kass, who has bought and shorted
Berkshire since. “But I was committed.”
Warren Buett invited a short seller to make the case publicly
against Berkshire Hathaway stock at his famous annual meeting at
Omaha, Nebraska’s cavernous CenturyLink Center May 4, 2013. Kass,
not averse to the limelight, stepped up to the challenge. As hordes of
Buett-worshipping shareholders looked on—the attendees totaled
more than 30,000—Kass questioned whether the sage of Omaha was
doing the kind of detailed due diligence on his investments that he
had in the past, citing his 2008 investment in Bank of America Corp
as an example. Buett responded that he learns his lessons and can
reapply them.
“Are you at the point where the game interests you more than the
score?” Kass asked Buett.
“I think you have to love something to do it well,” Buett
responded. “The passion has not gone, I promise you.”
Kass also questioned Buett’s decision to name his son Howard, who
has limited operating experience, to be executive chairman after Buett
left the scene. Buett responded that Howard’s responsibility would be
to make sure the CEO who was eventually chosen didn’t go astray, not
to run Berkshire.
200 THE MOST DANGEROUS TRADE
Then, in his own charmingly characteristic self-promoting style,
Kass asked whether Berkshire Hathaway would hire him to manage a
$100 million short portfolio. Buett turned him down at, noting that
he himself had identied frauds and inated stocks in the past.
The normally reticent Berkshire Hathaway vice chairman Charles
Munger couldn’t help but chime in. “Shorting is a game that doesn’t
appeal to us,” he said.
For the record, Berkshire’s class A shares traded at $162,904 the day
before the annual meeting. In late 2014, the stock was $221,925, a gain
of 36.2 percent.
Kass began to suspect Apple Inc. was baked fruit in late 2012. On
September 12, the Cupertino juggernaut unveiled the iPhone 5—
slimmer, lighter, and with a bigger screen than its predecessors. The
media enthused, even if the device itself was more an evolutionary
improvement than the kind of game-changing quantum leap that
had thrilled Apple enthusiasts in the past—music player iPod; Siri,
the voice-activated butler; and iPad, the e-book reading laptop
substitute. Kass didn’t like the feel of the device, which he thought
lacked heft.
Still, rst-weekend sales topped ve million. Time magazine named
the iPhone 5 gadget of the year. Shares, up 65 percent through August,
pierced $700—which admittedly sounded pretty cool. Kass, who in
2011 had zinged out bullish Apple comments on his blog, thought it
was time to reappraise the stock and its prospects. “My experience is
in looking at innovative companies that become market darlings,” says
Kass. “I’m wired to look for the storm clouds gathering at successful
companies like Apple, Chipotle, Salesforce.com, and Google.”
Valuation was problematic as a starting point. Apple shares were trad-
ing at a seemingly ridiculously low 9.9 trailing earnings in September.
If you backed out the cash on Apple’s balance sheet, $110 billion worth,
the remaining company would be trading for just 7.9 trailing earnings.
That was two-thirds the P-E multiple IBM traded for—and less than half
that of Google.
The problem with that calculation was that it wasn’t a particularly
useful metric given Apple’s history of super-splashy product launches
and super-high margins, which were likely to be unsustainable as rivals
caught up. Kass, like some other analysts, preferred to look at the
Kass: Nader’s Raider Hits the Street 201
company’s share price compared to its annual sales. On this count, at
4.4 times sales, Apple was wildly expensive compared to other hardware
makers like Hewlett-Packard and Dell, which traded for 0.5 times sales.
In his characteristically exhaustive style, Kass published a litany of
other observations: Apple products, while still costlier than those of rivals
like Samsung, Google, and Hewlett Packard, were no longer qualita-
tively better. The company faced product cannibalization—new, cheaper
oerings like the iPad mini did the same job as pricier models. Carriers
like AT&T and Verizon, pinched by tough economic terms forced on
them by Apple, were pushing rival phones on customers. And most of
the apps that tied users to the Apple ecosystem were now available on
Android and Microsoft. “The rst-mover advantage was evaporating,”
says Kass.
Of course, Steve Jobs’s death the previous year had left a huge hole
in the company: Apple’s attempt to replace Google Maps with its own
version was evidence of that. It was a asco; the app generated streets in
the wrong neighborhoods, and the company was forced to reintroduce
the Google application for its iPhones. “The map boner was one of the
signs that a Jobs-less company was less attentive to quality,” Kass says.
“Pride goeth before a fall.”
The reaction to Kass’s e-mail post of September 26 was immedi-
ate. “The blogosphere went ballistic,” says Kass. “Few addressed my 10
points. There is a tendency to spout sparkly generalities and not address
issues.” One example: “These guys should be caged in the zoo with all
the other animals.”
Kass published his research just days after Apple’s all-time high of
$702. When Apple released fourth quarter earnings on October 25, 2012
the $8.45 earnings per share were 10 percent shy of analysts’ consensus
estimates and gross margins were down. The stock, trading at $609.54,
fell to $604. Shares continued to break down over the rest of the year,
ending at $532.17. The fact that the company beat estimates by only 2
percent in January 8 spurred another downward leg. Kass covered his
short position on February 4, 2003, at $442. He gures he gained 25
percent—and went long Apple for a couple of days that month as well.
Jerry Jordan likes to tell the tale of Kass’s call on the bottom of the
nancial crisis in February 2009—about the time he was closing out his
Berkshire Hathaway short. The two friends talked about the market.
202 THE MOST DANGEROUS TRADE
“Doug, this market is moving into a climactic bottom,” Jordan recalls
telling him.
“I think it is, too,”
That Friday, Kass wrote: “This is the market bottom I’ve been talking
about.”
Kass covered most of his shorts and went long.
Then, just over one month later, he about-faced—selling all his posi-
tions and writing that he planned to go short.
Jordan asked him why.
“I don’t like the way it feels,” Kass responded.
As Jordan explains, at his core, Kass will never be comfortable as an
optimist. “He truly is a bear,” says Jordan.
Kass doesn’t argue the point. “The average long-short investor sees
the world as America and apple pie,” he shrugs. “We are facing secular
headwinds that have been accumulating for decades. I view the world as
a kaleidoscope of problems.”
Chapter 8
Tice: Tr u th Squad
Leader
C
ongress was in for some reworks. It was June 2001 and the
House Subcommittee on Capital Markets was investigating the
ties of Wall Street analysts to their investment banker colleagues.
“We are going to inquire into disturbing media and academic reports
about pervasive conicts of interest,” Chairman Richard Baker told the
half-empty chamber, lled mostly with sundry aides and lower level
staers milling about. But if the Louisiana Republican thought the pro-
ceedings were going to be dry, he didn’t know much about the rst
witness—David Tice, founder of his eponymous investment rm.
Tice lived and breathed research; a numbers geek, he had devoted the
better part of his career to picking apart nancial statements, using what
he found as the cornerstone for not one but two thriving businesses—an
accounting-focused market research service and a short-selling mutual
fund. Tice let loose.
“This is an outrage,” he proclaimed. “Wall Street’s research is riddled
with structural conicts of interest.”
203
204 THE MOST DANGEROUS TRADE
Tice said bogus analyst recommendations were just the tip of the
iceberg. The entire nancial system had become irredeemably tainted.
“This problem is much larger,” he said. “A sound and fair marketplace
is at the very foundation of capitalism.”
The corruption of hundreds of stock analysts contributed to the
channeling of vast sums of money into risky and money-losing ven-
tures. “When the marketplace’s reward system so favors the aggressive
nancier and the speculator over the prudent businessman and investor,
the consequences will be self-reinforcing booms and busts, a hopeless
misallocation of resources, and an unbalanced economy,” Tice said.
He linked Wall Street excesses to the growing credit bubble—one
that would explode years later in the credit crisis of 2008–2009. “The
nancial sector is creating enormous amounts of new debt that’s often
being poorly spent,” Tice said. “Wall Street’s lack of independence has
fostered this misdirection and camouaged the fact that our U.S. econ-
omy is in danger because of our capital misallocation and credit excess.”
Representative Baker eventually cut him o, but Tice says he’s proud
of his ery testimony that day. “We were the good guys,” he says. “I liked
to refer to us as ‘the truth squad.’”
Tice’s career was built on this blunt outspokenness. He was among
the rst in the 1980s to sound the alarm about a rising tide of account-
ing distortions. Worried that small investors were being suckered into a
rigged investment game, Tice launched his rst mutual fund—the Pru-
dent Bear—dedicated to shorting stocks promoted by Wall Street. As his
understanding of the bubble economy grew, Tice says he connected dots
and saw that the inated technology stock prices of the late 1990s were
manifestations of a bigger issue: out-of-control credit that had for years
levitated the stock market. By 2001, that bubble was collapsing—and
vaporizing trillions of dollars of speculative capital as it did.
Tice was never one to lay low. He penned columns and opinion
pieces at every opportunity and grabbed television time whenever he
could. In 1999, he sponsored a conference at New York’s Waldorf
Astoria hotel entitled the “Credit Bubble and Its Aftermath—A
Symposium.” Keynotes were delivered by Henry Kaufman, the former
Salomon Brothers chief economist dubbed “Dr. Gloom”; hedge fund
manager Marc Faber, publisher of the Gloom, Boom & Doom Report;
and former Federal Reserve Governor Lawrence Lindsey, at the time
Tice: Truth Squad Leader 205
the top economic advisor to presidential candidate George W. Bush.
The Wall Street Journal cited Lindsey’s bearish outlook expressed
at the symposium on the front page: “In an era of prosperity and
optimism, the economist shaping Republican presidential front-runner
George W. Bush’s economic thinking has been one of the country’s
leading pessimists.”
A bearish outlook is no way to make friends. He received hate
mail. When his rm, David Tice & Associates, moved to larger space,
Tice made sure his own oce was as distant from the front entrance
as possible—with a nearby stairwell through which to beat a hasty exit
if necessary. He kept a loaded Smith & Wesson revolver in his top
right hand drawer—part of Texas gun culture, but also a sign of his
relentless wariness.
Nobody cut through smoke-and-mirrors accounting like Tice’s
“truth squad.” At the threadbare oces in Dallas, the blond-haired
CPA led a motley group of a dozen analysts and others who delved
into the adjustments, special items, and footnoted ephemera of nancial
statements. Every ve or six weeks, Tice sent out his $10,000 sub-
scription newsletter, Behind the Numbers, agging stocks with dubious
accounting. The newsletter became an arsenal of potent short-selling
ideas for storied investors—George Soros, Jim Chanos, and Michael
Steinhardt among them.
Among the hits: a 1990 item on Procter & Gamble. The com-
pany reported sizzling earnings-per-share growth of 23 percent, but
Tice showed that when adjusted for restructuring charges and other
aggressive accounting, pre-tax earnings were up just 7 percent. P&G
shares lagged those of rivals over the next year. In a 1998 Behind the
Numbers issue, Tice’s analysts questioned the write-os that WorldCom
took after buying MCI Communications. Analysts calculated that of the
$1.97 earnings per share Wall Street forecast for 1999, $1.50 was due to
aggressive accounting. WorldCom’s CEO Bernie Ebbers is now serv-
ing a 25-year sentence for fraud. It was dead-on, lethal research. Tice
eventually turned the newsletter over to the analysts who worked on it.
A populist of sorts, Tice fretted that it was mostly hedge fund barons
beneting from his bearish analysis. So in late 1995, Tice started Prudent
Bear with the purpose of shorting the stocks that Behind the Numbers was
warning about. “I felt I could help protect the great unwashed public
206 THE MOST DANGEROUS TRADE
who were listening to Merrill Lynch analysts,” he says. “Wall Street was
selling people a bill of goods. I felt that was morally wrong.”
Tice’s timing was astonishingly poor. The stock market had entered
a historic speculative frenzy—the fund dropped 13.7 percent in 1996,
4.3 percent in 1997, 34.1 percent in 1998 and 23.4 percent in 1999—a
span during which the Standard & Poor’s (S&P) 500 Index delivered a
26.3 percent annualized return. Fund assets were just $160 million at the
end of the decade. Tice notched an expense ratio of 2.5 percent. Critics
savaged Tice and the fund, which nancial publisher Morningstar named
to a roster of “top wealth destroyers.”
Did Tice worry that his bearish stance was a disastrous mistake?
“No,” he says. “I told myself, ‘This is just an asset bubble.’”
Did he consider pulling back—say, buying Treasuries to balance his
negative bets?
“No. We told investors that we would be there for them,” Tice says
as he leans back in his 12th-oor oce overlooking downtown Dallas’s
gleaming, skyscraper punctuated skyline. “We were a hedge.”
Tice remained constant. “We told them that we would be that ship in
the storm when the market goes down.” Having that lodestar to refer to
helped him through much of the worst of Prudent Bear’s losses. “People
asked ‘Weren’t you pulling your hair out? Didn’t you think you were
wrong?’” Tice recalls. “No. I was bloodied but unbowed.”
When the technology bubble burst in mid-March 2000, Tice was
vindicated. The S&P 500 tumbled 21 percent that year as Prudent Bear
surged 30.5 percent. Tice rolled out the Prudent Bear Safe Harbor
fund, which buys short-term sovereign debt of nations with strong
currencies—Norway, Singapore, and Switzerland. “I felt with all the
credit being created, our currency would decline,” says Tice. “People
needed a fund that would protect them.” Safe Harbor notched a
7.1 percent return annualized from its founding in early 2000 to the
end of 2008, with only a single money-losing year.
As for Prudent Bear, Tice adroitly navigated the fund through the
treacherous rebound years of 2002–2004, working to keep losses man-
ageable as the S&P 500 surged and surged—and even successfully posted
prots in 2005–2007.
The surprise payo for Tice, though, came in December 2008.
As credit markets seized up across the globe, Tice struck a deal to sell
his funds to Pittsburgh-based Federated Investors, a big money fund
Tice: Truth Squad Leader 207
manager. Tice got $43 million up front, with a further $99.5 million over
four years conditional on asset growth. That totaled 8.4 percent of assets
versus the usual 4 percent or less that an asset manager fetches. “We were
able to justify that because we were the only fund doing what we were
in shorting individual stocks,” says Tice. “We were very protable.”
On a warm November afternoon in Dallas, Tice wears a
black-and-white check polo shirt and black corduroy slacks. He is ve
feet eight inches tall and weighs a lean 160 pounds. Tice is hyperkinetic.
He stands and sits frequently over the course of an interview, is quick
to laugh, and speaks with the slight drawl of his adopted state. Having
divorced his wife Louise in 2006, Tice lives in a high-end 22nd-oor
bachelor pad, with pricey modern furniture and a genteel feel of clutter
about the place.
Away from short selling, Tice continues to work a 45-hour week,
hopping into his black Mercedes-Benz sedan to speed o to meetings
and oversee a half dozen projects and businesses he’s since embarked
upon. Tice is chairman of his family oce, Tice Capital LLC and of
Encryptics, a Frisco, Texas–based cyber security company he funded. He
has put money into a Singapore diamond exchange, stem cell research,
and social media ventures. Tice also heads his own 501(c) nonprot, True
Spark, that encourages children to watch movies that provide ethical role
models—he’s funding it to the tune of $3 million over ve years.
Hollywood is a particular interest and a lucrative one. As executive
producer, Tice bankrolled Soul Surfer, a 2011 movie about a evangelical
Christian girl who loses her left arm to a tiger shark, and then goes on to
embark upon her professional surng career. It stars AnnaSophia Robb,
Dennis Quaid, Holly Hunt, and Carrie Underwood. With a domestic
gross of $43 million, it is the highest grossing live action surf lm in his-
tory. He also scored when, together with legendary Hollywood execu-
tive Peter Gruber, he co-nanced the script for “When the Game Stands
Tall”, a 2014 inspirational movie starring Jim Caviezel about famed high
school football coach Bob Ladouceur, who took the De La Salle Spartans
from obscurity to a 151-game winning streak. It grossed $30 million.
Closer to Tice’s market roots: The Bubble, a documentary about
the causes of the nancial crisis, written as a response to the Academy
Award–winning polemic Inside Job, by director Charles Ferguson. While
Inside Job focuses on avaricious bankers, compromised government reg-
ulators, and co-opted academic research, The Bubble, directed by Jimmy
208 THE MOST DANGEROUS TRADE
Morrison, highlights the Federal Reserve and failed Keynesian policies,
as well as—and I’m not sure I get this—the Community Reinvestment
Act of 1977, which encouraged banks to lend to the economically disad-
vantaged. It’s based on the New York Times bestseller Meltdown by Thomas
F. Woods Jr. (Regnery Publishing, 2009). Tice says he pulled out because
it didn’t meet his standards.
A middle child, David Wayne Tice grew up in Independence, Mis-
souri, the birthplace of Harry S. Truman, a President who had no prob-
lems tilting against popular opinion. His father, a radiologist, and mother,
a Presbyterian church elder, were children of the Great Depression, and
drilled into him the value of a dollar earned.
Born in late September, Tice was typically the youngest in his class.
He was less social, at times a loner. “I didn’t date much,” he says. “I don’t
have good friends from back then.” Tice was no prodigy. “I was a decent
student,” he says. “But super excellence was not my goal.”
A sports enthusiast, Tice’s stature held him back, as did his near-
sightedness, which required his wearing thick, two-toned horn-rimmed
glasses as early as the third grade. Tice’s father encouraged his interest in
golf; ultimately, he couldn’t make much progress with his stroke. Tice
showed much more promise in high school math—geometry, trigonom-
etry, and mathematical analysis. His Scholastic Aptitude Test (SAT) scores
were evidence of his talents—580 verbal and 640 math.
Tice found a surrogate for athletic stardom in a fantasy baseball
game—Strat-O-Matic. Tice excelled at selecting imaginary teams
of star players and then rolling the dice to see how they performed.
Strat-O-Matic mixed probability with research and depended on
understanding numbers—skills that would later come in handy. “You
could play the 1962 Minnesota Twins against the 1967 Yankees,”
Tice recalls. “You were putting together the line-up, you could make
decisions about relieving pitchers, and you rolled the dice, so there was
an element of luck.”
His mother interested him in the stock market, tuning in to the
television program Wall Street Week in its earliest days. She opened a
brokerage account in his name.
After high school, Tice headed out of state—seeking to put some
distance between his teenage years and the vibrant future he hoped
Tice: Truth Squad Leader 209
would lie ahead. Texas, with its sun, warm climate, and booming
economy, beckoned. It was 1972, the oil boom was in full swing, and
Tice landed at Texas Christian University in Fort Worth, known for
its tan-bricked beaux arts campus and its premed and undergraduate
business programs.
There, Tice hit his stride, academically and socially. It helped that
freshman year, he lived across the hall from a scion of the local Budweiser
beer distributorship. “I was in with a cool group of guys, we played
intramural baseball and basketball,” Tice says. Neither he nor his friends
rushed for TCU’s popular fraternities. They preferred being outsiders.
The 1973–1982 bear market dragged on. TCU business majors were
held in low esteem at TCU by some of his classmates. “If you were just
a business major, people would say, ‘So what, you’ll run a Pizza Hut
someday,’” Tice says.
Tice impressed professors—especially with his ability to tie together
disparate subjects in class discussions. “He had the amazing ability to
integrate economics and accounting and even history,” associate profes-
sor Chuck Becker told a campus newsletter. “He was really ahead of
his time.”
TCU oered an elective called the Educational Investment Fund
(EIF), a sponsored $100,000 pool of money run by a team of 12
students—who were required to pitch two investment proposals.
Competition was tight, but Tice landed an analyst slot. “It was easy to
see who had talent and who didn’t,” Tice says.
From his work on the fund, Tice decided that uency in accounting
dierentiated superior managers from their peers. He resolved to become
a CPA. Tice thought he was headed for the Big Eight accounting rms
he applied to. Instead, upon graduation, Tice was turned down by each
of them. He blames a green and blue tweed suit he wore. “They were
looking for partnership material,” he says. “I did not exude condence.”
Without prospects, Tice opted to shoot for an M.B.A. in nance
and won a paid teaching internship. Gathering up his degree in 1977 he
again applied to the Big Eight. Despite his graduate school grade point
average, each of them again rejected him. He was wearing the same green
and blue tweed ensemble. Ruminating as he looks out over the Dallas
skyline, Tice says: “I should have just gotten a navy blue suit.”
210 THE MOST DANGEROUS TRADE
A despondent Tice took a job at the oil giant Atlantic Richeld
(ARCO), which had an army of 500 accountants working at eight
oces in cities like Bakerseld, California, and Tulsa, Oklahoma.
They kept track of oil production history, revenues, and royalties. The
ARCO career path was clear. “I saw my boss’s job, I saw my boss’s boss’s
job,” Tice recalls. “I knew I didn’t even want my boss’s boss’s boss’s
boss’s job.”
After four years, Tice left for ENSERCH Corporation, an explo-
ration and production company that wanted an eye on its prospective
purchases. Tice helped draft acquisition memos that went to the board
of directors, laying out discounted cash ow scenarios, prospective rates
of returns, and the impact of acquisitions on ENSERCH’s earnings.
By 1984, it was time for a change. The bull market was in gear and
Tice joined nancial planning rm Concorde Financial, which catered
to wealthy doctors and businessmen. His focused on real estate, energy
partnerships, and tax shelters. But Tice gured Concorde could save
money by corralling stocks into a fund which he launched, Concorde
Value, hiring Gregg Jahnke, an alumnus of the TCU’s Educational
Investment Fund, to run it.
The hours were long. Tice had a young wife, a new baby. Late one
night, driving down Dallas’s Central Freeway, Tice looked up and saw
a single light burning near the top oor of an otherwise totally dark
skyscraper. “I didn’t want to be that person,” Tice says. “I wanted some-
thing else in life.”
A change in Wall Street regulation pointed the way. More than
10 years earlier, an adjustment had been made to the Securities &
Exchange Act of 1932, allowing for independent analysts to sell research
to clients and be compensated by third-party brokerage rms. An
independent analyst would publish a report. If a buy-side rm found it
useful, it could place a trade through a designated brokerage, identifying
the analyst involved. The brokerage executed the trade and split the
commission with the analyst. This was the start of what became known
as “soft dollar research.” Now, in the late 1980s, the bull market was
fueling demand for such independent analysis.
His friend, Jahnke, had already jumped ship to start JKE Research.
Tice gured he too could make a living doing something he was good at
Tice: Truth Squad Leader 211
doing. “I had skepticism toward Wall Street,” says Tice. “I knew 95 per-
cent of recommendations were nonobjective.”
Tice launched Behind the Numbers in 1987, just months before the
October meltdown. Working at a card table in a spare bedroom with two
plastic chairs, Tice loaded a Compaq portable computer—a 45-pound
behemoth equipped with a 5.25 inch oppy drive—with SuperCalc
spreadsheet software and subscribed to information provider Compu-
stat for nancial data and news. Tice keyed in nancial data from the
300 companies whose nancial reports he received.
Macros, preprogrammed commands, would go to work churning
out calculations of days sales of inventory, which show investors how
long it takes to turn inventory into nished goods, or the growth rates of
earnings per share, research and development, and advertising expenses.
It was rudimentary stu. But it allowed Tice to ag potential problems.
Clients loved it.
Tice personally drummed up sales, keeping a brutal travel schedule.
Still in his early 30s, Tice looked 10 years younger. “I grew my mous-
tache,” he recalls. “I was so young then and wanted to look mature and
credible.”
Clients included New York investors Leon Cooperman, George
Soros, Stanley Druckenmiller, Jim Chanos, and Carl Icahn. Tice would
travel there and schlep his Compaq from one client’s oce to the next, in
summer months perspiring in the hot New York City subways. Booking
nine or ten meetings a day, it was as far from the glamor of Wall Street
as possible.
Initially focused on pure accounting, Tice began incorporating fun-
damental analysis—venturing opinions about acquisitions, capital alloca-
tion, and marketing eorts. “Sometimes I’d see fundamental issues and
no quality of earnings issues,” he says. “Sometimes I’d see quality of
earnings issues and no fundamental issues.”
If Behind the Numbers found an accounting concern, it would ag
the stock with a warning for investors to sell. If no further problems
surfaced after six months, that would lapse. In early 1989, Behind the
Numbers showed inventories at Noxell Corp., a cosmetics company,
were growing far faster than sales. Tice duly placed a warning on
the stock.
212 THE MOST DANGEROUS TRADE
Procter & Gamble, as it turned out, bought Noxell in October 1989
for $1.6 billion—a 31 percent premium. Visiting Michael Steinhardt,
Tice walked him through some issues relating to another company.
Steinhardt erupted.
“You’re full of s--t!” Steinhardt yelled.
The hedge fund manager took the passel of research Tice had
brought with him and dumped it into a wastepaper basket.
“Noxell was acquired!” he shouted, his veins bulging. He accused
Tice of deliberately not revealing the accompanying price run up in its
performance gures. He told Tice Behind the Numbers was cooking its
own numbers.
“You’re misrepresenting your track record!” Steinhardt said.
Tice walked to the trash bin and removed his research.
“No, Michael,” he said calmly. “You were looking at a report on
Noxell from a couple of years earlier.”
He then showed the subsequent appropriate Behind the Numbers ref-
erence that acknowledged the Noxell buyout, showing that the rec-
ommendation was indeed unprotable. Everything had been properly
disclosed.
Tice needed analysts willing to dig, infuriate companies, and settle
for pay that might be half what they could get on Wall Street. One of
his rst hires was a Wharton MBA with investment bank experience.
He lasted two months.
Tice gathered an eclectic crew, recognizing overlooked talent. Many
were neophytes whom he trained personally, molding business majors
from TCU into balance sheet-devouring analytical animals. “What
makes a great analyst?” says Tice. “Someone who thinks outside the
box, can be skeptical, understands accounting, will dive deep, and uses
his time well.”
They made an interesting cast. The disheveled Jahnke was an
ex-card-counter who for a couple of years made a living at Las Vegas
blackjack tables. Albert Meyer, a former accounting professor at Spring
Arbor College of Michigan, had in the early 1990s uncovered a Ponzi
scheme run by the nonprot Foundation for New Era Philanthropy.
Will Garner was a semipro golfer whose resume included a stint at
Grant’s Interest Rate Observer. Over the years, Tice’s roster of analysts
included an aspiring football coach, and sundry graduates of TCU,
many of whom had participated in the EIF.
Tice: Truth Squad Leader 213
Oces were spartan. There were cubicles and wood-laminated
desks—barebones. “If you walked in, you’d say I don’t know what
this business does, but managing money would be the last thing you’d
expect,” says Jim Smith, a personal friend.
Forensic sleuthing could be epically frustrating. Beginning in early
1990, Behind the Numbers zeroed in on General Electric, captained by
CEO Jack Welch. Lionized in the business press for promising pre-
dictable earnings growth of 15 percent, Welch delivered it. In a Fortune
article, he had vigorously defended the practice of managing earnings.
“What investor would want to buy a conglomerate like GE unless its
earnings were predictable?” he asked.
Tice poked around General Electric’s nancial unit, mostly the part
known as GE Capital—and what he found set o alarms.
GE Capital’s loan portfolio, at $30 billion to $40 billion, made
the nancial unit look like a money center bank—it was about the
size of J.P. Morgan & Co. at the time. Banks traded at ve to eight
times earnings, while GE was selling at 12 times earnings. Other
analysts—daunted by GE Capital’s complexity—downplayed it, prefer-
ring to view the company as a specialized manufacturing juggernaut,
worthy of higher valuation.
Tice, instead, zeroed in on GE’s growing exposure to commercial
real estate loans, residential mortgage insurance, and—amidst a collaps-
ing junk bond market—dicey leveraged buyout (LBO) loans. He noted
that GE Capital’s credit card lending and other consumer loans were
vulnerable in a recession. The upshot was that Tice didn’t think it likely
that the GE parent company would grow at 15 percent because of GE
Capital’s sensitivity to credit losses.
Nobody paid attention. “Our criticism was a gnat on an elephant,”
Tice says.
Nevertheless, he persevered, pointing out ve months later the sus-
picious manner in which GE Capital was reporting its nonperforming
loans. The company shifted repossessed loans from its leveraged buy-
out category into an asset called “other investments,” that was similar to
“real estate owned.” Tice knew most analysts were not aware that this
maneuver, while legal, was hiding growing nonperforming loans. From
1988 to 1989, “nonperforming loans” dropped from 1.4 percent to 1.2
percent. Adding in “other investments,” however, they grew from 3.0
percent to 3.8 percent. Investors generally hit the panic button when a
214 THE MOST DANGEROUS TRADE
bank’s total nonperforming loans rise above 1.5 percent, and GE’s gure
was twice that.
Tice kept at it, and in October, with the stock down 20 percent,
Barron’s published a bylined story by Tice reiterating his concerns. The
stock fell 3 percent the next Monday morning in Europe. The gnat,
it seems, was a major nuisance. GE held a conference call disputing
Tice’s analysis.
Ultimately, though, investors preferred Welch’s sleight of hand to
Tice’s hard-nosed analysis. “I can’t say this was a great success nan-
cially,” Tice says about the analysis. “GE went on to do great for another
10 years. The warts remained hidden because they were able to keep bor-
rowing in the commercial paper market and were able to grow out of
their potential problems.” GE outperformed spectacularly throughout
the 1990s.
Tice and Jahnke chewed over their idea for a “bear” mutual fund.
Each day, they would cross the street to discuss their plans at the local
outlet of a Mexican restaurant chain, Taco Bueno. Texas didn’t allow
mutual funds registered there to short more than 25 percent of their
portfolios. Tice petitioned the Texas State Securities Board, explaining
that any savvy manager could circumvent the restriction by buying put
options and selling call options, essentially creating a synthetic short posi-
tion. The securities board voted to lift the 25 percent limit. “The board
members hated derivatives more than they hated short selling,” Tice
laughs. “We should have a Taco Bueno law degree.” So Tice started the
fund with $500,000, most of it his own money.
The dynamics of running a short mutual fund were daunting. Say
Prudent Bear was usually targeting a 70 percent short exposure and had
assets of $100 million. That means $70 million of its assets would be
short. But if stocks rallied 10 percent in a quarter, assets would draw
down to $93 million. The value of its short positions—assuming it main-
tained the same share exposure—would rise to $77 million, increasing
Prudent Bear’s net short exposure to 83 percent. Unlike hedge funds,
which have lock-up periods that prevent investors from pulling their
money, mutual fund investors can redeem daily. A market move of 10
percent would prompt outows. If investors pulled just $5 million, the
move would send short exposure to 88 percent. Invariably, they added
money after market sellos and redeemed after spikes.
Tice: Truth Squad Leader 215
Tice worried that as a short-selling fund, they would be deliberately
singled out for punishment by bulls to squeeze. “This was dangerous for
me,” Tice says. “Wall Street didn’t like me because I was going against
Goldman Sachs. I was putting out sell recommendations on Merrill
Lynch’s corporate clients.”
Dallas, though, provided a nurturing climate for the short-selling
sentiment Tice espoused. Texas, after all, was the epicenter of the
saving and loan (S&L) crisis—huge money makers for short sellers
in the late 1980s and early 1990s. Around that time, the Feshbach
Brothers made headlines betting against and publicizing frauds. The
three brothers—Joseph, Kurt, and Matt—were all based in Palo Alto,
California, but much of the rm’s research was run out of Dallas by
Tom Barton. In 1993, the Feshbachs closed shop after an ill-timed
short against Wells Fargo & Co. The Feshbachs moved on, and so did
Barton’s short-selling analysts in Dallas, including such notables as Jim
Carruthers of Third Point.
Among other noted Dallas short sellers were Frederick “Shad”
Rowe of Greenbrier Partners, who penned a column for Forbes mag-
azine in which he often ruminated on his métier. A gifted writer, he
referred to short selling as the Financial Bear. “Central to the Financial
Bear is the notion that somewhere out there is Financial Truth and that
when people learn the Financial Truth they will be better for it,” he
wrote. He describes short selling as not dissimilar to two adversaries
standing 30 feet apart throwing footballs at each other’s crotches.
“The fun of winning is nowhere equal to the pain of losing,” Rowe
chuckles. It was his mother’s comment that prompted him to abandon
the profession. Noting his moodiness after a spate of particularly upbeat
economic news, she tried to comfort him. “Now don’t worry, Shad,”
she told him. “I’m sure something terrible will happen sooner or later.”
Today, Rowe runs a mostly long portfolio at Greenbrier as well as an
annual investor conference that benets Parkinson’s disease, from which
he suers.
There was also Rusty Rose, founder of Cardinal Investments LLC,
best known for buying the Texas Rangers Baseball Club and installing
George W. Bush as its general manager, raising his public prole after
his departure from Harken Energy and setting him up for his successful
run for Texas governor in 1995 and President in 2000, a campaign to
216 THE MOST DANGEROUS TRADE
which he contributed generously. Rose, who garnered a reputation for
high prole litigation, was a frequent visitor to Camp David during the
Bush administration.
And Kyle Bass, not related to the Bass brothers, was a local Bear
Stearns broker who founded hedge fund Hayman Capital in 2006 and
wagered massively against subprime mortgage–backed securities to post
a 300 percent prot in 2007. He is proled in Michael Lewis’s book
Boomerang (Alfred Knopf & Co. 2009). The list goes on. “I do think
Texans are pretty independent, more commonsensical, more libertar-
ian,” says Tice. “They’re less likely to buy into the bubble.”
Tice often did best steering clear of blue chips. In May 1993, Behind
the Numbers began coverage of Paging Network, the largest independent
paging services provider in the United States. The stock was trading at
$30.25, or about 15 times cash ow, dened as earnings before interest,
taxes, depreciation, and amortization (EBITDA). Wall Street empha-
sized the price relative to EBITDA in research reports—and on the
surface, it seemed like a reasonable way to value a paging company.
Paging required big capital expenditures on things like transmitters, relay
towers, and individual pagers. Since these all depreciate over time, ana-
lysts argued, it made sense to price the stocks based on cashow, which
ignores both depreciation and capex. Analysts often do the same with
cable companies.
Tice thought dierently. That’s because 55 percent of the capital
expenditures were on pagers that had to be replaced every year or two
just to keep the business operating—Tice labeled them “maintenance
capital expenditures.” These were required ongoing cash expenditures
which had to be made or the company wouldn’t remain competitive.
This was far dierent from some capital expenditures that were more
discretionary as they supported expansion into new business.
The dierence was crucial. “In the paging business, you needed a
huge amount of maintenance cap-ex just to keep the business alive,”
Tice says.
Behind The Numbers ran its own calculations, subtracting, what it
called “maintenance depreciation” from the reported EBITDA. By
1994, Paging Network was trading at a heady 16 times EBITDA,
but the newsletter’s adjustment for maintenance depreciation cut the
EBITDA gure by more than half, and meant it was trading at a sky
high 44 times adjusted EBITDA.
Tice: Truth Squad Leader 217
Meanwhile, according to the newsletter’s calculations, revenue per
pager at Paging Network was steadily declining from $29.30 in early
1993 to $26.09 in September 1994. Long-term debt and interest expense
had more than doubled over that time. And Behind the Numbers showed
that the average purchase price for a paging company ranged from $140
perpagertoahighof$353perpager.PagingNetwork,Ticepointed
out, was already trading at nearly $500 per pager. “Maybe P.T. Barnum
was right,” Tice wrote.
Ultimately, mobile phone technology wiped out Paging Network.
The company had big plans for rudimentary text messaging and voice
services, but by the mid- to late-1990s, cellular phone prices were
plummeting and usage surging. Paging was obsolete for most general
applications.
Tice isn’t sure when the Prudent Bear Fund began shorting Dallas-
based Paging Network. The fund’s September 1996 annual report, its
rst full-year version, shows it was short 10,000 Paging Network shares,
worth $20 each for a total exposure of $200,000—its third-largest short
position at the time. The next year, the fund’s semi-annual showed no
short position in Paging Network—that might have been because it was
temporarily covered for any number of reasons. But in 1998 the fund
was again short the stock—40,000 shares at $6.00, for a total exposure
of $241,250. By then, the company was on the ropes, as were many
paging services. Paging Network led for bankruptcy in August 2000.
Over time, Tice and his analysts recognized patterns in prospective
shorts. One was the tendency of one accounting distortion, once uncov-
ered, to be followed by more. Another was for confusion thrown up
by serial acquisitions, restructurings, and one-time charges to obscure a
company’s performance, hiding disappointing news from shareholders.
A marquee example was Sunbeam Corp., the home appliance maker
run by “Chainsaw” Al Dunlap, a self-styled turnaround artist recruited
by Michael Price, head of the Mutual Series Funds, which controlled 20
percent of the company’s shares. Dunlap’s track record included restruc-
turings and layos at companies like Crown Zellerbach and American
Can. His most recent success was Scott Paper, which he quickly cut
down to size and sold to rival Kimberly-Clark Corp., tripling its share
price in his two-year tenure.
Dunlap took the reins at Sunbeam in July 1996, as the company’s
prots were sandbagged by the cost of both a new factory and a steep
218 THE MOST DANGEROUS TRADE
peso devaluation in Mexico, where it did a lot of business. Dunlap
publicly savaged previous management. Under his own “dream team”
of new executives, his cronies, Dunlap promised to double sales to
$2 billion from $1 billion over three years, boost operating margins
to 20 percent, and post a return on equity of 25 percent. “A new
Sunbeam is shining—and the best is yet to come,” he wrote in the 1996
annual report.
Sunbeam embarked on restructurings and plant closings, laying
o half its employees. Shares rose from under $30 to a high of $50 in
October 1997. For the 1997 calendar year, net income swung from a
loss of $228.3 million in 1996 to a prot of $109.4 million in 1997.
Then, in early March, the company announced three acquisitions:
Coleman Co., the camping gear company; appliance maker Mr. Coee;
and re alarm manufacturer First Alert. Shares surged to $52.
Je Middleswart, the lead analyst at Behind the Numbers,wasskepti-
cal. Sifting through the charges the company booked, he felt the goal was
to make 1996 look as bad as possible compared to 1997, when Dunlap
could begin taking credit for improvements. Sunbeam booked a $92.3
million inventory charge at the end of 1996 for goods it actually sold in
1997. It was legal, but shy. Dunlap hiked Sunbeam’s advertising bud-
get 25 percent in 1996, only to slash it the following year. Likewise,
the company took a sharply higher, $23.4 million bad debt expense in
1996, as well as a steep $5 million hit as “other expenses.” Both expenses
declined sharply in 1997.
It t a pattern. “CEOs realize they have the latitude to take all
these charges,” says Tice. “Dunlap was classic. Just take big restructuring
charges.”
Behind the Numbers accused Sunbeam of “channel stung”—
shipping goods and booking sales to customers in amounts greater than
they are likely to sell as a way of frontloading earnings and sales. Why
was there a sudden rush to buy outdoor grills in the winter? Sunbeam’s
accounts receivables soared to $355 million in 1997 from $213 million
in 1996.
The goods Sunbeam was sending to retailers, it turns out, were
going to third-party warehouses. The tactic is legal as long as the
company books the sale after the product is shipped, but it’s still channel
stung. Neither Sunbeam nor its backers ever complained to Tice
about Behind the Numbers’ accusations. “We never heard from Dunlap
Tice: Truth Squad Leader 219
or his backers,” says Tice. That may have been because even worse
news was percolating.
Just weeks after its March acquisitions announcement, Sunbeam
announced it might miss consensus earnings estimates for the quarter
ending March 1998. It was clear the company was not going to grow
25 percent. Shares plummeted 26 percent to $38. In the second quarter
of 2008, Sunbeam lost $60 million, as stores refused shipments of
additional grills, toasters, and hand irons. It was as Behind the Numbers
had forewarned. In August 1998, Sunbeam directors red Dunlap.
Prudent Bear had 105,500 shares short on Sunbeam on September
30, 1998, equal to $745,500 or $7.07 a share. That was after the vast
majority of damage had been done. The next year, lings show no short
position on Sunbeam. Federated Investors declined to provide access to
Prudent Bear trading records. Nevertheless, it took until February 2001
for Sunbeam to le for chapter 11 bankruptcy. In September 2002,
Dunlap paid $500,000 to settle SEC charges that he had defrauded
investors by inating sales gures. Dunlap did not admit or deny guilt,
but agreed not to work for a public company again.
Management at Prudent Bear was evolving. Doug Noland joined
Prudent Bear as market strategist in 1999, bringing with him a
macro-orientation hitherto lacking: A talented, experienced, and highly
strung short seller who had worked with Bill Fleckenstein. Noland
was a fan of the writings of Kurt Richebacher—an economist whose
writings helped Tice understand asset bubbles. Richebacher was a
newsletter publisher and acolyte of the Austrian School of economics,
which includes such laissez faire stalwarts as Ludwig von Mises and
Friedrich Hayek.
While John Maynard Keynes wrote that central banks should act to
spur demand during recessions by lowering rates, printing money, and
using other stimuli, Richebacher and his ilk argued such moves reinate
bubbles, postponing and worsening the day of reckoning. To Tice and
other “credit bubble bears,” economics boils down to a series of truisms.
“What goes up, must come down,” Tice says. “You can’t borrow against
the future. I don’t think you print your way to prosperity.”
Noland began writing the Credit Bubble Bulletin, oering trenchant
analysis of trends—trade imbalances, credit, cheap money––from an
Austrian School perspective. Noland’s track record as a prognosticator is
not well known. In the bulletin and elsewhere, he forecast the market’s
220 THE MOST DANGEROUS TRADE
future calamities with breathtaking acuity—ballooning derivatives
exposure, the housing bubble, the collapse of Fannie Mae and Freddie
Mac, the risks to money market funds. Going as far back as the 1990s,
Noland nailed them all.
In 2013, Noland—who declined to talk with this author—forecast
a cataclysmic deationary cycle. Since the sale, he has served as portfolio
manager for Prudent Bear, which has lost money in every year since
Tice’s departure as the stock market has rallied.
What in the 1990s the sharp-eyed Tice had seen as myriad instances
of accounting legerdemain began to t into a larger pattern of economic
dislocations. By the turn of the 21st century, total credit market debt
outstanding had nearly doubled to $26 trillion since 1991, and the money
supply was ballooning to close to $7 trillion. With access to such easy
money, investors and corporations had become dangerously speculative.
The stock market was in the midst of a swelling asset bubble and the
house croupier—Alan Greenspan—was dispensing chips at the casino,
in critics eyes, as he strove to keep things humming.
As the new decade progressed, Tice began turning responsibilities
for Behind the Numbers over to Middleswart, now research director at
the rm. That gave Tice and Noland time to overhaul and rene the
management of Prudent Bear. The goal of the fund remained to serve
as a hedge to the overall stock market. That did not mean that the fund
shouldn’t try to mediate losses when the stock market was rising, how-
ever. “Our feeling was that we are going to try and lose as little money
as possible,” Tice says.
Tice employed defensive tactics—he would avoid the stocks of com-
panies with high short interest, for example, viewing them as subject to
likely squeezes. Noland would keep watch on the portfolio, suggest-
ing Tice cover a position if it began to rise higher than the market
overall—again, a sign it might be targeted for a squeeze. Noland was
on the lookout for stocks as they began to “break down,” or tumble.
The tactic risked leaving him empty-handed as he tried to locate stock
to borrow, but it reduced the possibility of being caught at-footed in a
short squeeze or being pummeled if a company were acquired.
“I called him the ‘secretary of defense,’” says Tice. “We were a great
team. People said I was too aggressive. People said he was too defensive.”
The bottom line was that the partnership worked.
Tice: Truth Squad Leader 221
Tice saw that gold prices had been moving inversely to stocks—not
unusual. The London spot price for the metal had ratcheted down to
$252 per ounce by the end of 2000 from a high of $415 in early 1996.
The Philadelphia Stock Exchange Gold & Silver Index lost 60 percent of
its value peak to trough between 1997 and 2000. And big gold-miners
like Barrick Gold and Newmont Mining were unloading mines around
the world.
A Vancouver broker named Cal Everett of Pacic International
Securities cold-called Tice in early 2000 pitching small gold miners
that were early stage exploration companies often selling for nickels and
dimes. Many such stocks were frauds, little more than a phone and a
desk looking for money. But Everett was seasoned and a geologist and
who knew rsthand which mines had reasonable merit. He scoured
Africa, North and South America, and Asia.
Prudent Bear piled into the “junior miners” in industry argot. Cap-
stone Mining Corp. surged from 50 cents to $3.50, East Asia Minerals
Corp. from 15 cents to $5.00, Western Silver Corp. from $1.35 to $15,
and Fortuna Silver Mines from 50 cents to $7.50. All told, Tice estimates
the mining stocks contributed $100 million in prots to the Prudent
Bear Fund.
The change in Prudent Bear’s management style and move into
gold stocks was crucial. In the bear market year of 2002, when the
S&P 500 dropped 22 percent, Prudent Bear shot up 62.9 percent. More
impressively, Tice managed to keep losses manageable as the stock mar-
ket roared back in 2003 and 2004, when the broad S&P benchmark
soared 28.7 percent and 10.9 percent, respectively. The fund lost 10.4
and 14.1 percent those years—nothing to cheer about, but acceptable.
Tice could take losses—the fund prospectus said so. “I never said we’re
so damn smart we’ll make money every year. That made it easier.”
Then, as the index rose 4.9 percent, 15.8 percent, and 5.5 percent in
the bull market years of 2005, 2006, and 2007, Prudent Bear managed
gains of 2 percent, 9.1 percent, and 13.4 percent.
Unlike other short sellers who built bearish positions before push-
ing their analysis on journalists, Tice wouldn’t initiate a short before
he issued a research note in Behind the Numbers, and waited 10 days
after publication before doing so. On occasion that meant missing an
opportunity.
222 THE MOST DANGEROUS TRADE
Tice and Noland would huddle. They’d look at the macro picture,
but also ask where the stock was breaking down. Is the likelihood of
a short squeeze growing? What is the cost of the borrow? Should they
cover ahead of an earnings pre-announcement? Is it rallying back?
These were not the kinds of questions Behind the Numbers was meant
to answer. The contribution of the newsletter’s recommendations to
Prudent Bear’s short portfolio steadily declined. In 1996, they comprised
an estimated 80 percent of Prudent Bear’s short exposure but only a
quarter by 2000 and ve percent by 2005. “What David learned was
that short selling was 90 percent tactical. When you’re getting crushed,
you have to get out,” says Jahnke. “There’s a big dierence between
publishing research and running a publicly traded short portfolio.”
Instead of concentrating on individual stocks, the increasingly
macro-focused fund was shorting exchange-traded funds (ETFs) and
similar index-like products such as HOLDRS. By March 2000, more
than a third of the fund’s short positions were on ETFs and their
ilk—NASDAQ-100 Shares, DIAMONDS Trust Series I, S&P 500
Depositary Receipts, the B2B Internet HOLDRs Trust, the Internet
Architect HOLDRs Trust, and the Internet HOLDRs Trust. Later, as
the technology bubble collapsed and the universe of ETFs expanded,
Tice would use them to wager against the specic sectors of the
economy most likely to suer: the Industrial Select Sector SPDR Fund
or the Financial Select Sector SPDR Fund.
Prudent Bear was in the process of evolving from a bottom-up fun-
damental portfolio to using more of a macro model. In fact, the fund
didn’t make a nickel o of what turned out to be Behind the Numbers’
most famous call—Tice’s 10-day rule prevented it. In early 1999 he hired
Albert Meyer, a South African-born accountant. The new hire’s previous
big hit: In 1995, Meyer had uncovered a Ponzi scheme at the Foundation
for New Era Philanthropy that cost universities millions.
In July 1999, Meyer wrote a report on Tyco International Ltd., the
fast-growing Hamilton, Bermuda–based multinational conglomerate led
by Dennis Kozlowski. Tyco, with $60 billion in revenue in 1999, was a
classic roll-up whose shares had risen an astonishing 54 percent annu-
alized over the previous ve years as it bought companies, shuttered
factories, and found ways to goose productivity. It made everything from
medical devices and home alarms to heat-shrink tubing to electronics
parts, and it did so in scores of countries.
Tice: Truth Squad Leader 223
Meyer began investigating Tyco because so many sell-side analysts
were recommending it. To this day, Meyer isn’t quite sure why the
report garnered the reaction it did—he made no accusations of nan-
cial improprieties, and only a passing criticism of Kozlowski’s colossal
pay package.
The crux of the report was simply an analysis of the company’s
operating prots and associated margins from 1996 through 1999. Tyco
reported total operating prots of $6.3 billion over that span, reecting
margins of 15 percent. That, however, excluded nonrecurring restruc-
turing and merger-related charges that totaled $4 billion. Including those
numbers would have reduced prots to just $2.3 billion, and operating
margins would have been just 6.4 percent. Meyer questioned whether
the “nonrecurring” charges, which seemed to be booked with clocklike
regularity, should be considered “nonrecurring” at all—a fairly standard
complaint among skeptical accountants.
Meyer also pointed out that the various merger-related accruals Tyco
booked for plant closings, lease terminations, and severance seemed con-
sistently higher than necessary, leaving the company with hundreds of
millions of dollars of reserves—reserves that theoretically could be used
to boost earnings in the future. He warned that a “cookie jar” of accru-
als was developing—but made no accusations that anything was being
done with them. “Surely, this is not what accounting rules based on
accrual accounting have in mind,” he wrote. This is not the prose of a
gasoline-soaked anarchist.
The report was issued October 6, but—perhaps because of its tame
language—didn’t have a major impact until the following week. Then
shares plummeted from $41.03 to $31.57 over seven days, a drop of
23 percent. (They eventually bottomed in early December at $21.77.)
The New York Stock Exchange stopped trading in Tyco shares due
to an order imbalance in the options market. Kozlowski went on the
oensive on CNBC, Bloomberg News, and in press releases sent around
the world. Kozlowski continued. “We don’t know this David Tice,” he
said in a statement. “He has never spoken to anyone at Tyco, and we
don’t know who he is or what he does.”
It continued. “I heard the reports being circulated about our com-
pany. And I can state unequivocally that they are false and baseless.” He
then proered a not-so-veiled threat to Tice. “Because we take our com-
mitment to our shareholders and our reputation very seriously, we will
224 THE MOST DANGEROUS TRADE
pursue this matter until we are satised that both have been adequately
protected.”
Wall Street analysts lined up behind Tyco—lacerating the Behind the
Numbers report even if there were no major contentions that were even
debatable. “It’s a bad report, and the more I look at it the worse it gets,”
hued Jack Blackstock, an analyst with Donaldson Lufkin Jenrette Secu-
rities. “I hope they covered their short position because I think the stock
is going up tomorrow.” Of course, Tice held no short position—and
by the time 10 days had lapsed, the cost of borrowing Tyco shares had
spiked, and short interest made it unattractive.
“There was a battle of words,” says Tice. “Twenty-six Wall Street
rms came to the defense of Tyco. The company was, after all, a
fee-generation machine for Wall Street.”
Tyco shares rebounded in December—until the SEC disclosed an
inquiry into Tyco’s accounting practices, which may or may not have
been linked to Meyer’s report. Ultimately, on unrelated matters, the
SEC demanded Tyco restate earnings going back ve years. Tyco shares
rebounded, hitting a high of $48.40 in January 2001.
Meyer’s Behind the Numbers warnings were eectively brushed aside.
But in 2002, Kozlowski was charged, along with chief nancial ocer
Mark Schwartz, by New York District Attorney Robert Morgenthau
with grand larceny, conspiracy, securities fraud, and nine counts of fal-
sifying business records. Most of the charges stuck: Kozlowski was sys-
tematically looting the company, to the tabloid papers’ delight. Among
other things, he had helped himself to a $25 million Manhattan apart-
ment on the shareholder’s dime, complete with a $14,000 umbrella stand
and $6,000 shower curtain. Then there was the matter of Kozlowski’s
wife’s 40th birthday party on the Italian island of Sardinia, which cost
$2.1 million and featured an ice statue of Michelangelo’s David urinating
vodka, all paid for by Tyco.
More than 200 of Tyco’s top 250 managers were red for either
accommodating Kozlowski’s pilfering—or knowing about it and doing
nothing. He served eight years after convictions on tax evasion, theft, and
other charges. Tyco the company, it should be pointed out, not only sur-
vived Kozlowski, but thrived. The company, whose shares traded $40 in
early 2015, has gone through multiple spinos and sales of business lines.
Tice: Truth Squad Leader 225
The stock has generated annualized returns of more than 13 percent since
their nadir in July 25, 2002, when they hit $6.36.
By the mid-2000s, Tice was arguably at the top of his defensive game.
Despite a surging S&P 500, which in 2005, 2006, and 2007 notched
gains of 4.9 percent, 15.8 percent, and 5.5 percent, Prudent Bear was
not only not losing money—thanks largely to its gold mining stocks, it
was making money for fund shareholders: 2 percent in 2005, 9.1 percent
in 2006, and 13.4 percent in 2007.
Things were changing in the world of research. In the mid-2000s,
institutions—especially mutual funds—were becoming less willing to use
soft-dollar brokerage arrangements to pay for research. The feeling was
management rms should use their own money, and not the brokerage
commissions that came out of their shareholders’ pockets. Business at
Behind the Numbers suered. At the same time, Tice was shorting more
indices and ETFs, and using more futures than ever before. By 2005,
just 5 percent of the short positions in the portfolio were generated by
Behind the Numbers’ research. Tice decided to turn the research service
over to employees, led by Middleswart, in 2007. It became a stand-alone
company.
As the housing bubble inated in the mid-2000s, Tice built and
maintained big short positions in nancials like Lehman Brothers Hold-
ings, Bank of America, Citigroup, Wachovia, and Washington Mutual, as
well as collateralized debt obligation (CDO) insurers MBIA and Ambac
Financial Group, and homebuilders KB Home, Lennar, and Toll Broth-
ers. Yet the game had changed. Tice says he had no edge on the account-
ing problems that enveloped Lehman, MBIA, or others. He was in many
cases betting on industries, not stocks. “We fear the risk of a run on ‘Wall
Street nance’ and resulting systemic credit crisis is high and rising,” Tice
told investors in his 2007 annual report. The stock selection was more
likely to be driven by such issues as the short interest in a stock or other
essentially technical factors.
By 2007, Prudent Bear, now with $900 million in assets, had just 10
short positions of more than $7 million on individual stocks. Prudent
Bear had a quarter of its short exposure in ETFs—Industrial Select Sec-
tor SPDR Fund and the iShares Russell 2000 Growth Index Fund, for
example. The individual stock shorts were weighted to liquid, heavily
226 THE MOST DANGEROUS TRADE
traded names—Starbucks, Wal-Mart Stores, Xerox. That theoretically
minimized the likelihood of short squeezes. Tice avoided trades in stocks
that were crowded, as quant-driven funds and classic long-short hedge
funds all found themselves piling into the same short positions.
Tice was already shifting gears in early 2008, switching out of the
increasingly heavily shorted nancials—staying a step or two ahead of
the crowd. But other positions turned against Prudent Bear—retailers,
homebuilders, and restaurants. Even the fund’s gold positions began
falling. The world was turning to Tice’s viewpoint, turning the market
into a gigantic crowded trade. As it fell, the short-term rebounds were
steep, sometimes 10 percent in a couple of days. Individual stocks like
FreddieMacandFannieMae,ontheirwaytozero,orclosetoit,would
reverse course back up 10 to 20 percent. It was time to cover—at least
the most obvious shorts. Prudent Bear was out of nancial stocks by the
time the SEC issued its short-selling ban on them in September 2008.
Instead, Prudent Bear targeted a swath of big cap technology
companies—EMC, Lam Research, KLA-Tencor Corp., and Juniper
Networks. This was a reection of Tice and Noland’s belief that the
economic trauma shaking the markets would extend far beyond the
housing and banking sectors. He also targeted consumer stocks like
Coca-Cola, Amazon.com, ConAgra Foods, and Sara Lee. The thinking
was that in a general collapse, some of the stocks that held up best
would have more downside pain ahead of them.
The sale of the Prudent Bear funds to Federated went though as
planned—closing on December 8. The agship, Prudent Bear, under
Tice and his colleagues, had fullled its promise to the funds investors,
nishing out 2008 with a 26.9 percent gain in the midst of the greatest
nancial calamity since the crash of 1928.
It’s not unlike a line by AnnaSophia Robb, who plays Bethany
Hamilton in the movie Soul Surfer. “I don’t know why terrible things
happen to us sometimes,” she says. “But I have to believe that something
good will come out of this.” Whether it does or not is still very much
open to debate.
Chapter 9
Pellegrini: Behind the
Great Subprime Bet
P
aolo Pellegrini has a nose for trouble. He smelled it in the rising
housing prices of early 2006, when he cranked through decades
of home price data and concluded the bubble was poised to burst.
Pellegrini then engineered a series of massive wagers against subprime
mortgages that catapulted Paulson & Co. hedge funds to 2007 gains of as
much as 590 percent—and rm-wide prots of more than $15 billion.
The negative bets boosted Paulson, his rm, and Pellegrini himself to
superstar status in the world of short sellers and beyond. (Parts of this
chapter are based on an article written by the author for a Bloomberg
Markets magazine article published in the November 2009 issue, as well
as other stories he wrote.)
Pellegrini, a former computer programmer with an engineering
degree, pocketed $175 million as a bonus for 2007, allowing him to
buy a couple of what he laughingly calls “entry-level supercars”: a silver
Ferrari F430 with a base price of $168,000 at the time and a black
227
228 THE MOST DANGEROUS TRADE
Audi R8. He decamped from a one-bedroom apartment in suburban
Westchester, New York into a sprawling yet spare full oor apartment
overlooking the pastoral dells and bridle paths of Central Park. Today,
he sails the Mediterranean in a 48-foot sailing yacht.
The trade did more than make Pellegrini and his colleagues rich.
It triggered a U.S. Securities & Exchange Commission (SEC) suit alleg-
ing that Goldman Sachs, the investment bank with which Pellegrini
worked most closely, committed fraud by withholding critical informa-
tion from clients on a key and lucrative deal that Pellegrini worked on.
So Paulson & Co., its founder, and Pellegrini himself were soon
lumped together, perhaps unfairly, with Goldman Sachs Group in the
public’s eye as avatars of the greed, conicts and deceit that fueled the
crisis. The SEC, however, ultimately only accused Goldman Sachs
of wrongdoing, charges that the investment bank settled for a record
$550 million, along with a hapless low-level salesman whose case
became tabloid fodder.
The collapsing housing market that Pellegrini wagered on played to
his hidden aptitude. “I’m more drawn to doing analysis of scenarios of
what can break down and go wrong instead of go right,” he says. “It’s
an engineering thing. For shorting to work, certain things have to take
place and then it happens quickly. Escalator up, elevator down.”
By April 2008, the Rome native was smelling danger again. Nearly
six months before the collapse of Lehman Brothers Holdings and the
bailout of American International Group, he and his colleagues at
Paulson & Co. foresaw that the unfolding crisis would trigger U.S.
government intervention: costly bank rescues, a massive stimulus plan,
and yawning decits. Those moves would eventually undercut the
dollar and U.S. stocks, unleashing market havoc, Pellegrini reasoned.
“The losses would be massive,” he says. “I knew the policy response
would be commensurate.”
So, after wowing the investment world with Paulson & Co.’s sub-
prime bet, Pellegrini went on to show he was no one-hit wonder. While
still working for Paulson, Pellegrini plowed a chunk of his personal
winnings from the subprime bet into PSQR LLC, a private fund he
created to protect his newfound riches. He began shorting bank-heavy
exchange-traded funds (ETFs) and later, as the stock market collapsed,
those that track the broader Standard & Poor’s (S&P) 500 Index.
Pellegrini: Behind the Great Subprime Bet 229
Then, at the end of 2008, as panicked investors stampeded into
Treasuries, sending the yield on the 30-year bond down 184 basis points,
or 1.84 percentage points, to 2.52 percent, Pellegrini began betting
against U.S. Treasury futures with underlying maturities of 15 to 30 years.
PSQR’s returns initially set Wall Street abuzz. From its launch
on April 15, 2008, through December of that year, the fund gained
52.4 percent, according to a fund document.
That’s when Pellegrini quit Paulson & Co. to start his own rm,
PSQR Management LLC. He seeded his rm with $100 million of his
own money.
Pellegrini continued his aggressively contrarian short-selling strategy.
As the markets collapsed, he was in his element, like a Yankee slug-
ger on a hitting streak. In January 2009, Treasury prices plunged, with
30-year yields rising 92 basis points. PSQR’s short position generated a
return of more than 65 percent that month, contributing to an 80 per-
cent gain for 2009, according to fund documents. It was as if he could do
no wrong.
Pellegrini, a former member of Italy’s Radical Party with a Harvard
Business School M.B.A., continues his against-the-grain strategy,
wagering on fundamental world economic trends. Like such storied
short-selling macro investors as George Soros and Julian Robertson
before him, he buys and sells futures on government bonds, stock
indexes, currencies and commodities like oil. It was Soros who
famously structured one of history’s most protable shorts—wagering
in 1992 that the Bank of England would be forced to devalue the British
pound, which it ultimately did, netting the Hungarian-born investor a
prot of $1 billion.
PSQR returned outside investors’ money after losing 11 percent in
the rst eight months of 2010.Yet Pellegrini continues to manage his
own substantial fortune.
Friends and former colleagues say Pellegrini has a rare ability to
apply rigorous analysis to complex nancial markets, as he did with the
subprime trade. “Paolo is a deep thinker,” says William Michaelcheck,
founder of Mariner Investment Group, a New York hedge fund rm
where Pellegrini worked. “He was able to synthesize the situation into a
hedge fund position. It’s the iconoclast’s ability to see things other people
can’t see.”
230 THE MOST DANGEROUS TRADE
Pellegrini described his contrarian operating style in a 2010 letter to
PSQR investors: “We look to develop insights from readily available but
complex data—same information, dierent conclusions—and position
ourselves for the market to catch up.”
Pellegrini is especially critical of the bouts of quantitative easing,
engineered by former Federal Reserve Chairman Ben Bernanke and his
successor, Janet Yellen. So-called QE, in macro-speak, refers to the Fed-
eral Reserve’s purchasing of long-term Treasuries and mortgage bonds
to keep interest rates articially low. The easing is hammering responsi-
ble investors by making it impossible to preserve the ination-adjusted
value of one’s assets without taking uncontrollable risk.
“The [social] implications of QE are horrendous because it pun-
ished responsible savers while rewarding a nancial-services industry that
should be vigorously curbed as it extracts an exorbitant rent from soci-
ety,” Pelligrini wrote in response to a Bloomberg View editorial on the
Federal Reserve in September 2012. “There’s no way to achieve posi-
tive real returns in an extreme QE environment without being leveraged
long, and there is no way to protect oneself from crippling losses if one
is caught leveraged long at the wrong time. The trick is to be leveraged
long only at times of market-moving policy decisions.”
That was one reason Pellegrini returned money to investors in his
hedge fund in 2010 and decided to manage only his own money.
Pellegrini, who is six feet two inches tall and weighs 183 pounds, is
a former jazz disc jockey whose views on how to x global nance
are downright radical—at least for a career-long Wall Streeter. In its
response to the nancial crisis, the U.S. government shamelessly placed
bank interests ahead of the common good by bailing them out, he says.
He sees no reason why Americans should deposit their savings in private
banks at all, since the government already guarantees those deposits.
Indeed, there is no need for banks at all. The public’s cash, he says,
can be held with the Federal Reserve in individual accounts. Loans can
be made by nonbank lending institutions—entrepreneurial pools of cap-
ital that could include hedge funds or similar entities that would never
become too big to fail.
At a minimum, Pellegrini says, there should be limits on bank
prots—perhaps a 10 percent return on equity—to keep them from
taking the kinds of risks that led to the housing bubble. “You need a
Pellegrini: Behind the Great Subprime Bet 231
system where people won’t be incentivized to take risks,” Pellegrini
says. “We don’t need bankers to take risks with our money.”
Pellegrini, who lives on the Upper West Side of Manhattan with his
third wife, Henrietta, and her daughter, seems incapable of sugar-coating
his insights for expediency’s sake. He has a predilection for long, free-
wheeling conversations in which he tosses out incendiary snippets.
How has the Federal Reserve handled the crisis? “It’s going to be
viewed on a par with the torture at Guantanamo Bay,” he says, sipping
from a bottle of mineral water.
What does he think about the U.S. central bank otherwise? “The
Fed steals from everyone,” Pellegrini snorts. “It is printing money, as
instructed by the nancial services industry, so that they can stick all of
us with the bill.”
And ex-Federal Reserve Chairman Ben Bernanke? “I think he is a
buoon—I have zero condence in what the Fed is doing.”
Pellegrini has oered his subversive solutions for the nancial system
in opinion pieces on nancial Web sites and blogs and in correspon-
dence to legislators and senior ocials in the Obama administration.
One proposal was to use the Term Asset-Backed Securities Loan Facility
(TALF) program, enacted as part of the 2008 bailout to help strug-
gling homeowners, as a mechanism to reset inated real estate prices.
Hedge funds and private equity rms would get cheap funds from TALF
to help homeowners renance their underwater mortgages at realistic,
lower levels. To do so, they would bid for their own homes in com-
petition with other prospective buyers. The existing mortgage holders
would get paid the reduced amount the auction fetched and be forced
to eat the dierence—punishment for their proigate lending practices.
The homeowner’s credit rating would be damaged—the price for erasing
the debt.
“Nobody escapes reality and the pain is apportioned fairly,” he wrote
on the New York Times DealBook website in May 2009. “Credit starts
owing again and the market decides what houses are actually worth.”
Economists have taken note of Pellegrini’s maverick ideas to
drastically reduce the footprint of behemoth banks, known as “narrow
banking” in academic argot. “They are very crisp and dierent and
provocative,” says Kenneth Rogo, an economics and public policy
professor at Harvard University. “As an academic, I nd that refreshing.”
232 THE MOST DANGEROUS TRADE
With his professorial air and penchant for theorizing, Pellegrini
muses that he might have made a better contribution as a policy planner
or macroeconomist than an investor. “I’ve been completely in the
wrong place as an actor,” he chuckles. “I could have helped design
dierent mechanisms for running the nancial system, and guiding
the economy.”
He argues that the Federal Reserve’s policies are based on analyses
that are unreliable—an example of the so-called Lucas critique, which
states that predicting the impact of changes in economic policy based
solely on historical information is dangerously simplistic.
In this case, the notion that historically low long-term rates will
generate gross domestic product (GDP) and job growth has proven
unfounded. “Whenever the central bank decides to use a particular
indicator to measure an economic outcome, it ceases to be a relevant
indicator,” Pellegrini says.
The Federal Reserve has succeeded in pumping up asset prices—
pushing investors into riskier asset classes, Pellegrini says. People in
general are frightened of missing a run-up in equities, and the system is
awash in excess liquidity. “We are basically through the looking glass,”
he says. “Now all the old relationships have become irrelevant.”
This is all bad news for those who champion a free-market economy.
“If you think ours is a market-based system, what Bernanke is doing is
making this less of a market economy,” Pellegrini says. “The system is
not in balance.”
Pellegrini says his fund’s name, PSQR, is a play on his own initials:
P.P. or P Squared. And it’s also an anagram for SPQR, the initials of the
ancient Roman Republic that stand for Senatus Populusque Romanus,
or the Senate and the People of Rome. The four letters are still embla-
zoned on monuments, buses, and signs around Rome, where Pellegrini
was born and spent his rst ve years amid the cobblestoned alleys of the
bohemian neighborhood called Trastevere—that is, on “the other side
of the river Tiber.”
Pellegrini’s quantitative disposition traces back to those early years.
The oldest of three children, Paolo Marco Pellegrini was born in 1957
to a household steeped in the sciences. His father, Umberto, was a
physics professor, and his mother, Anna, worked as a biology researcher.
Pellegrini: Behind the Great Subprime Bet 233
Paolo was dierent. As a four-year-old, he used LEGO blocks to build
a replica of a bank—perhaps a portent of his future interests.
The Pellegrinis moved north from Rome in 1962 when Umberto
was appointed a professor at the University of Milan. There, Paolo took
up classical piano and attended a “liceo classico,” studying Latin and
ancient Greek. Dinner table conversations were often political. While a
teenager, Paolo joined the Partito Radicale, a pacist, antiestablishment
party that advocated the legalization of divorce and abortion.
His antiestablishment stance found ample expression at school too.
“I was what you called a very uncooperative student,” he laughs. “I was
daydreaming in class, not doing my homework.” One requirement was
to read a Greek tragedy, whose title eludes him today. “I didn’t buy the
book,” he says. “It wasn’t that I didn’t read it carefully. I didn’t buy it
at all.”
Nevertheless, in 1975, he was admitted to Politecnico di Milano,
where he pursued a degree in electrical engineering. Many nights, he
volunteered as a disc jockey at Milan’s Radio Radicale, spinning vinyl
by bebop greats Dizzy Gillespie, Bud Powell, and Charlie Parker.
While a student, Pellegrini circulated Radical Party petitions,
including one calling for the strengthening of civil liberties. He stayed
clear of demonstrations and student groups advocating violence. The
1970s and early 1980s were Italy’s Years of Lead, during which hundreds
were killed or wounded in bombings and assassinations by both left-
and right-wing extremists. In 1978, Red Brigade terrorists kidnapped
and murdered the former Christian Democratic Prime Minister
Aldo Moro.
Pellegrini focused on school, especially computer programming
classes, at which he excelled. In the summers, he found work at big
multinationals, including a stint in France with Hewlett-Packard and
another with Honeywell International in Boston. He graduated cum
laude in 1980.
Amid the strikes and demonstrations, the Italian economy was a
shambles. “There were few opportunities in terms of a real career track,”
Pellegrini says. He looked abroad and landed a low-level job in the
Netherlands at Praxis Instruments, a computer company. He found the
work boring. “Business school seemed like a good investment,” he says.
234 THE MOST DANGEROUS TRADE
Pellegrini headed to Harvard Business School in Boston, where
professors stoked his interest in nance, economics, and especially the
markets. Pellegrini’s eld study adviser was Professor Andre Perold.
“He was into data and patterns,” Perold says. “He was intrigued by the
potential of math-based systems to trade stocks.”
At Harvard Business School, Pellegrini also met his rst wife—Claire
Goodman, daughter of the prominent New York State Senator, Roy
Goodman, a progressive Republican. The two, who married in 1984,
wouldgoontohavetwoboys.
Michaelcheck, a partner in the xed-income division of Bear,
Stearns & Co., recalls recruiting the Italian student as a summer
associate that year. Pellegrini wrote pitch books on possible mergers
and acquisitions for the rm’s clients.
There, Pellegrini shared an oce with a mergers and acquisitions
(M&A) vice president and a fellow Harvard Business School graduate
who also had something of an independent streak—John Alfred Paulson.
He and Pellegrini soon became friends.
With his Harvard M.B.A. in hand, Pellegrini landed an associate’s
position in corporate nance at Dillon, Read & Co., a small investment
bank with a prestigious pedigree. The bull market was in full swing.
It was 1985, and swashbuckling raiders—Carl Icahn, Ronald Perleman,
T. Boone Pickens—had corporate America on the run. “I must have
worked on a dozen major deals over a few months,” Pellegrini says.
Dillon Read itself was bought by Travelers Corp. in 1986, and
Pellegrini moved to Lazard Frères & Co., the Franco-Anglo-American
investment bank run by Michel David-Weil. Pellegrini specialized in
insurance, an industry that appealed to him for its complexity and
quantitative orientation. Among other deals, he advised Munich-based
Allianz AG on its 1990 acquisition of Fireman’s Fund Insurance Co., a
unit of Fund American Cos.
At Lazard, the pace was famously brutal. Pellegrini often worked
14-hour days, turning o the overhead lights in the oce at night and
blasting Mozart and Beethoven on his stereo. He trolled through reams
of insurance data generated by his clients and their potential targets or
acquirers.
Yet Pellegrini was not a natural investment banker. “It involved a lot
of salesmanship,” he says. “That’s not my forté.”
Pellegrini: Behind the Great Subprime Bet 235
Pellegrini’s blunt honesty was likely a hindrance, as was his Italian
accent. Did he really understand the ne print? And his often biting
sense of humor sometimes did not go over well with some American
clients. Nor did it help that his marriage had run into trouble, too—he
separated from Claire that year.
In 1994, the fees he was generating dropped as he failed to rope in
new clients. The next year, Pellegrini says, Lazard’s head of investment
banking at the time, Kendrick Wilson, red him.
In 1996, Mariner’s Michaelcheck teamed up with Pellegrini to start
a Bermuda-based rm called Select Reinsurance Ltd. He also remar-
ried, this time to another prominent socialite—Beth DeWoody Rudin,
daughter of powerful New York real estate developer Lewis Rudin. After
two years, he and Michaelcheck, together with the rm’s board, decided
an executive with more sales experience should replace him.
“I was red from that too, I suppose,” he says.
In 1999, he started a consulting rm named Global Risk Advisors
LLC to counsel companies on reinsurance and other risk-related matters.
The venture didn’t gain traction, and Pellegrini closed it in 2002. “Trying
to reinvent myself was tricky,” he shrugs.
Pellegrini compares these wilderness years to his treks as a youth
in the Italian Alps. “There are times when you are hiking that you are
really exhausted; you just put one foot in front of the other,” he says.
The important thing is to keep walking. “When you sit down, that’s
when things just fall apart,” he says.
Pellegrini found his way back to Mariner, where Michaelcheck hired
him as an analyst in early 2003. At the time, a Mariner hedge fund was
trading CDOs, or collateralized debt obligations—bundles of housing
loans and other debt—and Pellegrini developed a fascination with these
complicated pools of bonds and other loans, as well as a relatively new
kind of insurance-like derivative called a credit-default swap.
Eventually, Michaelcheck assigned him to the fund. Innately curious
and fascinated by complex systems, the former computer programmer
and engineer delved into the details of the esoteric instruments—how
they were structured, how they traded. “Mariner was at the frontier of
what was being done at the time,” says Pellegrini.
In fact, CDOs and their predecessors were hardly new, having been
around for more than a generation; they were the latest iteration of the
236 THE MOST DANGEROUS TRADE
mortgage-backed security, originally pioneered in the 1980s by Lewis
Ranieri, the amboyant Salomon Brothers trader proled in Michael
Lewis’s best-selling book Liars’ Poker (Viking, 1989).
CDOs were the high-octane fuel behind the growth of the skyrock-
eting housing market. By allowing banks and other lenders to package
loans into securities and unload them onto investors around the world,
they freed up bank capital, permitting them to make still more loans
in a seemingly unending virtuous cycle. Because the loans were pack-
aged and sold o so quickly, little attention was paid to their quality, and
lending standards dropped precipitously. Originators like Ownit Mort-
gage Solutions, People’s Choice, and Ameriquest Financial led the way,
ogging interest-only, low-document and even no-document mortgages
along with option arms and payment option arms. These were simply
mortgages that were destined to fail, but they could be fed into a kind
of nancial instrument that could seemingly transform them into con-
servative bonds—the CDO.
At its simplest, a CDO is a pool of residential or commercial
mortgage-backed securities and other debt instruments whose projected
payment streams are mixed and sliced into tranches, based on the
likelihood of their continuing to be paid out over time. The most secure
of these, the super senior slices, paid out the lowest rates, (e.g., 5.5 or
so percent in 2005), since the probability that they will stop paying was
perceived to be quite low.
As rating agencies like S&P got into the business of measuring the
riskiness of CDOs, these senior tranches would usually get labeled as
triple A, equivalent to the top-notch grade of the U.S. Treasuries at the
time. Further down the pecking order, successive CDO tranches were
built to absorb the hits when problems arose. These slices would stop
paying investors when mortgage holders defaulted. They might be rated
A or lower and so sport higher yields, 6 or 8 percent.
The so-called “equity” tranche of the CDO was called that because
it was assumed to be the riskiest—designed to be the rst slice to stop
making payments at the rst hint of trouble. However, until it imploded,
this risky slice paid double-digit rates of return.
The ratings from S&P, Moody’s, and Fitch were based on a fallacy:
that the geographic diversity, mix of dierent kinds of mortgages and
Pellegrini: Behind the Great Subprime Bet 237
sophisticated modeling of projected payments would allow the agencies
to anoint tranches with a high-grade rating, even if the underlying mort-
gages were shaky. That proved disastrously wrong when housing prices
reversed gears.
The credit default swaps (CDSs) Mariner was trading, by contrast,
were of more recent vintage, having come into fashion only in the early
2000s. The CDSs were originally designed to provide insurance for
investors holding corporate bonds. Credited to a red-haired JPMorgan
derivatives whiz, Blythe Masters, the concept is straightforward: A bank
or insurance rm, say, JPMorgan Chase or MBIA Inc., writes an insur-
ance contract on a particular corporate bond, oering to pay the interest
and the full principal amount if the issuer defaults. That’s why it is
routinely referred to as protection.
Originally, swaps were bought by holders of a particular bond, who
paid, say, 10 basis points, or $100,000 annually for insurance on $100
million of bonds. Beginning in 2000, swaps were increasingly traded
independently of whether the purchaser owned the underlying bonds.
The value of the swap would rise as the creditworthiness of the bond’s
issuer declined or fall as its outlook improved. That could be helpful if,
say, Bear Stearns was nancing your business and you wondered whether
the investment bank would go belly-up.
So swaps became an ecient way to wager against a particular com-
pany or its bonds. They had fewer hurdles than shorting a company’s
bonds—the diculty of nding bonds to borrow and the unpredictable
cost of buying them back if somebody engineered a short squeeze on
those particular bonds.
It was the combination of CDOs and CDSs that was to prove critical
to Pellegrini when he found his way to Paulson & Co.
At Mariner, Pellegrini worked on a project to build a triple A-rated
derivatives product company to sell CDS protection on highly rated
bonds, including CDOs. Because the bonds were of high quality, the
company could have obtained a triple-A rating from credit agencies even
if it insured a very large portfolio of bonds. As a result, the company
could generate a high return on equity. Given its rating, the company did
not need to “collateralize” the swaps it wrote and, therefore, had a better
chance of surviving a market downturn. (The need to provide collateral
238 THE MOST DANGEROUS TRADE
on credit default swaps was what brought down American International
Group Inc. and its AIG Financial Products subsidiary.) Soon, though, he
began casting about for other work.
A Harvard Business School alumni service mentioned that Paulson
& Co. was looking for a chief operating ocer. Pellegrini, then 47, called
John Paulson in the summer of 2004, even though he suspected he was
underqualied. Paulson seemed happy to hear from him. The COO job
had been lled, and the only thing available was an analyst’s position that
had opened up.
Pellegrini said immediately he was interested.
Paulson was hesitant. “My analysts are more junior than you,”
he said.
“I don’t care,” Pellegrini responded.
Today, Paulson’s ascendancy into the pantheon of short-selling greats
is Wall Street legend—and the subject of a best-selling book, The Greatest
Tra d e E v e r , by Gregory Zuckerman (Crown Business, 2010). Paulson’s
tale, like Pellegrini’s, is that of an outsider catapulted into the uppermost
echelons of the investing world.
Paulson long kept a low prole, even by hedge fund standards. Raised
in the waterside neighborhood of Beechhurst, Queens, he was the third
of four children of Alfred and Jacqueline Paulson.
Paulson’s father, Alfred, was an accountant who became chief nan-
cial ocer of public relations rm Ruder-Finn. His mother, Jacqueline,
was a child psychologist. Paulson gives credit to an unlikely institution
for giving him an early lift—the New York City public school system,
with its programs for gifted children and accelerated curriculums, which
are often under re because they tend to exclude blacks and Hispanics
disproportionately.
“I always had reading and math skills four or ve years ahead of my
grade,” Paulson says.
Yet, Paulson had an entrepreneurial side even in elementary school.
He would buy packages of six Charms lollipops for eight cents, breaking
them up so he could sell the individual pops for ve cents each—quite
amark-up.
By eighth grade, in New York City’s accelerated program, he
was studying Shakespeare and calculus. And after graduating from
Bayside High School in Queens, he headed to New York University,
Pellegrini: Behind the Great Subprime Bet 239
where he earned a bachelor’s degree in nance, summa cum laude, in
1978. As valedictorian, Paulson gave a graduation speech on corporate
responsibility.
He went on to earn an M.B.A. at Harvard Business School in 1980,
nishing in the top 5 percent of his class—a Baker’s Scholar. Paulson
decided on a career in nance. At the time, banking jobs were scarce,
and he settled for a spot at Boston Consulting Group, a relatively obscure
proving ground whose alumni include former U.S. presidential candidate
Mitt Romney and Israeli prime minister Benjamin Netanyahu.
Two years later, he landed an associate position at New York-based
Odyssey Partners, an investment rm run by the legendary Leon
Levy and Jack Nash. An Odyssey specialty was risk arbitrage, in
which traders often buy the stock of takeover targets and short that of
the acquirer.
Paulson says Levy and Nash, both now deceased, taught him the ins
and outs of risk arbitrage, real estate investing, and how to prot from
bankruptcies. “Leon was brilliant,” Paulson says. “A lot of what I know
about deals today, I learned from them.”
Paulson left Odyssey to join Bear Stearns’ M&A department in
1984, rising in just four years to managing director. The rm had an
outsider status on Wall Street under chairman Alan “Ace” Greenberg,
eschewing standard Ivy League M.B.A.s in favor of what he called
“PhDs”—candidates who were poor, hungry and with a deep desire to
become rich.
Paulson wasn’t thrilled when Bear sold shares to the public in 1985,
and he eventually decided he didn’t want to work for a big, publicly
traded company, where the impact of his work was diused. In 1988 he
joined privately held Gruss Partners, another risk arbitrage rm. Founder
Joseph Gruss taught Paulson an important lesson.
“Joseph Gruss used to say, ‘Risk arbitrage is not about making
money; it’s about not losing money,’” Paulson says. That lesson seared
in his psyche a career-long aversion to risk that, despite reversals in
2011 and 2012, continues to this day.
Paulson set out on his own in 1994, initially taking a desk at the
oce of his old colleague, Manuel Asensio. Paulson & Co. started as an
arbitrage rm. Over the years, Paulson launched new funds to exploit
market trends and on occasion closed them. Still, by the time Pellegrini
240 THE MOST DANGEROUS TRADE
approached Paulson, the rm was known primarily for two strategies.
First was the aforementioned merger arbitrage—playing takeover can-
didates. The other was event arbitrage—a fancy way of wagering on
corporate developments such as earnings surprises and stock buybacks.
The distinguishing feature at Paulson & Co. was risk control. “We
always operated with a lot of hedges,” Paulson says. “We try to minimize
market correlations. If you don’t, you’re going to be exposed when a
market event happens.”
Paulson explains his philosophy thus: “Investors will forgive you if
your returns are below average for a period. They won’t forgive you if
you lose money.”
By the time Pellegrini joined in 2004, the merger arbitrage business
was getting tough. There was plenty of volume—Pellegrini worked on
the three-way merger that created Mitsubishi UFJ Financial Corp—but
too much competition. “There was so much capital chasing any return,”
says Pellegrini. “Merger arbitrage spreads were being compressed more
and more.”
The agship Paulson Advantage Fund, with $300 million in assets
returned just 5 percent net in 2005, versus 9 percent for the average
hedge fund. “That gave John the incentive to look for other oppor-
tunities,” Pellegrini says. “What we tried to do was identify situations
where betting against the consensus was inexpensive in both relative and
absolute terms.”
The signs of a growing real estate bubble were evident for anybody
who cared to take note. Manhattan cocktail parties buzzed with news of
the latest $25 million celebrity coop sale. The S&P/Case-Shiller 20-City
Home Price Index had more than doubled from 2000 to mid-2006.
Paulson had witnessed roller-coaster rises and drops in the volatile Man-
hattan coop market. “I did not subscribe to the theory that real estate
prices only go up,” Paulson told the Financial Crisis Inquiry Commis-
sion. Meanwhile, investment banks were printing massive amounts of
CDOs—$157.8 billion in 2004, $251.3 billion in 2005, and $520.6 bil-
lion in 2006.
“John was worried about a credit bubble, particularly a consumer
credit bubble,” says Pellegrini. Although he shared Paulson’s concerns
at the time, Pellegrini insists that Paulson deserves the lion’s share of the
credit for initiating the trade. Paulson did and still does make all investing
Pellegrini: Behind the Great Subprime Bet 241
decisions at his rm; in Wall Street argot, he “pulls the trigger.” Besides,
as Pellegrini puts it: “I’m always pessimistic about everything, so John’s
view was more signicant.”
In his hedge fund’s oces in the black granite IBM Building on
Manahattan’s Madison Avenue, Paulson and Pellegrini began discussing
ways to prot from a collapse in the housing bubble he suspected was
developing in early 2005. One obvious way was shorting the shares
of banks with outsize exposure to the subprime mortgage market. In
February 2005, Paulson & Co. initiated short positions on Countrywide
Financial Corp., the Calabasas, California, mortgage lender co-founded
by CEO Angelo Mozilo (the well-tanned poster child of the housing
boom), and Washington Mutual, a Seattle bank that had expanded at
breakneck pace across the country to comprise a nationwide network of
more than 2,200 bank branches.
The danger of shorting nancial stocks in a housing bubble was
soon apparent. In little more than a two-week period from mid-April
to early-May in 2005 the shares of both companies surged more than
12 percent, partly based on takeover rumors. Pellegrini calls the shorts
modestly protable. Both Countrywide and Washington Mutual were
in fact eventually purchased by Bank of America Corp. and JPMorgan
Chase & Co., respectively, but long after Paulson & Co. covered its posi-
tions. Paulson also bought credit protection on MBIA, a municipal bond
insurer that had expanded into the faster-growing business of writing
CDSs on CDOs. At the time the Armonk, New York, rm was the
target of a short campaign by Bill Ackman, founder of Pershing Square
Capital Management LP, who had spent years criticizing the rationale
behind the triple-A ratings it was accorded by S&P and Moody’s. The
trades were only modestly protable.
The lesson to Pellegrini was clear. “I told John the better way to
express a negative view of consumer credit was to short subprime mort-
gage debt through credit derivatives,” he says.
The lure of doing so was simple—by using a swap to bet against a
bond, the only capital at risk was the premium paid. That was often as
little as .50 basis points—or $50,000 for protection on $10 million worth
of bonds. That was chump change if the bonds performed. But if they
defaulted, swapholders would win a 2000 percent return on the invest-
ment. By contrast, shorting a stock in the traditional fashion leaves an
242 THE MOST DANGEROUS TRADE
investor virtually unlimited downside if, for example, an acquirer oers
to pay signicant premium to the market price.
Paulson began buying protection on tranches of Residential
Mortgage-Backed Securitizations (RMBS)—specically those rated
BBB, or one step above junk. This, to his mind, was the sweet spot:
The swaps cost just 100 basis points, or $1 million to cover $100 million
of bonds. If he had dipped down just a single rating point, to the BBB-
tranches, the price would have tripled.
The problem for Paulson & Co., with $3 billion in assets under man-
agement at year-end 2005, was supply—it was endishly dicult to nd
enough BBB tranches to buy protection on, since that particular slice
represented less than 2-3 percent of the RMBS capital structure. Wall
Street, innovative as always, was working on the problem with a new
instrument—the synthetic CDO, a product of which Pellegrini was well
aware.
By now, Pellegrini was devoting most of his eorts to analyzing the
housing bubble. “We began to peel the onion,” he says. He was worried
that his work so far on mergers hadn’t been particularly impressive—and
wanted to show his old oce mate and friend that the decision to hire
him had been right.
The rst year the trade was in eect was a nervous time, even though
the Paulson Advantage Fund’s notional exposure was relatively small.
“From early 2005 to early 2006, it wasn’t clear the trade was going to
work,” Pellegrini says. He would wake up in the night pondering the
trade. “People thought we were throwing money down the drain. We
asked, ‘Are we missing something?’” It turns out they were.
Initially, he and Paulson believed that housing prices were a function
of the current low “teaser” rates on many residential mortgages—just
4.25 percent on an adjustable-rate subprime mortgage in late 2005.
Once mortgage rates “reset” to the higher contractual rate at the
end of the typical two-year teaser-rate period, homeowners would
begin to default on their adjustable-rate mortgages—and the bubble
would burst.
At a November 2005 conference at New York’s Grand Hyatt Hotel,
New Century Financial Corp. CEO Robert Cole gave an upbeat
presentation to analysts. Afterwards, Pellegrini approached Cole at the
lectern, asking him whether the “rate reset” rates would trigger defaults.
Pellegrini: Behind the Great Subprime Bet 243
Cole blithely responded that defaults would be minimal because
New Century would simply renance existing mortgages coming up for
rate resets with new, larger mortgages starting out again at the low teaser
rate. The upfront renancing fees New Century charged the homeown-
ers would compensate for the lower initial rates.
Paulson and Pellegrini suddenly had a problem. They had staked
their housing bet on the premise that rising mortgage rates would trig-
ger a wave of defaults. Now the head of one of the biggest subprime
mortgage originators had told them the company was happy to renance
mortgages to avoid such defaults.
What Paulson & Co. needed now was some sort of proof that
housing prices were unsustainably high and due for a major correction,
regardless of the direction of mortgage rates. In such a scenario, home-
owners would not be able to renance their mortgages because the
value of their homes would have declined below the existing mortgage
balance, rendering a renancing impossible. As it was, housing bulls
were arguing loudly that home prices had never declined in value in the
United States—and they were proering plenty of evidence that there
was good reason for housing prices to be as high as they were.
Paulson desperately needed evidence that prices were out of whack
and Pellegrini volunteered to look for it. “The mortgage market lends
itself to deep quantitative analysis and modeling,” Paulson says. “Paolo
excelled in this area.”
Pellegrini and his colleagues zeroed in on numbers from the Oce
of Federal Housing Enterprise Oversight’s home price index from 1975
to 2000. Previously, research had shown that, indeed, home prices had
never fallen on a national basis—a key argument for housing bulls. How-
ever, the argument overlooked the fact that ination had declined sub-
stantially since 2000.
Pellegrini decided to ination-adjust all the numbers. Sure enough,
ination-adjusted prices showed peaks and troughs—when he drew a
regression line through the data points, it showed prices would have to
fall 30 percent to 35 percent in ination-adjusted terms just to get back to
the historical trend. With almost zero ination, this meant that nominal
prices would have to fall by a similar percentage. And since falling prices
tend to overshoot in a sell-o, the United States and much of the world
were facing a meltdown of cataclysmic proportions. “After hearing a lot
244 THE MOST DANGEROUS TRADE
of arguments for and against the presence of the bubble, we had a simple
and clear insight of our own to go by,” Pellegrini says.
He recalls that Paulson broke into a smile when he showed him the
proof that houses were overpriced. “John doesn’t smile,” Pellegrini says.
“Itfeltgreat.”
The next step was to determine the relationship between home
prices and defaults. Pellegrini hired a New York rm called 1010Data
Inc. to help him integrate two databases: One, compiled by Santa Ana,
California–based First American Corp. and called LoanPerformance,
tracked 6 million securitized subprime mortgages. The other was based
on a Case-Shiller home price index, sorted by postal code. The com-
bined database showed that even if home prices merely attened, defaults
would surge. “There was a very strong relationship between mortgage
losses and home prices,” Pellegrini says.
Even before the exchange with New Century’s Cole, Pellegrini
and Paulson were ramping up the housing bet. One way of doing that
was what acronym-happy Deutsche Bank Securities called the Static
Residential Trust, or START, series of CDOs, which Pellegrini called
cash-synthetic CDOs. Paulson & Co. would be involved from the
beginning, buying protection on various tranches—typically those rated
BBB by S&P. Work started in the summer of 2005. “I decided it was
better to buy wholesale than retail,” says Pellegrini.
Better yet, it meant Paulson & Co. wouldn’t have to buy in the open
market, upsetting prices and tipping its hand. Paulson purchased the risky
equity tranches, too. These were the hardest to sell, but necessary in this
structure to get the entire deal done. Though the equity tranches were
the rst to be wiped out as defaults rose, until they did, they generously
paid 10 percentage points above the London Interbank Oer Rate or
LIBOR, reducing the impact of the eventual loss.
START and most synthetic CDOs worked like this: Bullish
investors put their money into the CDO, which “referenced” to a
portfolio of existing mortgage-backed securities selected by Deutsche
Bank or other rms. The synthetic portfolio was tracked and sliced into
tranches, just as if there were real residential mortgage-backed securities
in it, as they would in a normal CDO. Those looking to bet against
the housing market bought credit protection on the specic tranches
they wanted. The bearish investors’ premium payments then owed to
Pellegrini: Behind the Great Subprime Bet 245
the bullish investors, mimicking cash ow payments of the referenced
mortage-backed securities.
The CDO tranches absorb losses on all the residential mortgage-
backed securities referenced by the CDO in reverse order of seniority.
If an RMBS is written down, the equity tranche absorbs the loss. If the
equity tranche is wiped out, the next tranche absorbs the loss and so on.
In that situation, the cash paid in by the long investors is used to pay the
buyers of the credit protection on the CDOs.
Because START didn’t hold actual mortgage-backed securities,
Deutsche wasn’t limited by the supply. It could simply “reference”
existing ones and crank out cash-synthetic CDOs to meet demand.
Paulson & Co. bought almost all the credit protection on two
START CDOs—the $900 billion START 2005-C and the $1.2 billion
START 2006-B, launched in December 2005 and February 2006,
respectively. Loreley Financing, an investment rm, later sued Deutsche
Bank, accusing it of using synthetic CDOs, including START, to
defraud it by designing them to fail. The suit was settled for undisclosed
terms in March 2012.
But now, Paulson & Co. had hit another wall. The funds he was
making his investments through, Paulson Advantage and Advantage Plus,
were ostensibly event arbitrage funds. He rationalized to investors that his
growing bets against the housing market were a kind of market hedge.
Now, with the notional value of the trades teetering at more than a
$2 billion dollars, that artice rang hollow.
Paulson resolved in early 2006 to launch a fund dedicated to the
subprime bet—Paulson Credit Opportunities I, and later, a less lever-
aged version called Credit Opportunities II. Pellegrini was charged with
nding a portfolio manager for the two funds—a tall order, since he
would be hiring somebody to take over the trade that he had played so
large a role in developing. Paulson eventually surprised him by naming
him co-portfolio manager of the funds.
Paulson and Pellegrini launched a full-court press to market their
investors on Credit Opportunities. It was a tough sell. “There was skep-
ticism and hostility from people within the industry,” says Pellegrini.
“They told us we were early, that we didn’t understand the game.”
With the housing market still galloping upward, investors wanted
details of both Paulson & Co.’s research and how the trade would work.
246 THE MOST DANGEROUS TRADE
“I remember Paolo stopping by the oce at 5 p.m. and staying to 9 p.m.
explaining his research,” says Jack O’Connor, chief investment ocer of
AI International Corp., a family investment oce. “We were impressed.”
So were others. Over nine months, the rm raised $1.1 billion.
As home prices continued to rise, Paulson & Co. took advantage,
paying as little as one cent for every dollar of credit protection. Former
investors still marvel at the payo. “It was technically a beautiful trade,”
one money manager says. “The asymmetry was incredible.”
The housing market peaked in mid-2006. “Once the year-over-year
change in home price appreciation went negative in June 2006, we
thought the collapse of the market was almost inevitable,” Paulson says.
Not everybody agreed. Indeed, Paulson and Pellegrini were furious
at the refusal of bank counterparties to their swaps to mark their CDS
positions down to realistic prices. All the data showed rising defaults,
but the counterparty banks simply pretended that had no impact on the
sometimes thinly traded credit protection.
Fortuitously, the Markit Group had just launched an index tied
to the value of subprime mortgages—the ABX Index. The benet
of the new benchmark, as for most indices, is that it provides a tool
for enhanced liquidity and soon Paulson was buying protection on
the index in force—another tactic to extract prot from the housing
collapse he was predicting.
Even better, the index was calculated to show the returns of spe-
cic tranches—BBB, Single A, and so on. Accordingly, Paulson had a
pretty good idea of the rm’s real winnings, even if its counterparties
were fudging their marks on the swaps the rm had bought. For the
last half of 2006, Credit Opportunities gained 19.4 percent, according
to investors.
Although extremely liquid, and useful in expanding the Paulson &
Co. subprime wager, betting against the ABX Index was far more expen-
sive than buying CDO protection. Finding counterparties to wager with
was also tough.
With the new funds up and running, Paulson kept looking for ways
to expand, enhance, and press his subprime bet. The rm was in constant
discussions with Wall Street rms, asking about their willingness to struc-
ture synthetic CDOs that Paulson & Co. could bet against. Originally
Pellegrini: Behind the Great Subprime Bet 247
targeting the tranches rated BBB, as home prices declined and defaults
began rising Paulson & Co. started buying protection on those rated A
as well.
In early 2007, Josh Birnbaum, head of Goldman Sachs’ CDO trad-
ing desk, stopped by Paulson & Co.’s oce with some colleagues to meet
with Paulson, Pellegrini and the rm’s head trader, Bradley Rosenberg.
They wanted to meet the hedge fund that was beginning to have a major
impact on their prot and loss statement (P&L) and to deliver a mes-
sage: Paulson & Co. was overreaching. “Basically, he said, there’s no way
the single A tranches were going to have write-downs,” says Pellegrini.
“They had been accumulating single A credits.”
Birnbaum oered to buy back some of the protection Goldman
Sachs had sold Paulson & Co. Paulson said he’d think about it.
Birnbaum then began probing for an idea about how big a bet
Paulson & Co. was planning on CDOs. He pitched the notion that
Goldman Sachs was there to help. Goldman, after all, was the hedge
fund’s main prime broker. It had helped Paulson & Co. raise capital.
“We’re partners,” Birnbaum said. “You should tell us how much you
intend to buy so we can make a market.”
Paulson didn’t commit to anything. Still, with two new hedge
funds ramping up, Paulson & Co. needed to buy more CDO protection
quickly.
Morgan Stanley was one prospect. Pellegrini approached Trust
Company of the West (TCW) about acting as portfolio selection
agent on a structure like START. TCW replied that Morgan Stanley
would have a problem with Paulson shorting tranches of a CDO it was
sponsoring. “Morgan may have a tough time with [Paulson] shorting
the whole portfolio,” one TCW executive wrote.
Pellegrini turned to Paulson & Co.’s own prime broker, Goldman
Sachs, a growing force in CDOs, with the idea of buying protection
on $1 billion of residential mortgage-backed securities through a new
synthetic CDO, the latest in a series of synthetic CDOs under the
ABACUS moniker—rolled out by Goldman some years earlier. His
day-to-day contact was an aable and wise-cracking young Frenchman
named Fabrice Tourre, a vice president in the group called Structured
Product Correlation and Trading.
248 THE MOST DANGEROUS TRADE
Dubbed ABACUS 2007-AC-1, the CDO would be what Pellegrini
likes to call “synthetic-synthetic.” No cash would be paid into the CDO,
although the long “buyers,” as in the case with the START CDO, would
still receive the protection payment streams from the swapholders and pay
them when downgrades and defaults occurred.
Getting a deal done quickly was crucial. By eschewing real securities
and real cash and relying on credit default swaps to mimic cash ows
of real securities with underlying collateral, a synthetic CDO could
be done quickly—a critical consideration because the market, as
Pellegrini and Paulson gured, was beginning to crumble. This type
of CDO also didn’t require every tranche of the synthetic CDO to
be spoken for.
Goldman Sachs’s Tourre suggested hiring a “portfolio selection
agent” who would determine which mortgage-backed securities to
include in the referenced portfolio.
Again, there was pushback. Tourre and Pellegrini met with GSC
Partners LLC, a Florham Park, New Jersey, asset manager run by a
group of former Goldman Sachs distressed debt traders to see if they
would serve as portfolio selection agent, working with Paulson, who
they acknowledged intended to short the CDO. No dice.
Later, when GSC was approached by Goldman to participate as an
investor, it had a withering response. “I do not have to say how bad it is
that you guys are pushing this thing,” the e-mail read.
At least one other asset manager was also approached, and ultimately
did not sign on.
By contrast, ACA Financial, a once-staid underwriter of municipal
bond insurance, was hungry. Bear Stearns’ merchant banking division
had bought a 28 percent stake in the company in 2004, pushed aside
existing management and refocused ACA on managing and insuring
CDOs. By year-end 2006 it had $15.7 billion in assets under manage-
ment, a combination of credit default swaps, asset-backed securities like
CDOs, and leveraged loans.
Heading the ACA CDO business: senior managing director
Laura Schwartz, a former Merrill Lynch asset-backed nance exec-
utive who took charge of the portfolio selection process. Whatever
mortgage-backed securities Pellegrini wanted in the reference portfolio
would have to meet with her approval.
Pellegrini: Behind the Great Subprime Bet 249
What ensued was a months-long game of complicated, billion-dollar
gin rummy, played out in e-mails, face-to-face midtown meetings, and
one dimly lit bar in Jackson Hole, Wyoming. Pellegrini would pitch
to Schwartz a portfolio of risky securities to be included in the refer-
ence portfolio. Schwartz would volley back, nixing some and approving
others and suggesting replacements. It was an arduous process.
Troves of e-mails were disclosed in the SEC’s suit against Gold-
man Sachs and Tourre, and in another suit led by ACA itself against
the investment bank and Paulson & Co. as well as in hearings by the
U.S. Senate and House of Representatives concerning Goldman Sachs’
role in the nancial crisis. They shed light on how the CDO factories
worked—as well as the characters involved.
Throughout, the personable Tourre hustled to keep both par-
ties at the table, encouraging them to come to terms. Along the
way, he e-mailed his girlfriend in London, Marine Serres, another
Goldman Sachs yearling, opining on the housing bubble’s impending
collapse—segueing seamlessly between English and French as he did.
“More and more leverage in the system the entire building at risk
of collapse at any moment … the only potential survivor, the fabulous
Fab,” one whimsical missive reads. “Standing in the middle of these
complex, highly levered, exotic trades he created without necessarily
understanding all the implications of those monstruosities!!!”
From the start there was confusion on ACA’s part about Paulson
& Co.’s role in putting together the deal. In a January 8, 2007 e-mail,
Schwartz questions a colleague of Tourre’s about it, after an early meet-
ing. “I think it didn’t help that we didn’t know exactly how they [Paulson
& Co.] want to participate in the space. Can you get us some feedback?”
Whether Schwartz ever got feedback is unclear—the issue was the
crux of ACA’s suit against Goldman and Paulson & Co. The insurer
claimed that Goldman and Paulson conspired to hide the fact that the
hedge fund planned to short the ABACUS portfolio and not, as is
implied in subsequent Goldman e-mails, buy the equity tranches.
In fact, like a lot of bearish investors at that time, Paulson often did
both. Cash ows from equity tranches, which threw o double-digit
payments, were often sucient to pay for the credit protection the com-
pany was buying on the rest of the portfolio—so the trade could be
self-nancing. In the second half of 2006, more than half of the equity
250 THE MOST DANGEROUS TRADE
tranches of CDOs were bought by hedge funds that also shorted other
portions, according to the Financial Crisis Inquiry Commission.
In the kind of housing meltdown Paulson and others predicted,
defaults would be triggered across the CDO’s capital structure—not just
the unrated equity tranche.
Schwartz was aware of the strategy, since in a January 28 e-mail
she described Paulson as a “Magnetar-like equity investor,” referring to
the Chicago-based hedge fund whose bets against subprime mortgages
were accompanied by long investments in the equity tranches. ACA had
served as selection agent on at least one of those CDOs.
On January 9, Goldman forwarded to ACA a roster of 123 mortgage
securities that Pellegrini was suggesting for the reference portfolio. ACA
had previously purchased more than half of the securities—and was thus
reasonably comfortable with them. A Goldman colleague of Tourre’s
emailed Schwartz that he was “very excited about the initial portfolio
feedback.”
Still, negotiations were tortuous. In general, Pellegrini sought out
pools of mortgages from California, Nevada, and Arizona, the so-called
“sand states” with the sharpest run-ups in home prices. He also wanted
a high percentage of adjustable rate mortgages sold to homeowners with
low FICO credit scores.
In a January 14 e-mail to a Tourre colleague, Schwartz fretted she
might have been too tough with him, and once again referred to her
understanding that Paulson was an equity investor in ABACUS. “I cer-
tainly hope I didn’t come across too antagonistic on the call with Fabrice
last week but the structure looks dicult from a debt investor perspec-
tive. I can understand Paulson’s equity perspective but for us to put our
name on something, we have to be sure it enhances our reputation.”
About a week later, on January 22, Schwartz e-mailed Tourre and
colleagues a list of 86 subprime mortgage securities that ACA would
consider for the reference portfolio. Just 55 of Pellegrini’s original 123
names were included. She wrote:
We do not recommend including the other 68 names because
either: 1) we did not like them at the recommended attachment
point; 2) there are lower rated tranches that are already on negative
watch; and 3) some names (i.e. Long Beach and Fremont) are very
susceptible to investor push back.
Pellegrini: Behind the Great Subprime Bet 251
Schwartz added that the names she was suggesting were mostly new
issues, which she believed to be of higher quality.
Despite the back and forth, four days later, on January 26, Tourre felt
condent enough to start asking about lawyers for the deal, engagement
letters, and fees.
Pellegrini took a couple of days o to go skiing with his elder son in
Jackson Hole, Wyoming, booking a room at the Snake River Lodge. By
coincidence, he bumped into Schwartz, who was attending a structured
product conference sponsored by UBS at the nearby Four Seasons Hotel.
The two agreed to meet up at the bar at Snake River Lodge to
work on the all-important portfolio composition. Schwartz ordered a
soft drink and Pellegrini a beer. They then opened up their respective
laptops and began working through changes to the roster of reference
securities. Pellegrini says the negotiations reected their dierent out-
looks. “This is one the few examples where a dierence in intellectual
paradigm determined the outcome,” he says. “They missed completely
the notion—what happens if home prices go south?”
Pellegrini recalls having a spreadsheet with 100 or so lines of data
on it. By contrast, he says, Schwartz had a 20-page report on each
securitization.
For an hour, the two swapped the securities in and out of the hypo-
thetical ABACUS portfolio. “We changed the portfolios four or ve
times before we were done,” Pellegrini says.
Certainly, the one-on-one smoothed the path for ABACUS. “He
may be as much of a nerd as me since he brought a laptop to the bar and
he also seemed to have a worksheet from DB and another manager,”
Schwartz joked in an e-mail to Tourre the next day, January 28. “I cer-
tainly got the impression he wanted to move forward on this with us.”
Goldman, Paulson, and ACA continued to cull and add names to
the portfolios: At Goldman’s suggestion, out went SAIL 2006 BNC1
M7 and SAIL 2006 BNC2 M7, which Moody’s had placed on negative
credit watch; in came GSAMP 06-HE-4 M8 and GSAMP 06-HE5 MB.
At least one long investor, Jorg Zimmerman of IKB Deutsche Indus-
triebank, a huge buyer of CDOs, asked for his own changes to the
portfolio, specically to remove bonds serviced by Fremont General and
New Century. The securities in question remained in the portfolio.
On February 5, Schwartz e-mailed two lower level colleagues, Keith
Gorman and Lucas Westerich. “Attached is the revised portfolio that
252 THE MOST DANGEROUS TRADE
Paulson would like us to commit to—all names are at the Baa2 level.
The nal portfolio will have between 80 and these 92 names. Are ‘we’
okay to say yes on this portfolio?”
Gorman responded. “Looks good to me. Did they give a reason why
they kicked out all of the Wells deals?”
Though there is no record of Schwartz’s response, Wells Fargo was,
in fact, known for its relatively strict underwriting standards.
Two days later, lightning struck. While New Century’s share price
had held up amid mounting worries in the housing market, Paulson had
begun shorting the stock in January. He neither believed the rm’s cul-
tivated reputation at the time as a conservative lender nor respected the
fact that Greenlight Capital founder David Einhorn, a successful hedge
fund manager, sat on its board.
New Century reported that it would restate earnings for most of
the previous year’s results because banks were returning troubled loans it
had sold them. The next day, New Century shares plunged 36 percent.
More importantly, the news triggered a rout in the ABX Index, which
tumbled ve points that day. Holding $25 billion in subprime insurance,
Paulson & Co. earned $1.25 billion in a single day.
ABACUS 2007-AC1, though, moved forward. On April 10,
Schwartz e-mailed ACA CEO Alan Roseman. She stated Paulson &
Co. was a buyer of the equity tranches. “We did price $192 million in
total Class A1 and A2 today to settle April 26,” she wrote. “Paulson
took down a proportionate amount of equity (0–10% tranche).”
In 2010, Laura Schwartz told the FCIC she was blind to Paulson &
Co.’s intentions to the end. “To be honest, [at that time,] until the SEC
testimony I did not even know that Paulson was only short,” she said.
Whether she believed the rm was net long or short would be a good
question.
The fateful CDO closed on April 26, as the subprime mortgage mar-
kets accelerated into a vortex of home wealth destruction. Credit was
drying up and bids for subprime loans fell below the cost to originate
them. Firms like Fremont General and New Century stopped making the
loans altogether. Two prominent Bear Stearns hedge funds that invested
heavily in subprime mortgage bonds racked up double-digit losses for the
month, triggering headlines and stirring panic among investors.
Pellegrini: Behind the Great Subprime Bet 253
The mortgage markets just kept getting worse—which is to say,
much better for Pellegrini and his funds. For March, Credit Opportu-
nities posted a 66 percent return—one investor called to complain that
there was there was a typo in the e-mail announcing the fund’s gain. It
must have been 6.6 percent, no?
The ABX Index, however, soon rallied from its February plunge as
bargain hunters entered the market. After tumbling from 100 to 60, in
March the index began a climb to 70 and then nearly 80 by mid-May.
Paulson Credit Opportunities gave back half of its year-to-date gains.
The rally had no legs. By mid-May, the ABX was collapsing once
again. And now the bad news seemed relentless, mounting into the sum-
mer. In late June, Bear Stearns paid $3.2 billion to shore its hedge funds;
those were shuttered the next month when rating agencies S&P and
Moody’s downgraded billions of dollars worth of subprime mortgage
bonds. IKB, the German bank that had been the biggest long investor in
ABACUS 2007-AC1, had to be bailed out by German bank regulators
because of soured U.S. mortgage bets.
The Goldman Sachs CDS trading desk, by going short the subprime
mortgage market in late 2006, was well positioned to observe the carnage
and prot from it.
Birnbaum, for one, was in awe. “Many accounts throwing in the
towel,” he wrote to a colleague in July as the bad news mounted. “Any-
body who tried to call the bottom left in bodybags.” His colleague was
eusive. “We hit a billsky in PNL today,” he wrote, using trading desk
argot for $1 billion for a single-day prot. “I’m no John Paulson though.”
At Paulson & Co.’s midtown oces, with their muted blond wood
built-ins and bold Alexander Calder gouaches, Paulson and Pellegrini
kept a measured calm, even as their prots began to accelerate. Twice a
day, the rm’s head trader, Brad Rosenberg, would walk into Paulson’s
oce and tell him the marks, or prices, of the rm’s credit default swaps.
Employees, many of whom kept real-time quotes of the ABX Index
on their computer screens, would strain to read Paulson’s expression
as he did so—but the former investment banker usually succeeded in
maintaining a perfect poker face—revealing nothing.
By August, the ABX had tumbled to 35. Pellegrini, his net worth
tied up in the fund, begged Paulson to be allowed to cover at least part
254 THE MOST DANGEROUS TRADE
his funds’ short positions. Paulson agreed to Pellegrini’s pleas to take
some prots—but initially covered only its subprime short positions in
its merger and event arbitrage funds. He, Pellegrini, and research director
Andrew Hoine by now realized a logical corollary to their mounting
riches—if they and other hedge funds were racking up outrageous gains,
who was ultimately going to book the losses to pay them? The answer
to one degree or another had to be the thinly capitalized banks.
Paulson assigned the project to Hoine, a former investment banker
at JPMorgan Chase. Paulson’s funds began buying credit protection
on a range of nancial institutions—Bear Stearns, Lehman Brothers,
UBS, and Credit Suisse Group—at prices as low as 20 basis points, or
$200,000 for protection on $100 million worth of bonds. At prices that
low, Paulson & Co. could spread his bets around.
Assets had been pouring into the funds—especially Credit Oppor-
tunities and Credit Opportunities II, the two swelling to a combined
$8.9 billion. They stopped taking new money in late- and mid-2006,
respectively. New money was going to the Advantage funds. By Octo-
ber, though, Paulson & Co. had covered 60 percent of its subprime bets.
By that point, every security in the ABACUS 2007-AC1 reference port-
folio had either been downgraded or placed on negative credit watch.
Investors lost $1 billion, including $15 million lost by Goldman Sachs
itself, when it failed to unload or hedge a portion of Paulson’s credit
protection. Paulson made about $1 billion on the CDO’s collapse.
Who bears the onus for ABACUS 2007-AC1? In an interview
with the Financial Crisis Inquiry Commission, Schwartz for one did
not deect responsibility. “ACA … selected that portfolio,” she said.
“[E]very name in that portfolio has been reviewed by ACA.”
Perhaps the whole issue is a bit of a straw man. Paulson, in his FCIC
interview points out that synthetic CDOs are by their nature zero sum
bets between two parties with losers and winners. In this case, arguably,
the scales were tipped in his favor with the help of Goldman Sachs.
Schwartz herself points out that ABACUS 2007-AC1 did not
perform particularly poorly, in light of the thorough collapse of the
mortgage markets. “Unfortunately, almost every deal went bad,” she
says. “ACA’s structured credit business lost a signicant amount of
money on almost all the super-senior protection it wrote.”
Pellegrini: Behind the Great Subprime Bet 255
For his part, Pellegrini says the evidence backs his claim that the
portfolio of residential mortgage-backed securities included in ABACUS
was meant to create a reection of the subprime market, not engineer
a train wreck. “We wanted a CDO that wasn’t better than the mar-
ket, wasn’t worse than the market,” he says. If that’s not the case, he
was less than expert. Those securities he initially recommended for the
doomed CDO, and that Schwartz rejected, ultimately performed better
than those Schwartz selected to replace them.
Pellegrini, when questioned twice by the SEC, in December 2008
and again in March 2011, said he told them that he doesn’t recall specif-
ically telling Schwartz about his Paulson & Co. plans to short ABACUS.
The SEC suit, led in April 2010, alleged that Goldman Sachs
defrauded investors by not telling them that Paulson & Co. had helped
select the ABACUS reference portfolio. Goldman settled that suit
in October 2011 for $550 million, a record. “The marketing mate-
rials for the ABACUS 2007-AC1 transaction contained incomplete
information,” the rm said in a statement:
In particular, it was a mistake for the Goldman marketing materials
to state that the reference portfolio was “selected by” ACA Manage-
ment LLC without disclosing the role of Paulson & Co. Inc. in the
portfolio selection process and that Paulson’s economic interests were
adverse to CDO investors.
Tourre, not surprisingly for a junior-level investment bank employee,
was left holding the bag. In August 2013, he was found liable for six of
seven of SEC fraud charges in connection with the case. His lawyers, paid
by Goldman Sachs, brought no witnesses in his defense. He was ordered
to pay $650,000 in civil nes for defrauding investors. And Tourre was
also required to give up his $175,463 bonus that derived in part from
the ABACUS deal. Tourre entered the University of Chicago to pursue
a doctorate degree in economics.
By contrast, in 2007, Paulson Credit Opportunities posted a 590
percent return. In 2008, a year when the average hedge fund lost 19
percent, Credit Opportunities posted an 18.3 percent return. Firm assets
rose to $36.1 billion at the end of 2008 from $7 billion two years earlier.
Over two years, the rm’s total gains amounted to a stunning $19 billion.
256 THE MOST DANGEROUS TRADE
Pellegrini’s lucrative Paulson & Co. trade was based on numbers.
“People were pretending they were earning a living, and they were
not,” he says. “Banks lent them the money so they could live beyond
their means, and I don’t mean lavishly.” That’s a lesson and a warning
going forward.
Chapter 10
Cohodes: Force
of Nature, Market
Casualty
“
G
aston! Gaston!” It was November in Las Vegas, and Marc
Cohodes, general partner of Rocker Partners LP, was calling
across the convention oor of Comdex 1999, the giant con-
sumer electronics show. He had just caught sight of Gaston Bastiaens,
CEO of Lernout & Hauspie Speech Products, a Belgian maker of voice
recognition software, switchboards, and other gear. Bastiaens was not
happy to see Cohodes—and began making his way to the exits, with
a posse of underlings in tow. Rocker Partners had been shorting the
company’s shares since July 1998, soon after Cohodes discovered its
speech-to-text software didn’t work—just 15 percent of the words a
person spoke would be accurately transcribed. The salespeople at big
box retailers agreed the stu was junk and told him so. L&H, as people
called it, would claim revenues of $344.2 million that year, but already
257
258 THE MOST DANGEROUS TRADE
Cohodes was having a hard time guring out who was buying the
software. Neither L&H rivals nor Wall Street analysts could gure it
out either.
Bastiaens had a checkered past. He had helped preside over Apple
Computer’s disastrous Newton personal writing tablet, a pen-based
device that that bombed spectacularly in 1993. Bastiaens went on to
head Quarterdeck Oce Systems, a software company that amed
out in the late 1990s. Other than his nationality—Bastiaens too was
Belgian—Cohodes could see no credentials that qualied him for the
topspotatL&H.
“Gaston! Gaston!” Cohodes called out again as he hurried through
the crowded exhibition oor lled with booths of software and elec-
tronic gadgetry. “I want to ask you some questions.”
Bastiaens quickened his pace ahead of Cohodes, who at six feet two
inches and 260 pounds made for a formidable, bearlike pursuer. The
CEO’s retinue of handlers tried to keep up as best they could.
Bastiaens certainly knew about Cohodes—a regular visitor to L&H
chat rooms, where he posted critical questions under his own name.
Cohodes was open about his short position on L&H, and grilled
Bastiaens’ investor relations sta on any number of issues. He even
bashed L&H on an Internet radio program he hosted.
“Gaston, don’t run away like a girl,” implored Cohodes. “I want to
ask you about the sales.”
Bastiaens didn’t respond. The head of L&H public relations, Ellen
Spooren, a tall blonde Dutch woman, positioned herself between
Cohodes and her boss.
“Go away,” she scolded. “You’re a bad, bad man!”
Cohodes continued peppering Bastieans with questions.
“Keep away,” Spooren warned. “I’ll call security.”
Soon, guards arrived to unceremoniously escort Cohodes from
the building. The next day he was back, undaunted, but Bastiaens was
nowhere to be seen. Cohodes picked up some L&H T-shirts from the
corporate booth for his son and Rocker Partners analysts.
Cohodes relishes the limelight as much as some fellow short
sellers disdain it. In the end, combined with persistence and spot-on
investigative work, this has proven lethal for a roster of companies.
Cohodes: Force of Nature, Market Casualty 259
In the case of L&H, the short seller’s dogged research, and that of his
colleagues, triggered a fusillade of damning media coverage, including
Herb Greenberg, who wrote for Marketwatch.com at the time, and
most notably, the Wall Street Journal’s Jesse Eisinger and Mark Maremont.
The company was forced to open an internal audit, the U.S. Securities
& Exchange Commission began an investigation, and L&H led for
bankruptcy before year-end 2000.
The enduringly bitter dynamics of the short-selling business insured
that Rocker Partners’ investors suered. Initially shorting L&H at
prices as low as $10 a share, Cohodes agonized as the stock rose in
1999 to $23. The company was billing itself as the premiere play in the
white-hot translation software market, and using its rising stock to buy
out rivals—including Dragon Systems of Newton, Massachusetts, and
Dictaphone, a Stratford, Connecticut-based company. The leaders of
the U.S. technology industry bought into the hype, and Microsoft Corp
at one point became the largest holder of L&H stock, with a 10 percent
position. Intel was in, too.
As reported L&H sales accelerated, the stock went into hyperdrive,
hitting $72.50 at the peak of the technology bubble in March 2000.
Rocker Partners was losing tens of millions of dollars. By mid-2000,
even as tech stocks in general were tanking, L&H shares were up 70
percent for the year. “This thing had tripled on us,” Cohodes recalls.
“We’re getting killed. We were losing clients.” Following the immutable
laws of short-selling, the Rocker Partners’ exposure was growing as it
was forced to post more collateral to maintain its position. Because the
share price was rising, L&H was accounting for more and more of the
Rocker Partners’ portfolio—7 to 8 percent instead of the normal 4 to
5 percent.
Cohodes, normally self-assured, began to doubt his own research.
“You start losing your ability to realize you’re right,” he says. “The stock
is going against you so you can’t see right.”
Then came a serendipitous phone call. On his radio show, Cohodes
had been speculating on the identities of L&H customers. Who would
purchase the software that he and others found so awed? At his oce
in Larkspur, California, Cohodes picked up the receiver one morning
to hear what he’d been hoping for—an ex-L&H executive, Michael
260 THE MOST DANGEROUS TRADE
Faherty, who’d headed sales in the northeast region of the United States.
“You’re dead right,” Faherty told him. “I used to work there in sales.
We make the stu, we ship them out, we write up false invoices.”
The call proved a game changer. “It was like nding the proverbial
needle in a haystack,” says Cohodes, who put Faherty in touch with
the SEC’s enforcement division, with whom he had been sharing infor-
mation about L&H. Faherty’s revelation was the rst clear evidence the
company was fundamentally a fraud. Certain now that he was on the
right track, Cohodes redoubled his eorts—and resolved to maintain
his short position with invigorated condence.
More damning evidence was en route. L&H’s purchases of Dragon
Systems and Dictaphone meant the majority of its assets were now
domiciled in the United States. L&H was now required to le 10-Qs,
the extensive quarterly nancial information required of U.S. compa-
nies with the SEC, rather than the less specic, semiannual reports that
foreign-based corporations can get away with.
The new disclosures cast light on L&H’s business. Specically, the
company’s 1999 10-K broke out sales by geographic region, showing
that revenues in Europe and North America were falling. The 70 percent
rise in 1999 sales to $342.2 million, which had helped to fuel the rise in
L&H shares, was almost entirely attributable to a spike in South Korea
and Singapore. In those two countries, sales had risen from just $300,000
in 1998 to $143.2 million in 1999. Now, Cohodes thought he knew
where most of the suspicious revenues were being generated. “Korea
is one-tenth the size of the United States, but it’s generating the same
volume of business,” Cohodes recalls thinking. “How can that be?”
Cohodes hired an Asia-based analyst to track down the purported
customers that L&H listed in its SEC lings. Many, it turned out, had
never heard of L&H. Others had bought some software, but in amounts
far lower than L&H was claiming.
There was also the matter of special purpose entities that were set
up by “independent” investors to develop speech translation software
applications for more than a dozen languages—Urdu, Czech, Arabic,
Polish and Farsi, for example. These entities paid L&H between $3 to
$4 million for software franchise rights tied to specic languages. It was a
byzantine nancing scheme that, multiplied many times over, drastically
boosted revenues. L&H declined to provide anything like a complete
Cohodes: Force of Nature, Market Casualty 261
roster of the investors. One, however, was FLV Fund—an entity set up
by L&H founders Jo Lernout and Pol Hauspie, who had stepped back
from management but remained co-chairmen. Though the pair were no
longer connected to the FLV fund, Cohodes viewed it as a sign of rife
conict—a bright red ag.
As the importance of these vehicles sank in, L&H shares dropped,
tumbling 19 percent on August 8 alone. On August 15 the company’s
somnambulant board stirred, ordering an audit of its South Korean
operations—and ten days later CEO Bastiaens resigned. The Wall Street
Journal reported on September 21 that the SEC was investigating the
company. In October, Bastiens’s replacement, John Duerden, ew to
South Korea to confront the local business head—Joo Chul Seo. During
a meeting, three toughs barged into the oce and hauled Seo out of
the oce, and he was never heard from by L&H again. The company
announced on November 9 it would restate nancial statements for two
and one half years because of “errors and irregularities.” By the end of
the year L&H was bankrupt, with its shares trading in the pennies.
Despite L&H’s ignominious collapse, Rocker Partners’ prot was
slim on the trade—about $10 million over two and one half years. In the
interim, the $700 million hedge fund had been forced to endure paper
losses of as much as $100 million, exacerbated by customer redemptions.
Rocker Partners sued L&H’s investment banker, SG Cowen & Co.
and auditor KPMG Peat Marwick. Without their assistance or negli-
gence, the suit argued, L&H would not have been able to continue
its fraud and run the company’s share price up to the nosebleed lev-
els it reached in early 2000, costing Rocker Partners so much money.
“We weren’t able to maintain a position because of what they had been
doing with their accounting,” says Cohodes. The suits were settled for
undisclosed terms, but Rocker Partners made some money—not a lot.
“Lawyers got most of it,” he shrugs. Still, the case was vitally important
in establishing the legal rights of short sellers to sue for damages.
Such conviction stands as a Cohodes hallmark. “Marc’s tolerance for
being wrong until being proven right is amazing,” says Carter Dunlap,
of Dunlap Equity Partners, a San Francisco investment rm. “That
condence, or capacity to stand the pain, is what sets him apart.” So
does his humor and utter lack of pretense—Cohodes would most typ-
ically show up at investor conferences in his trademark polo shirt, khaki
262 THE MOST DANGEROUS TRADE
shorts, and Crocs, the brightly colored rubber clogs beloved by chefs
and gardeners. Cohodes has a way of connecting—persuading people
by force of his personality. “When he says something, you believe it,”
says Paul Landini, an analyst colleague of Cohodes at Northern Trust
Company in Chicago in the 1980s. He has a way of connecting with
people—even adversaries—winning them by both logic and charisma.
Says Landini: “He means it. Marc Cohodes is an amazing human being.”
L&H certainly validated Cohodes’s pit-bull tenacity and investigative
techniques—including stake-outs and endless cold-calling combined
with hours of forensic accounting. “Marc understands how to research
a company,” says Landini. “He turns over stones, he grovels, he is
relentless.”
Like many dedicated short sellers, Cohodes is juiced by a passion for
calling out bad actors. His hit list over the years includes a roster of com-
panies whose products, at least in some people’s eyes, could arguably be
called as dubious as their share prices. In 2003, Cohodes began shorting
the stock of Kansas City, Missouri–based NovaStar Financial, a subprime
mortgage lender that targeted the poorest, most vulnerable population
seeking to buy a home, saddling them with untenably expensive mort-
gages. In 2005, he wagered against Taser International, a Scottsdale,
Arizona, maker of high-voltage stun guns that were found to induce car-
diac arrest in people with common heart conditions. The company calls
the studies detailing the phenomenon awed. Cohodes’s bet against the
shares of high-ying Monster Beverage Corp., the Corona, California,
maker of caeinated energy drinks, included having one of his ana-
lysts stake out emergency room admissions of teenagers who mixed the
brew with vodka or other alcohol. Monster says its energy drink has less
caeine than many Starbucks beverages. “As dicult as it is, winning
becomes that much sweeter,” says Cohodes.
Ultimately, Cohodes’s tale would end disastrously—a case study in
how a short seller can be upended by the forces arrayed against them:
government agencies, a dysfunctional legal system, and, perhaps, the
machinations of Wall Street banks. The successor fund to Rocker Part-
ners, Copper River Partners, was forced to liquidate in late 2008, even
as other short sellers were minting fortunes in the meltdown of the
nancial crisis.
Cohodes: Force of Nature, Market Casualty 263
Navigating the winding back roads of California’s Sonoma County,
Cohodes ruefully shakes his head as he talks about his former line of
work. In the distance are the Mayacama Mountains, from which you
can see the Pacic Ocean and, to the south, San Francisco. At Hunt
& Behrens, a cavernous farm supply store, he swaps banter with the
owner and sta, who load $450 worth of feed onto the atbed of his
Dodge “Viper” pickup—it has the V10 engine of a Viper sports car—on
a sunny December afternoon. “There’s a lot of wear and tear in the
business,” Cohodes says in a booming voice as he careens along. Since
Copper River’s liquidation, he is focused on Alder Lane Farms, a 20-acre
equestrian center, where he also raises free-range organic chickens whose
eggs fetch $12 a dozen in San Francisco markets.
“I’ll never be in the business again,” he says. “Underline ‘never.’”
Back at Alder Lane Farms, Cohodes sits at the kitchen table in a
sparsely furnished, immaculate, sun-dappled dining area. On the table
are fresh-baked bread, butter, and jam made from pluots—a mouth-
puckering hybrid of plum and apricot. There are no artworks on the
white walls, no computer terminals, and no mementos to remind him
of his colorful career. It’s as if Cohodes has wiped away his short-selling
past. Regardless of his height, he lls up the room even more with his
persona than his physical presence. With a tendency for irreverent banter,
Cohodes has been a delight for quote-hungry journalists over the years.
Markets? “I think they are rigged,” he says.
Short selling? “The smart guys are extinct. The good minds are out
of the business.”
Goldman Sachs? “For them, everything is just a cost of doing
business.”
And on the meaning of his own short-selling career? Cohodes
pauses. “The question is whether you want to make a dierence or
not,” he nally responds, and knocks back a shot of espresso. He leans
forward and reveals a truth that informs his life and work “What you
see is not what it really is,” he says.
For all his talk about outing bad guys and protecting Joe Six-Pack,
Cohodes describes himself as a bounty hunter—surprisingly not too far
from what his adversaries call him. He credits his successful years as a
short seller to an innate sense of pattern recognition that goes a long
264 THE MOST DANGEROUS TRADE
way in helping him sni out dubious businesses programs. Bad com-
panies sport some similar characteristics that turn up again and again.
Their headquarters tend to cluster geographically, for example. “There
are no legitimate companies in the state of Utah,” Cohodes declares
atly. Other prime breeding grounds for problem companies are Florida,
Arizona, and New York’s Long Island.
Cohodes looks for serial acquirers—so-called “roll-ups” who use
their inated stock to buy legitimate companies on the cheap. Account-
ing for mergers and acquisitions allows for all kinds of obfuscation, and
continual restatements and charges are a way to cover up a fundamental
lack of growth. He trawls in the mid-cap and small-cap stock arena, g-
uring that more often than not, larger companies have proven business
models. “I stay away from the [Standard & Poor’s] S&P 500,” he says.
“Those companies are big for a reason.”
Cohodes combs through senior management resumes—and his ears
prick up in cases where a CEO has a track record of poor performance,
as was the case with L&H’s Bastiaens. When an executive can’t answer
seemingly simple nancial questions about his business—say, about rising
inventories—warning lights go o. “You shouldn’t walk away from the
building, you should run away from the building,” he chuckles. “Then
you should short the f--k out of the building.”
This skill set in pattern recognition rises to ethnic proling on occa-
sion: He pays special attention to South Asian Indians and Sri Lankans.
“For nine years I told the SEC that Raj Rajaratnam was dirty,” Cohodes
fumes. “I’ve never met an honest Indian CFO or CEO.” Rajaratnam,
founder of hedge fund Galleon Group, was found guilty of conspiracy
and securities fraud in May 2011, sentenced to 11 years in prison, and
ned more than $150 million.
Cohodes’s rough-hewn disposition bespeaks a troubled and unhappy
youth—one that likely would have held a less determined person back,
but which no doubt contributed to his outsider’s perspective on the
world. Marc Cohodes was born on June 18, 1960, the oldest child of
Donald and Meryl Lyn Cohodes, who divorced when he was three.
Along with his younger sister, Nancy, he grew up on Chicago’s Near
North Side, an auent neighborhood adjacent to Chicago’s famed cen-
tral business district, the Loop.
Cohodes: Force of Nature, Market Casualty 265
Cohodes doesn’t wax sentimental about his past. “My father sold
water coolers,” he says, atly. “He was a drunk. He’s dead.” Cohodes
stares straight ahead as he says this, and then later mentions that he doesn’t
speak with his estranged mother, either—following his divorce from his
rst wife, Leslie. “It is what it is,” he says, and shrugs.
As a child, Cohodes didn’t seek to impress grown-ups—and was
quite successful at that. A second grade report card he keeps is stark about
his prospects. “It said that I’d end up in jail or a mental institution,” he
says. His mind wandered in class and he was derelict in homework assign-
ments. “In this era, I think you’d say I have attention decit disorder,”
he says. “I still have issues sitting still.”
Nature abhors a vacuum. Lacking a father gure, Cohodes found
one at sleepaway camp, in the form of a counselor—Bob Mercier. “He
taught me more about life than anybody before or since,” says Cohodes.
Foremost amongst Mercier’s admonitions: Don’t act on impulse. Analyze
a situation, research any predicament before acting. “When things get
squirrely or out of control, don’t just do something, stand there,” he
says. “Take the time. Think it out. Then act. People do something on a
dime and 95 percent of the time it’s the wrong thing.”
In high school, Cohodes’s situation improved. He attended the
private Latin School of Chicago, an elite preparatory school with a
curriculum heavily inuenced by the classics. Cohodes’s 10th grade
economics class piqued his interest in nancial markets—especially after
he embarked on a portfolio management project, picking and monitor-
ing stocks. It was not enough to inspire him to academic greatness.
With mediocre grades, Cohodes attended Babson College in
Wellesley, Massachusetts, a business-focused school known for turning
out nancial industry functionaries, as well as a fair number of
entrepreneurs. There, Cohodes noticed that the easier the work, the
worse his grades. He aced “Policy Formulation,” studying real-world
business case histories, while pulling Ds on gut introduction classes.
Cohodes worked part-time for a Merrill Lynch broker, the kind more
concerned with churning accounts than enriching clients. It gave him
a front-row seat to the markets. In 1976, Bache Group got swept up
in the Hunt Brothers’ failed attempt to corner the silver market—and
Cohodes watched in awe as the brokerage rm’s stock tumbled to $6
266 THE MOST DANGEROUS TRADE
from $32. “I remember thinking, if you could see this coming that
would have been really sweet,” says Cohodes.
The early 1980s provided Cohodes with his rst direct experience
with a stock collapse. He sank $50,000 of his own and clients’ money
into Blackwood, New Jersey–based Data Access Systems, a computer
terminal distribution company. The stock fell from $8 to $2 before he
got out. “The feeling was so awful,” Cohodes recalls. “I thought I bet-
ter bone up on my skills so this never happens again.” The company
eventually went bankrupt.
After graduation in 1982, Cohodes headed back to Chicago to
Northern Trust Company as an investment ocer, and was soon taken
under the wing of Paul Landini, a leisure and food stock analyst. It was
long before Regulation FD, and lucrative information could be gleaned
legally from conversations with corporate executives—if you knew who
to call and what to ask. Most days, around the close of business, the two
would huddle and call up CEOs or treasurers of the companies Landini
covered and, like lawyers at a trial, entice them into revealing clues
about sales, prots, or the competition. “We wanted information,” says
Landini. Often they got it.
Interest rates were at 20 percent and the Dow Jones Industrial Aver-
age at 776, down 40 percent from its high three years earlier. Chrysler
was in bankruptcy, and word was that Ford could join it.
Cohodes was innately contrarian. “I was so bullish I was dizzy,” he
recalls. Cohodes’s tendency was to see opportunity where others saw
danger, and vice versa. Example A was Coca-Cola Co., then trading at
a split-adjusted 70 cents a share. Cohodes gured people always drank
Coke and would continue to do so, regardless of economic vagaries. It
was yielding a fat 8 percent. “I bought a s--t-pot full of Coke,” he recalls.
It would go down as one of the best-performing large capitalization
stocks of the decade, returning some 1,000 percent.
Sugar prices were on the rise, and Archer Daniels Midland Co., the
Chicago-based grain processor, was making money on the low-priced
alternative, fructose. A conversation with Landini and an ADM executive
persuaded him that Coke would increase its use of fructose as a way
to expand margins. The upside was formidable. “We bought a s--t-pot
full of ADM,” Cohodes said. Shares more than tripled by the end of
the decade.
Cohodes: Force of Nature, Market Casualty 267
Cohodes learned the art of the short sale, too. One of the hottest
leisure stocks was Bally Manufacturing Co., maker of arcade games like
Pac-Man and Space Invaders. Cohodes walked to the local venue, Rubus
Games, and pestered the manager about which games were doing well.
“I’d ask, ‘What’s your coin drop today?” Cohodes recalls. “We shorted
the hell of Bally and shifted the money into Warner Communications,
whose video games were doing better.”
He was developing an alternate view of how things worked—a
priceless skill for a short seller. “I think most people are full of crap,” says
Cohodes. “I like to verify. I like to know. I view myself as a conviction
player.”
Still, most of Cohodes’s work at Northern Trust was handholding
accounts. “Marc wanted to succeed,” Landini says. “He didn’t want to
type up letters to little old ladies telling them their accounts were up
3 percent.”
Cohodes soon hooked up with a gru, New York-based hedge fund
veteran who was looking to hire an analyst as he got a new business o
the ground. It was 1985, the bull market in full swing, and nding a smart
analyst dicult. The two had breakfast at the Waldorf Astoria hotel. The
manager was David Rocker.
By this point in his career, Rocker, had paid his dues—with long
stretches at Mitchell, Hutchins & Co., Steinhardt, Fine, Berkowitz &
Co., and Century Capital Associates, where he was a partner. Rocker
today, following an acrimonious break up with Cohodes, won’t meet in
person, and doesn’t seem at all happy being quoted talking about his for-
mer partner. But interviews with acquaintances and former colleagues at
his former hedge fund, as well as rivals in the short-selling business, paint
a picture of Rocker as someone who thrived in the short-selling industry.
David A. Rocker was born in 1943 in Elizabeth, New Jersey, just
south of Newark. His father Robert, an accountant, and housekeeping
mother Beatrice, were aected by their experiences during the Great
Depression. Ever thrifty, they reexively switched o light-switches to
save a penny or two on electricity and never risked much career-wise.
As Jews, the family inculcated David Rocker in the credo of Tikkun
Alom, that a just person’s life mission is to repair a damaged world. And
Rocker embraced that notion. “Do the right thing,” he would say in
dicult times.
268 THE MOST DANGEROUS TRADE
Rocker says he learned that from his father. “My father was a very
honest man,” says Rocker. “He imbued me with that.” Rocker’s noble
intention in life, it should be noted, never prevented him from launching
a high-decibel take down of whoever was upsetting him.
Class president at West Orange High School, a sprawling working
class institution, Rocker excelled in the classroom and athletics. He won
admission to Harvard. “It was a big deal for me to get in there,” he says.
“West Orange was not a feeder school.”
In 1961, Rocker joined Harvard’s Naval Reserve Ocers Training
Corps, partly because he was a naval history bu but also on principle.
The Jewish kid from New Jersey was impressed by professor Otto
Eckstein, who helped develop the notion of core ination—which
excludes volatile food and energy costs. Rocker majored in economics.
Commissioned as a Navy ensign, Rocker spent two years on the
USS Little Rock, including six months in the Mediterranean where the
light cruiser served as the agship for the U.S. Sixth Fleet. He was ocer
of the deck when the Little Rock helped pick up the injured from the
USS Liberty, an American spy ship attacked in error by the Israeli Air
Force and Navy during the Six-Day War. He says he is ashamed of how
Vietnam War veterans were treated upon their return.
Having returned to Harvard Business School for his M.B.A., he
recalls learning a life lesson. His preoccupation with a new stereo pre-
vented him from properly preparing for a class one day. The professor
called on Rocker. He tried to wing it—and failed disastrously. “I got
torn apart,” he chuckles. “Justiably.”
Nevertheless he graduated with distinction and joined research
rm Mitchell Hutchins as a real estate and nance analyst under the
stewardship of Donald Marron, who later rose to head PaineWebber.
He covered the homebuilding industry and hung sell recommendations
on land developers whose accounting he thought misleading. Soon
after, their stocks collapsed. Rocker’s gutsy calls caught the attention of
buy-side managers.
From there it was on to what would become a famous hedge
fund—Steinhardt, Fine, Berkowitz, & Co. Rocker initiated his rst
professional short sale in 1977 on Tampax, the maker of tampons. Such
products were heavily restricted in their ability to advertise on television
or radio.
Cohodes: Force of Nature, Market Casualty 269
New rules were about to change that, and Rocker felt that Tampax
was due for a wallop. The rst weeks of the sale went awry as word
leaked about his short position. “Some schmuck at a bank who was long
Tampax heard about the short position and marked it up,” Rocker says.
The stock, briey rose to $125 from $115. Rocker ultimately covered
the position when Tampax shares dropped to $25.
Rocker remained until 1982 when he joined Century Capital Asso-
ciates. That rm was sold, and Rocker founded his eponymous rm
in 1985.
Rocker and Cohodes both recall their breakfast at the Waldorf
Astoria. “He was cheap and I was cheap,” says Cohodes. For his part,
Rocker says he was impressed by Cohodes’s enthusiasm. “He was
fresh-faced, honest, aggressive, a tireless worker,” says Rocker. “The
person who recommended him prophetically said, ‘He’s very smart and
aggressive, but you’re going to have to put fences around him.’”
Rocker says that advice was spot on. “Marc had intense passion,”
he says. “Why be short 100,000 shares when you can be short 300,000
shares? We’re going to win so why not win bigger?” Cohodes was taking
a risk, too, because Rocker Partners was a startup. And it was backed ini-
tially only by the Zimmerman family, owners of the Pic ’N’ Save stores,
which they had just sold. The pair developed a father-son relationship
over the years.
Rocker Partners started as classic long-short fund. David Rocker
eventually saw more opportunity in the short-selling side as the bull
market in stocks surged in the 1980s, raising hundred, even thousands
of companies to what he viewed as dubious valuations, and suspect
accounting ourished. The fund went net short in 1990. Besides, he
was a better short seller than long investor.
Rocker Partners was a distinctive outt in many ways. “It was like
a family,” says Rocker. “We adopted a cooperative rather than an eat
what you kill culture to foster cooperation.” Six of the twelve working
there were partners, sharing prots. Over 21 years, only two principles
left the rm. Rocker Partners responded to employee’s preferences to
work where they wanted. The chief nancial ocer, Phil Renna, was in
Millburn, New Jersey, with David Rocker and trader Carol Ju. There was
an oce in Manhattan’s Rockefeller Center, where Cohodes worked for
a while. Analyst Terry Warzecha out of Boston.
270 THE MOST DANGEROUS TRADE
Cohodes says he can’t remember what his rst short sale at Rocker
Partners was, but among his earliest was a toy company—Coleco
Industries, Hasbro Inc., or Tonka Toys. In 1986, all three had monster
fad products tearing up the market—and goosing their share prices.
Coleco hawked Cabbage Patch Kids, wildly popular cloth and foam
dolls; Hasbro had Pound Puppies, a droopy-eyed toyline of canines; and
Tonka ogged its Transformers, diminutive robots based on an animated
television show with movable parts that, as their name implied, could
change their shape and functions.
The stocks were true high-iers, trading for 27 trailing earnings or
more. In the case of Coleco, sales had more than doubled the previous
year. Cohodes did simple channel-checking to see how sales were going
at big retailers like Toys ‘R’ Us, Child World, and Toys Plus.
To be sure, at the time this was no dark art. Executives were generally
happy to talk about their businesses. “If you pester people enough and
are persistent, they’ll talk to you,” says Cohodes.
A typical phone call to, say, a Toys ‘R’ Us executive would follow a
template:
Cohodes: So how are Cabbage Patch Kids selling this season?
Executive: Here’s what we’re seeing. Sales are still growing fast but
not anywhere near last year.
Cohodes: So are we talking 10 to 20 percent growth?
Executive: More than that.
Cohodes: 30 to 40 percent?
Executive: That’s about right.
Cohodes: What are you budgeting for the upcoming season?
Executive: We’re guring high single digits.
Meanwhile, Wall Street analysts were forecasting growth of
40 percent—for the current and future years—as if such growth was
sustainable.
Naturally, as Cohodes points out, people are far more willing to
talk about the business of their suppliers or customers than they are
about their own. He isn’t sure how much money Rocker Partners made
shorting the toy companies. The shares of all three companies collapsed
Cohodes: Force of Nature, Market Casualty 271
spectacularly beginning in 1987, with Coleco ling for bankruptcy in
1989 and Hasbro eventually buying Tonka in 1991.
A life-changing event for Cohodes hit in 1987. His son, Max, was
born prematurely and diagnosed with cerebral palsy, the congenital dis-
order that impairs motor reex skills and sometimes intellectual devel-
opment. Max, who displays extraordinary aptitude in such areas as math,
name recognition, and memory, would be mostly wheelchair-bound for
his life.
Max’s diagnosis fundamentally changed Cohodes—in ways even
today he has trouble putting into words. “I really turned it up,” he says.
“I became edgier. Wherever I was before, I became more motivated.
I will out-hustle anybody.”
Cohodes’s research convinced him that the best treatment for
Max’s specialized issues was Feldenkrais therapy—a holistic approach
to alleviating pain, and fostering physical and intellectual development.
One leading Feldenkrais therapist was based in the San Francisco Bay
area. Cohodes told Rocker that he and his family were moving to San
Francisco. “Then Rocker Partners is opening a San Francisco oce,”
Rocker replied.
Separated by a continent, the two split some of the funds
responsibilities—Rocker dealing with outside investors and Cohodes
focused on portfolio issues and devoting time to personnel matters.
“He was Mr. Outside and I was Mr. Inside,” Cohodes says.
The fund’s 40 to 50 short positions were typically allocated between
the two. Generally, if Rocker initiated a position, he would be in
charge of maintaining it; ditto for Cohodes. “It was a high functioning
yin-yang,” says Russell Lynde, who worked at Rocker Partners from
2000 to 2007. “Marc was more of a risk taker and David was more
conservative. They balanced each other well.” Still, it was certainly a
dierent way to run a hedge fund.
The results were undeniably impressive—though volatile. Between
its founding and December 2007, it generated returns of about
11 percent. That included years like 1999, when Rocker Partners
gained 31.7 percent, and others like 2003, when it lost 35.6 percent.
Rocker says the rm’s alpha, excess returns provided by stock selection
above the S&P 500, was 17 percent annualized from its start until when
272 THE MOST DANGEROUS TRADE
he stepped down in mid-2006, oering investors the opportunity to
redeem if they chose to.
The volatility was the killer. As the L&H experience showed, being
right was by no means a guarantee of making money for investors.
Beginning in 1996, for example, Rocker initiated a short position on
America Online, the Internet access rm now known as AOL. Rocker
could see plainly that the company’s accounting stank. Though there
were several issues that came to light after its merger with Time Warner
in 1999, Rocker was initially concerned with the capitalization of
marketing expenses.
America Online did mass mailings of CD-ROMs that would allow
people to set up their AOL accounts and then dial into AOL to be con-
nected to the World Wide Web. To Rocker, and most anybody else with
an inkling of accounting savvy, these were clearly marketing expenses and
should be accounted for as such. AOL, however, insisted on account-
ing for them as capital expenditures, like plant and equipment—costs
that could be amortized over 10 years. This had the eect of articially
inating earnings.
Rocker, a regular contributor to Barron’s “Other Voices” section,
penned a letter on the subject to the nancial newsweekly’s editors.
“America Online would have huge losses today if it handled its
accounting as other Internet companies like PSI and UUNET do,”
he wrote. “America Online capitalizes subscriber acquisition costs,
whereas they expense them. To put this in perspective, America Online
reported pretax earnings of less than $12 million in its September [1995]
quarter, while capital acquisition costs increased $56 million.” The
stock didn’t budge. Even worse, after the SEC began an inquiry into the
matter, America Online about-faced and wrote o the $365 million of
capitalized costs in the fourth quarter of 1996. Rather than fall because
the company had lied to investors, AOL shares soared 15 percent,
because they were relieved the company needn’t amortize those costs.
The short-selling business is never short on irony.
For his part, Cohodes routinely disagreed with some of Rocker’s
positions, including AOL, which to this day he calls “another David
Rocker Special.” But he thrived on the independence Rocker gave
him, especially after being named general partner in 1987. Cohodes ran
the West Coast oce his own eccentric way. Tucked into a Larkspur
Cohodes: Force of Nature, Market Casualty 273
oce park in Marin County for most of Rocker Partners’ time there,
he held court over a tight-knit cadre of analysts who, at his urging,
expended copious shoe leather tracking down accounting chicanery of
various stripes.
Cohodes had a talent for attracting talent from curious corners.
There was Richard Sauer, a lawyer and former investigator with the
SEC who, after working on the L&H case, decided to hang his hat
at Rocker Partners working for Cohodes, his favorite tipster. There
was Mark “Monty” Montgomery, who had worked with short seller
Jim Chanos. Russell Lynde, a newly minted M.B.A. from Wharton,
stumbled into Rocker Partners after his wife got a fellowship at Stanford
University and an acquaintance recommended he call Cohodes. Jerome
Souza was a batboy for the Oakland A’s who developed a fondness for
Cohodes’ son Max, tossing him foul balls.
Much of Cohodes’s strategizing took place on long coee walks,
20 minutes each way, under the Highway 101 overpass that brought them
to the local Peet’s Coee in the adjoining town of Corte Madera. Like
a lot of West Coasters, Cohodes would go in at 5:30 a.m. and wrap up
by 2:30 p.m. He generally didn’t eat during market hours, preferring to
drink water out of a large cup. If his positions were paying o, Cohodes
would wear the same the clothes—often a Yale sweatshirt.
Cohodes prized creativity. Accordingly, he seldom did more than
suggest that he suspected something was amiss at, say, Joseph A. Bank
Clothiers, the Hampstead, Maryland, chain of discount business attire
outlets. Souza, now a Drug Enforcement Agency ocer, began by cold
calling stores.
“Are you busy?” he asked.
“No.”
“Do you have any sales coming up?”
“Sure.”
“I’m looking for a cashmere top coat, size 38 regular.”
“Wehavethat.”
“Do you have enough?”
“Wehavethree.”
With great patience, Souza created a reasonable facsimile of a
Joseph A. Bank store’s inventory. He learned what was selling or not.
He counted customers parked outside of Bank’s stores. And Souza even
274 THE MOST DANGEROUS TRADE
sent dress jackets to a lab to verify whether they were 70 percent wool
as advertised. (They were).
“I’d tell [Cohodes] what I found out and he’d hug and kiss me,”
Souza recalls.
For the record, Rocker Partners began shorting Joseph A. Bank in
early 2007, when it became apparent that the company was goosing
sales with frequent clearance events. The fund held that position until
September 2008.
Cohodes developed an encyclopedic understanding of the various
instances of corporate malfeasance. Friends, family, and anonymous
sources would routinely tip Cohodes o to questionable companies.
That was the case with AAIPharma, a Wilmington, North Carolina,
generic drug maker that Paul Landini, by then working at Morgan
Stanley, suggested he look into. The tell-tale signs were certainly there.
One red ag was the company’s changing business model. Up until
2002, AAIPharma had generated reasonable prots as a contract research
rm—performing the mountainous amounts of analysis and number
crunching necessary for big pharmaceutical companies to shepherd
their drugs through the exhaustive Food and Drug Administration
approval process. Shortly thereafter, it switched gears under CEO
Philip Tabbiner, moving in a new direction—buying rights to existing,
often problematic drugs such as painkillers Darvocet, Darvon, and
Roxicodone. Often AAIPharma could tweak formulations or dosages
slightly, notching up sales before rival generic manufacturers could tool
up to imitate the changes.
Cohodes was suspicious right o the bat. “The cash ow was
negative,” he recalls. “The receivables were out of control.” Cohodes
launched into his analysis of AAIPharma’s numbers and didn’t let up.
It worked like this: AAIPharma would signal to drug distributors
such as McKesson, AmerisourceBergen, and Cardinal Health that it was
going to increase prices ahead of time. Sometime it was a 10 or 20 per-
cent increase from $1.00 a dose, say, $1.10 or $1.20. Other times, it
was a bigger hike, as when the company jacked up the price of the
injectable asthma drug Brethine to $25 a vial from $2. The distributors
would order huge amounts of inventory to lock in the lower price. That
allowed distributors, who operate on relatively thin margins, to double
or triple them. AAIPharma sales would surge; though the price hikes
Cohodes: Force of Nature, Market Casualty 275
invited generic rivals to move in, that would take from several months
to a year. Distributors could return what they couldn’t sell of the inated
merchandise.
AAIPharma was in eect channel stung—pushing through sales
that were likely to be returned as a way of boosting current earnings.
One brokerage rm with a relationship to AAIPharma was
Raymond James Financial, of St. Petersburg, Florida. Its pharmaceutical
analyst was Michael Krensavage, who had a buy recommendation on the
stock when he received a call at his Manhattan oce. It was Cohodes,
who immediately began talking about some of the discrepancies he was
nding as he researched AAIPharma. “I saw the West Coast telephone
prex on my phone and gured it was some whacko,” says Krensavage.
“It didn’t take long for me to realize he knew his stu.”
At the time, Cohodes was struggling to stir interest in AAIPharma
with journalists and other analysts. When Krensavage showed interest,
he began calling him more frequently, daily, and even on nights and
weekends. Cohodes gured if he could turn one respected analyst, others
would become more receptive, not unlike a chink in a dam. He kept after
Krensavage. “After an earnings call, he would call and question charges
and accounting treatments,” Krensavage recalls.
Cohodes’s analysis made sense. The smoking gun: Data from research
rm IMS Health showed that AAIPharma claimed to be selling more
than twice of some drugs than the research rm showed was being
bought by institutions.
Ultimately, Krensavage downgraded the stock in March 2003 to
“underperform,” citing, among other things, skyrocketing inventories.
It was a move the company would not take lying down. AAIPharma
management swung into action, dispatching an investor relations execu-
tive to talk Krensavage out of the downgrade. When he refused to budge,
senior AAIPharma executives berated Raymond James executives, who
along with Krensavage and Cohodes were watching in horror as shares
rose from $11.90 to $30 by January 2004. That contributed to Rocker
Partner’s 2003 loss of 35.6 percent.
Things were hardly better at Raymond James. AAIPharma canceled
a loan facility with the rm. But a smattering of mostly local news
media began to pay attention—exactly what Cohodes was hoping for.
In March 2004, the company announced that outside board members
276 THE MOST DANGEROUS TRADE
would conduct an investigation into “unusual sales” in Brethine and
Darvocet.InMarch,theSECandtheU.S.AttorneyfortheWestern
District of North Carolina told the company they might issue subpoenas.
The company defaulted on $175 million in senior subordinated debt. It
led for bankruptcy in May 2005. Rocker Partners covered at a prot.
“We did quite well on that,” Cohodes says.
It was 1998 when Cohodes rst took note of NovaStar Financial—a
Kansas City, Missouri-based mortgage originator. He could hardly
avoid doing so: His brother-in-law at the time had taken a job there
and regaled him with tales of outrageous behavior. “All he would
tell me was what a complete and utter zoo the place was,” Cohodes
says. “These people would lend money to dead animals; they put in
hidden fees that their borrowers knew nothing about; they lied about
documentation.” The company was founded in 1996 by Scott Hartman
and Lance Anderson, who had worked together at a mortgage lender
called Resource Mortgage Capital, and was initially nanced by GE
Capital. Shares of NovaStar traded in penny stock territory at the time,
just $2 a share, and Cohodes had other sh to fry. His brother-in-law
soon left and Cohodes more or less forgot about NovaStar.
In 2004, his brother-in-law told him to take a look at the company
again. NovaStar’s shares had bolted to $30 amidst the booming housing
market—and the company was minting money. NovaStar had fashioned
a business making mortgage loans to subprime borrowers either directly,
through an expanding network of its own branch oces, or through
independent brokers. It would then securitize most of the loans,
eventually pooling them into various collateralized debt obligations
(CDOs) whose highest rated slices, or tranches, would be sold o to
bond investors. Novastar kept the lower-rated ones. The company also
serviced the loans, taking in 0.50 percent of the balances. New York Times
columnist Gretchen Morgenson and analyst Joshua Rosner do a great job
detailing the story in Reckless Endangerment (St. Martin’s Grin, 2011).
The lure for investors was NovaStar’s payout of 18.6 percent. The
company, like a lot of property-focused businesses, was structured as a
real estate investment trust (REIT). That meant 90 percent of earnings
had to be paid out as a dividend. Not surprisingly, NovaStar caught
the fancy of gullible and yield-hungry investors. “There was a whole
Cohodes: Force of Nature, Market Casualty 277
crowd of clowns that were attracted to NovaStar,” says Cohodes. There
seemed to be an organized eort to goose the shares. On the Motley F ool
message board, for example, investors would enthuse over the NovaStar’s
prospects. A nominally independent site called NFI-info.net also ogged
the stock, notably via the missives of a character who called himself Bob
O’Brien, who sang NovaStar’s praises and smeared critics and skeptics.
O’Brien, who creepily sometimes called himself “the Easter Bunny,”
blogged on his own site, SanityCheck.com, painting short sellers or most
any other critic of NovaStar as part of vast conspiracy to drive down the
share prices of fast-growing companies.
His talk veered to the scary-weird side, with O’Brien suggesting
investors use their credit cards to buy the stock. The spread between
12 percent card debt and the 18.6 percent yield on Novastar meant a
lock of 6 percent points. If investors loaned out their shares at 6, 8, or
10 percent, they would be sitting on a yield of 12, 14, or 16 percent.
The Easter Bunny was going to play a role in Cohodes’s fortunes beyond
NovaStar as well.
Sifting through NovaStar’s nancial statements, Cohodes zeroed in
on the crux of its gamey accounting. In calculating prots, the company
used “gain-on-sale accounting,” a dicey but thoroughly legal practice
that lets a company book today the prots it expects to realize on loans
it holds over extended period of time. If the interest rate environment or
credit quality changes, the company accordingly needs to book charges
or gains to account for that. In doing so, NovaStar had enormous lati-
tude in determining how much the portfolio was worth and its income,
based on such assumptions as the rate of prepayments, loan losses, or the
discount rate. It made full use of this. In the face of declining interest
rates which should speed up prepayments, Cohodes realized that man-
agement decreased the discount rate on some of its mortgages, along
with loss assumptions on others. That conveniently netted out the hit
from the expected rise in prepayments.
NovaStar’s dividend, of course, had to be paid in cash—not assump-
tions. Even a back of the envelope calculation proved to Cohodes that
the company was selling stock in order to nance the extravagant pay-
outs it was shoveling to shareholders. The math was simple enough.
NovaStar sold shares worth $94 million in 2003, $194 million in 2004,
278 THE MOST DANGEROUS TRADE
$142 million in 2005, and $143 million in 2006—Cohodes calculated
these approximated the total dividend payment for those years.
None of this even touched on the appalling underwriting practices
Cohodes’s brother-in-law had told him about years earlier. There was
plenty of evidence to suggest matters since then had gotten worse, not
better. NovaStar virtually boasted about it. In a 2002 interview with
American Banker, NovaStar CEO Hartman had crowed: “In 30 seconds,
brokers can complete an application and get multiple approvals back. In
a call center environment, it’s nice to give them approval on the phone.”
Cohodes found memos to brokers. One read: “Did You Know NovaStar
Oers to Completely Ignore Consumer Credit!”
He checked in with companies doing business with NovaStar.
Mortgage insurance brokerage PMI had simply stopped selling insur-
ance to NovaStar after it discovered blatant tampering with loan
documents—specically in areas dealing with borrowers’ income levels.
All the while NovaStar’s branch system was seemingly ballooning,
from 246 oces in the rst quarter of 2003 to 432 by the end of the
year. Yet general and administrative expenses grew just 19 percent over
that time. NovaStar was either hiring deadly ecient oce managers or
something was remiss. Cohodes decided to check out some of these new
oces. He drove out to Las Vegas, taking a tour of NovaStar’s branches
in Nevada, one of its fastest-growing markets. The branch oces were
often ctitious. One turned out to be a private residence, another a
massage parlor.
The State of Nevada noticed, too. In late 2003, it issued a cease and
desist order, shutting down the branch oces there because NovaStar
had never obtained appropriate business licenses. The move followed
a similar one by Massachusetts. And the Department of Housing and
Urban Development, which had been investigating NovaStar, issued a
critical report in the summer of 2004. It recommended penalties based
on the company’s violation of myriad HUD regulations.
More was to come. ABN AMRO, a big buyer of NovaStar mort-
gages, sued the company alleging fraud. All these cases had something
in common. NovaStar never bothered to tell its investors about the reg-
ulatory actions or the suit, despite their seriousness—and despite SEC
requirements that it disclose such material information.
Cohodes: Force of Nature, Market Casualty 279
Cohodes initiated his short position against NovaStar in January
2003, when shares were trading at $45 each. Soon, he began turning
over reams of data and research to the SEC. What investigators there did
with it remains unclear. Cohodes said there were frequent and lengthy
conversations, conference calls, and bucket loads of documents that he
e-mailed to Washington. Cohodes says he never got the impression that
the SEC knew the rst thing about how the subprime business worked.
Meanwhile NovaStar shares were climbing as the housing mania
expanded; Cohodes had counted on fraud, not a real estate bubble. He
began sharing his research with journalists—swapping tips and insights.
Cohodes was also active on message boards and blogging, discussing his
short position—and disparaging NovaStar’s business model and account-
ing. Even as Cohodes’s losses mounted, he was aware that the number of
ways he could win by betting against NovaStar were multiplying—there
was the sham accounting, a awed business model, an unsustainable
dividend. Nevertheless, rising shares of NovaStar, together with the bet
against AAIPharma, contributed to Rocker Partner’s 35.6 percent loss
in 2003, which would take years to recover from.
Cohodes wasn’t the only short seller beating the drums on NovaStar.
By the rst quarter of 2004, short interest comprised 16 percent of the
company’s shares. On April 12, the Wall Street Journal’s Jonathan Weil
wrote a column agging NovaStar’s problems with Nevada and Mas-
sachusetts regulators. The article included this damning observation: The
Nevada Department of Business and Industry’s mortgage lending divi-
sion found that of the 15 state branch oces listed on NovaStar’s website,
only 6 existed. NovaStar said it had shut some of its oces down recently.
“What happens in Vegas stays in Vegas,” Weil clucked. NovaStar paid an
$80,000 ne. Its shares, trading at $54, fell 31 percent in a single day.
Bob O’Brien, or Easter Bunny, was keeping busy in the message
boards. The revelation of NovaStar’s fraud infuriated him. He targeted
Cohodes for reprisal and posted a photograph of his special needs son,
Max, the one with cerebral palsy, along with his address. “Still feel like
playing?” O’Brien taunted. “This is coming up on game over time.
Figure it out. Your playbook is known.” Obviously, the Easter Bunny,
adept at threatening handicapped children from the anonymity of the
Internet, had no concept of Cohodes’s mettle.
280 THE MOST DANGEROUS TRADE
Eventually, Cohodes asked the Federal Bureau of Investigations
(FBI) to look into the harassment and threats. Nothing came of it.
Though O’Brien continued to promote NovaStar, the bloom was
denitely o the rose. An SEC investigation was launched in 2004,
which NovaStar duly noted in its public lings. The news of the inves-
tigation pushed NovaStar shares down to under $25 by year end 2005.
The stock was ultimately delisted by the New York Stock Exchange in
2007, a victory, says Cohodes, only insofar as it highlighted how the
exchange’s standards had sunk. “They’ll list a goat,” says Cohodes.
Rocker Partners began covering its position in 2005. Cohodes g-
ured the fund earned $20 million—over a span of two and one half
years. With the stock at $1.50, NovaStar co-founder Scott Hartman was
red by the board. Notably, Lance Anderson toils on. The company
survived the subprime meltdown, partly by helping itself to nancing
from the Troubled Asset Relief Program (TARP). A company that did
so much to feed the crisis was able to survive with the aid of a plan to
pick up the pieces. NovaStar changed its name to the Novation Com-
panies. Novation, it should be noted, is the act of swapping one party’s
obligations with another’s. Shares in June 2015 traded at 31 cents, and
Anderson continues to be well compensated, paid $750,000 a year. You
simply can’t make this stu up.
Even while the bulletin board range wars were raging over NovaStar,
though, Cohodes was zeroing in on his next target—Overstock.com, an
online retailer that specialized in closeout merchandise. It would not be
a pleasant experience.
The case unfolded over nearly half a decade and gained publicity
in the New York Times and elsewhere, and not just because it involved
lawsuits, wild accusations against prominent journalists, and a series of
rambling incoherent rants by Overstock.com CEO Patrick Byrne on the
company’s conference calls. Among other things, Byrne accused a Fortune
journalist of performing fellatio on Goldman Sachs traders, attempted
to board a commercial jet with a loaded Glock 23 pistol, and accused a
network of journalists and brokerage rms of engaging in a vast conspiracy
to undermine honest small cap companies all at the behest of an unnamed
Sith Lord—a reference to a dark character in the Star Wars movie series.
The story takes up a hefty portion of one of the unsung books on the
credit bubble and its run up: Selling America Short: The SEC and Market
Contrarians in the Age of Absurdity, by Richard Sauer (John Wiley & Sons,
Cohodes: Force of Nature, Market Casualty 281
2010). It bears repeating for the light it shines on the depth of corporate
malfeasance in America, the complicity of the country’s legal system in
covering up corruption, and regulators’ bumbling ineciency.
At the center of it all was Byrne—a more unlikely, certainly
multitalented corporate actor would be dicult to imagine. Strikingly
handsome, he burnished impressive pedigrees. His father was Jack
Byrne, a storied insurance executive who had once turned around
GEICO, Berkshire Hathaway’s best-in-class car insurance company,
before going on to lead White Mountains Insurance Group, a respected
New Hampshire–based underwriter. The elder Byrne served as
Overstock.com’s chairman until 2006, and then rejoined the board in
2008. He died in March 2013.
As for Patrick Byrne, he had some serious cred himself, having
served as CEO of another Berkshire Hathaway subsidiary, uniform maker
Fechheimer Brothers. Byrne has a B.A. in Chinese studies from Dart-
mouth College, a master’s degree from Cambridge University, and a
Ph.D. in philosophy from Stanford University. He speaks uent Man-
darin and, following a bout with testicular cancer, bicycled across the
United States on several occasions to raise awareness of the disease.
Byrne began his journey into the world of stock market promotion
soon after he, along with extended members of the Byrne family, bought
control of Overstock.com’s predecessor in 1999. It was the height of the
Internet bubble and the stock market was rife with dot-com hype, crazy
valuations, and fraud. Byrne, who called himself a dyed-in-the-wool
value investor, joined in the fanfare—touting Overstock.com and its
results with the energy of a carnival barker.
The company had two revenue sources. It bought closed out
inventory at a deep discount and sold it on its website. And it hawked
the products of independent fulllment partners, earning a piece of
each transaction as a commission. Competition was erce, not just with
brick-and-mortar retailers, but with fast-growing online juggernauts
like Amazon.com and eBay.
Before the company’s initial public oering in May 2002, Byrne
trumpeted Overstock.com’s protability. As it was a private company,
there was no way to verify his claims. In interviews, Byrne would brag
about how quickly the company had moved from startup to protability.
“That’s real GAAP prot,” he boasted to Business 2.0 magazine. “Not
Amazon bullshit prot.”
282 THE MOST DANGEROUS TRADE
After Overstock.com led its IPO prospectus, Cohodes could see
that Overstock had never turned a prot—at least not one recognized
under GAAP standards. It wouldn’t do so on an annual basis for nearly
a decade.
There was no need for Cohodes to dig deep. In a June 2001 inter-
view with the Wall Street Transcript, a stock research publication, Byrne
estimated sales of at least $120 million for 2001, $400 million for 2002,
and close to $1 billion the year after. Instead, revenues came in at $40
million in 2001, $91.8 million in 2002, and about $150 million in 2003,
even after adjusting for a change in accounting that dramatically revved
up sales. Forecast misses are one matter, but Byrne also emphasized
Overstock.com’s low marketing expenses, just $250,000 a month. The
prospectus showed they were nearly triple that. And Byrne had claimed
that Overstock.com required little if any new capital—yet just months
later, the company announced its initial public oering. Serial stock and
debt oerings followed.
There was also that classic red ag for short sellers—senior manage-
ment turnover. In 2003 alone, the chief nancial ocer, chief operating
ocer, and chief technology ocer were all replaced. Gradient Ana-
lytics, then operating under the name Camelback Research Alliance,
issued a negative research report on the company in June 2003, based on
its poor “earnings quality,” or how accurately the company appeared to
be reporting nancial information.
Overstock.com inated revenue. The most obvious example
occurred when it changed the way it accounted for the sales of its
fulllment partners, who typically received 85 percent of each sale, with
the 15 percent balance being paid to Overstock.com as a commission.
Beginning July 1, 2003, however, Overstock.com began reporting
its revenues from these sales on a gross basis, including not only the
15 percent commission but also the 85 percent that went to the
fulllment partner.
On December 1, 2003, Overstock.com released gures claiming
that total revenue over Thanksgiving weekend had risen to $6.0 million
from $1.5 million, a gain of 300 percent. It did not disclose the change
in accounting, and media outlets dutifully reported the outrageous
percentage gain. Overstock.com shares spiked 24 percent from $16.27
to $20.20 in a single day. It seemed like a plan to engineer a short
Cohodes: Force of Nature, Market Casualty 283
squeeze. When asked about the possibility that it was manipulating the
stock on CNN.com in 2003, Byrne said: “Opportunities come along
where we can knee the shorts in the groin; that’s always good for fun
and amusement.”
More negative reports from Gradient followed, including one in
December 2003 reducing its “earnings quality” grade to an F, the lowest
possible. Overstock.com press releases continued to trumpet the hyper-
bolic sales growth: “GAAP year-over-year Q4 revenue grew 197 percent
from $41.5 million in 2002 to $123.2 million in 2003,” it trumpeted in
a January 2004 release. The company was not disclosing that its new
methodology was grossly inating the sales growth gures.
If nothing else, the tone of Byrne’s communications should have
given investors pause. “Sales were super-de-duper,” he wrote. “They
truly were.”
Cohodes had initiated a relatively modest short position in February
2004 at $28. Yet, he was worried about Byrne’s erratic pronouncements.
One of Cohodes’s credos is to never cross a crazy man: The results are
dangerously unpredictable, though identifying such actors can be di-
cult at the time.
Rocker, however, looked at the Overstock.com balance sheet and
thought it was a lousy business. Over Cohodes’s objections, he took
over the management of the position, an unusual move at the rm. “We
must have told David Rocker 300 times not to get involved with Byrne,”
Cohodes recalls saying. (Rocker says Cohodes was aware of Byrne’s ques-
tionable behavior when he began the short). In New York, Rocker
attended a June 2004 road show for an Overstock.com equity oer-
ing. During the Q&A, he asked Byrne to explain why Overstock.com
had failed to meet his prot and sales targets by a long shot and why
he needed more capital when he had previously said he didn’t need any.
Byrne declined to answer.
In a July 2004 earnings call a Gradient Analytics analyst asked what
kind of prots would be generated when Overstock.com hit $2 billion in
revenues. Byrne pointedly did not reply. Short interest in Overstock.com
began to climb, and hit 15 percent in September 2004.
Rocker, sometimes witheringly condescending and always out-
spoken, didn’t hold back, writing an article on TheStreet.com entitled
“Overstock Overhypes.” He questioned an increase in Overstock.com’s
284 THE MOST DANGEROUS TRADE
prepaid expenses and other assets—two warning signs of possible manip-
ulation. Rocker also noted questionable increases in Overstock.com’s
cash ow and changes in general and administrative expenses.
Byrne, for his part, became increasingly strident. In an October 2004
letter to shareholders, he railed against critics. “The elephant in the room
during our conference calls and other meetings is the fact that out there
are a bunch of short sellers and their sycophants who bad-mouth every-
thing I do or say,” he complained. In the follow-up call the next day,
he lashed out at research rm BWS Financial for questioning a specic
transaction the analyst believed had been inappropriately accounted for.
And he tore into the “shoddy research” by Camelback, disparaging both
its accounting acumen and business model. “I understand how Camel-
back works is that hedge funds hire them, you pay them 30 grand a year,
and in return for which if you are a hedge fund you get a call up once
or twice a year and please do a hatchet job on company X,” he said.
Why Rocker Partners would want Gradient, as Camelback was now
called, to write a negative research report before the fund started shorting
the stock, however, was never explained. Gradient’s skeptical research
had begun over a year earlier.
The same conference call also included a toe-to-toe between Byrne
and Rocker. CNBC star and fund manager Jim Cramer had criticized
Overstock.com on TheStreet.com andonTV,citingablogpostfrom
Rocker. Byrne declared that Cramer was invested in Rocker Partners.
(Cramer wasn’t, then or ever).
Rocker was furious. “The Overstock guy wants to get into a ght,”
he e-mailed Cohodes. “Well, he has. I am in kill mode.”
Journalists were getting vicious e-mail from Byrne. Bethany
McLean, a senior writer at Fortune magazine who had once worked as
a junior-level analyst Goldman Sachs, wrote a somewhat dutiful article
optimistically entitled “Is Overstock the New Amazon?” in October
2004. Byrne e-mailed her, calling the article “crap.” He added: “Why
exactly did you become a reporter? Giving Goldman traders blow-jobs
didn’t work out?”
Around the same time, Gradient published a report questioning the
competence of an Overstock.com director, Gordon Macklin, a former
Cohodes: Force of Nature, Market Casualty 285
head of NASDAQ who had served as a WorldCom director as it engaged
in its earth-shaking accounting fraud. Byrne e-mailed Gradient research
director Donn Vickrey: “You deserve to be whipped, f----d, and driven
from the land.”
Strange things began happening to Overstock.com stock. In
September 2004, its shares began to rise—and quickly too, from $30.25
to $77.25 in December. Rocker Partners was losing millions on paper
in its short position. Curiously, Scion Capital LLC, a small hedge fund
managed by Michael Burry that would soon make a fortune in the
credit crisis, would later report that it bought 1.3 million shares of
Overstock.com in the third quarter of 2005, according to government
lings. White Mountains Insurance was a part owner of the fund.
Then things got more curious. In Overstock.com’s January 28, 2005,
conference call, O’Brien, the so-called Easter Bunny from NovaStar
Financial, surfaced again. He now introduced himself to Byrne and con-
ference call participants as a private investor, and he and Byrne both
feigned that they were strangers, though it soon turned out they had
known each other for months.
O’Brien laid out a conspiracy theory. “What I am going to describe
is what I call a systematic serial killing for small cap companies. And
I think you guys are a victim of it. I am talking more along the lines
of criminal manipulation, allusions, fraud libel, n---d short selling.”
O’Brien linked journalists including Cramer, Herb Greenberg of Dow
Jones Marketwatch, Liz MacDonald of Forbes,andtheWall Street Journal
and Bar ron’s to the plot. Federal regulators, who he did not identify, were
set to go after Overstock.com. Normally callers of this ilk are discon-
nected from calls. Not O’Brien. “Go ahead,” Byrne encouraged him.
“If you have a question that would be great, but if you have something
youwanttotellyoumaygoahead.”
With Byrne’s encouragement, O’Brien prattled on, drawing in the
Depositary Trust & Clearing Corporation (DTCC) and German stock
exchanges into his malign esta. The idea was that shares listed overseas
could be borrowed, as a sort of runaround to rules restricting n---d short
selling. The trades would not have to settle in the three days as domestic
shares would. It made little sense.
286 THE MOST DANGEROUS TRADE
Investors scratched their heads—and shares began falling. It’s unclear
whether the share price decline was a result of the conference calls or
because they had previously been articially boosted in what seemed like
a classic short squeeze.
Then came August 12, 2005, when on a special conference call,
Byrne let loose an epic rant announcing a civil suit he had led the
previous day against Rocker Partners, Gradient, and their key employees.
The suit alleged the defendants conspired to denigrate Overstock.com’s
business in order to reap personal prot. The negative Gradient research
reports on Overstock.com were disseminated, it said, without disclosing
that Rocker Partners had had a hand in preparing them.
The suit was laughable. It didn’t allege anything at all in the Gradient
research reports was inaccurate. Moreover, Rocker Partners had not con-
tacted Gradient before it initiated its short position—and hadn’t done so
for months afterward. Many of the assertions, namely about phone con-
versations and meetings between Rocker Partners and Gradient, simply
hadn’t occurred—and the accusations that they had came from a dis-
gruntled former employee, Demetrios Anifantis, who had been red
by Gradient “for cause” (misappropriating company property and other
misdeeds).
What Cohodes, Rocker, and Gradient couldn’t laugh o was
the consortium of six law rms the Byrne had brought on to handle
it—these included class action lawyers John O’Quinn, Adam Voyles,
and Wes Christian of Houston, Texas, a group that had famously
won a $17 billion settlement from tobacco companies in 1994. “It is
time someone stops these oshore hedge funds from taking advantage
of average working Americans and American public companies,”
O’Quinn said in a statement. “That someone is us.”
Still, it was Byrne’s bizarre accompanying diatribe that set Wall
Street abuzz. In it, he alluded to a vast short-selling conspiracy controlled
by a dark “Sith Lord,” whose name he would not divulge but who
was in fact a “criminal mastermind” from the 1980s. He connected
nefarious players, including journalists Jesse Eisinger of the Wall Street
Journal, Carol Redmond of Dow Jones, Cheryl Strauss Einhorn of
Barron’s, and Herb Greenberg of Marketwatch.com, with a network of
short selling plotters including Rocker and Gradient. The network
Cohodes: Force of Nature, Market Casualty 287
included plainti ’s law rm Milberg Weiss, several German stock
exchanges mentioned by O’Brien in the earlier call, and the DTCC.
Byrne dubbed the web the “Miscreant’s Ball,” drawing on the title of
the book by Connie Bruck, The Predator’s Ball (Penguin, 1989), which
portrayed the Drexel Burnham Lambert–nanced takeovers of that era.
In a series of charts, Byrne drew arrows between the names without
any elaboration—leaving it up to the viewer to gure out, say, the rela-
tionship that existed between Camelback and Greenberg, or the Depart-
ment of Justice and the Feshbach Brothers. The name of Leon Black,
CEO and founder of private equity rm Apollo Global Management
LP, pops up unconnected to anybody. “Leon Black I’ve put in there
just because he’s a well-known nancier hedge fund guy,” Byrne said.
“I’ve got nothing more to say about him.” Eliot Spitzer, New York State
Attorney General at the time, is included too. “Eliot wants to be gover-
nor,” Byrne declared.
David Einhorn, at the time engaged in a public short campaign
against Allied Capital Corp, makes an appearance—Byrne connects him
to corporate sleuths Kroll Associates, which he claimed was investigating
him. Einhorn was and remains married to former Barron’s editor Cheryl
Strauss Einhorn. “Anybody on the street understands Barron’s more or
less as just being a group of quislings for the hedge funds.” Byrne says.
Byrne, it turns out, didn’t much like the Wall Street Journal,either.
“I’ve dealt with the Journal before and they’re just a bunch of dishon-
est reporters,” he says. He went on to disparage Eisinger’s reporting in
particular, accusing him of harassment.
There were also references to among other things: money launder-
ing, Stinger anti-aircraft missile sales to Pakistani agents, as well as gay
bathhouses and cocaine use, which, he conded, he had only mentioned
as a way of guring out which of his acquaintances was leaking infor-
mation to the short-selling conspiracy.
Byrne snarled at his short-selling nemeses: “So I say to Rocker, to
Cohodes, and all the other miscreants. ‘Did I stutter? Did I stutter or did
I say I was going to take this ght to you? Well now you know what
I meant.’”
He ended his monologue by returning to the Sith Lord, the super-
natural demigod in the Star Wars movie series who is dedicated to the
288 THE MOST DANGEROUS TRADE
Dark Side of the Force: “And lastly, to the man I’ve identied here as
the Sith Lord of this stu, I just say, ‘You know who you are and I hope
that this is worth it, because if the feds catch you again, this time they’re
going to bury you under the prison. And I’m going to enjoy helping.’”
Later, some speculated the Sith Lord was identied as the former Drexel
Burnham Lambert junk bond kingpin Michael Milken.
When the conference call was over, investors were shocked.
Those with no previous skin in the game piled on. Short interest on
Overstock.com rose from 10 percent to 15 percent the following Friday.
Wall Street wags promptly nicknamed Byrne “Wacky Patty.”
As an aside, after SAC Capital Advisors, founded by Steven Cohen,
was indicted for systematic insider trading violations in July 2013, Byrne
published a full-page advertisement in the New York Times with his own
photograph. It read: “Congratulations on the indictment, Stevie, and
remember: roll early, roll often. Your friend, Patrick M. Byrnes, CEO,
Overstock.com.”
The Overstock.com suit, in any normal U.S. court would have
been summarily dismissed. But the case wasn’t going to be heard in
such a venue. Instead it was led in the Superior Court of the State of
California for the County of Marin, better suited for the adjudication
of tenant–landlord tis and noise complaints than securities litigation.
There, conspiracy-sympathetic judges repeatedly ruled in favor of the
plainti. Rocker Partners and Gradient tried to have the suit dismissed
under California’s anti-SLAPP laws, designed to prevent suits intended
to squelch public criticism. The court rejected that motion. Rocker
and Gradient appealed. The State Supreme Court ruled against them.
In November 2007, Rocker and Gradient led a cross-complaint, a
point-by-point rebuttal of Overstock.com’s suit. A nightmare.
The SEC decided to weigh in—naturally on the side of Overstock
.com. The agency in early 2006 issued subpoenas to the journalists
covering Overstock.com, including Herb Greenberg, Carol Remond,
and Jim Cramer—who stomped on the request on live television. First
Amendment advocates erupted in unison. SEC chairman Christopher
Cox quickly rescinded the subpoenas.
Meanwhile, another target of Rocker Partners was about to turn its
lawyers loose. In June 2006, Fairfax Financial Holdings, a Toronto-based
Cohodes: Force of Nature, Market Casualty 289
insurer, whose byzantine structure and opaque disclosures had invited
heavy short-selling interest from a range of hedge funds, led suit
in superior court in New Jersey against Rocker and a half dozen
high-prole rivals, including SAC Capital Management, Lone Pine
Capital, Third Point, and Exis Capital. The allegations were familiar:
that Rocker and other hedge funds were disseminating false and
misleading statements designed to drive down Fairfax’s share price.
There were connections. Fairfax’s CEO, Prem Watsa, was a one-
time protégé of Jack Byrne from White Mountains. And on Decem-
ber 20, 2006, Overstock.com disclosed it had sold 2.7 million shares
to institutional investors for $14.63 a share, a 12 percent discount to
where they were trading. Whether that discount was extended to Fair-
fax Financial is unclear, but the insurer did report its rst public position
in Overstock.com, 3.4 million shares, in the second quarter of 2007,
equal to more than 14 percent of the company.
The New Jersey court where Fairfax Financial had led the suit
dismissed Rocker Partners from it in October 2008. The charges against
the rest of the hedge funds were eventually dropped too.
In May 2006, the SEC subpoenaed Overstock.com for documents
related to its accounting as well as projections, estimates, forecasts—the
very things that Rocker had been focusing on. The commission also
asked for documents related to the Gradient suit. “I may be the rst
CEO in history to celebrate receiving an SEC subpoena,” Byrne said.
“Some of the requests suggest the whispering of the blackguards but I
remain unconcerned about their hokum.”
After a two-year investigation, the SEC forced Overstock.com in
October 2008 to restate ve years worth of results, from 2003 through
2007, shaving millions of dollars of earnings and revenues. “Other than
that, Ms. Lincoln, how did you like the play?” Byrne deadpanned.
With the lawsuit taking its time, Byrne kept busy. He refashioned
himself as a “new media” journalist and helped found and nance
websites and blogs, including one called Deep Capture, that detailed
his various and highly developed conspiracy theories—and served as a
platform for often personal attacks on business journalists who were
covering Overstock.com. Among those targeted on Deep Capture and
various Byrne-linked websites: Bloomberg News’s Susan Antilla, former
290 THE MOST DANGEROUS TRADE
Business Week reporter Gary Weiss, Dan Colarusso and Roddy Boyd
of the New York Post, Fortune’s Mc L ean, New York Times columnist Joe
Nocera, and Bill Alpert from Barron’s, as well as Eisinger from the Wal l
Street Journal and Redmond from Dow Jones.
With the suit against Rocker winding its tortuous way through
the California legal system, Overstock continued to ritually notch
millions in losses each year—$13.8 million in 2001, $4.6 million in
2002, $11.9 million in 2003, $5.0 million in 2004, $24.9 million in
2005, $101.8 million in 2006, $48 million in 2007, and $11.0 million
in 2008. “Financial results were poor,” Byrne wrote one quarter. “My
bad,” he admitted in another. “Terribly sorry,” he said still later.
As refreshing as it might have been to hear Byrne take responsi-
bility for the formidable capital destruction he was engaged in, it did
nothing to dampen his enthusiasm for blaming shorts and other “miscre-
ants” for the company’s losses—or for clogging the system with still more
lawsuits. In February 2007, Overstock led a $3.48 billion humdinger
against Morgan Stanley, Goldman Sachs, Bear Stearns, Banc of America
Securities, Bank of New York, Citigroup, Credit Suisse, Deutsche Bank,
Merrill Lynch, and UBS, alleging that they had executed short sales of
Overstock.com shares with no intention of delivering shares to settle the
trade—in other words, intentionally engaging in “n---d shorting.”
Getting to the crux of the suit requires a serious drilldown into the
workings of the stock market’s securities lending business. A hedge fund
that wants to short a stock begins by rst contacting a prime brokerage
and asking it to locate shares to borrow, usually from an institution eager
to earn 5 to 7 percent by lending the stock out. It’s only after the bro-
kerage arms the “locate” that the hedge fund can legally issue a sell
order for the number of shares it has agreed to borrow. The prime bro-
kerage is supposed to deliver the shares in three days to the hedge fund’s
account, typically at another brokerage. If it doesn’t, the company that
serves as a central counterparty to all broker to broker transactions—the
DTCC—marks the appropriate accounts, both the lender’s and the ulti-
mate purchaser’s, with a “failed to deliver”—a place holder of sorts.
These FTDs, or “Fails” as they are called, can pile up to such an extent
that they represent a big chunk of a company’s oat.
Cohodes: Force of Nature, Market Casualty 291
However, the truth is that a prime brokerage can arm a locate and
never borrow the stock without the short-selling hedge fund being any
the wiser for it. Indeed, the brokerage rm has every incentive to do so,
since it can both spare itself the eort of locating often-hard-to-borrow
shares and save the interest it would otherwise pay on them to the lender.
Doing so would goose it own prots enormously.
The Overstock.com suit alleged that that was exactly what had been
going on in the securities lending business—ironically, something that
many short sellers had quietly suspected. The amounts involved were
not pocket change: In 2008, securities lending generated more than $10
billion in prots for Wall Street. Tellingly, in 2010 Goldman Sachs settled
SEC charges that it had failed to borrow shares for its short-selling clients
for $450,000 without admitting or denying guilt.
The suit against the investment banks would eventually be dismissed
on procedural grounds; none of the allegedly crooked transactions took
place in California. Still, a screw-up by Goldman Sachs’ counsel was
about to prove very embarrassing and oer proof that—and here’s the
huge irony—the Overstock.com allegations were true.
By mid-2006, David Rocker retired—years after he had said he
planned to, because he felt it was wrong to leave while the fund was
below its high watermark—a result of its 34 percent loss in 2003. He
was barely on speaking terms with Cohodes, who blamed him for the
Overstock.com mess and who changed the rm’s name to Copper River
Partners. Rocker says: “The relationship between Marc and myself dete-
riorated after the diculties of 2003 because of changes in Marc’s behav-
ior. As for Cohodes, he says simply: “Rocker stayed too long in the
game.” The two have not talked to each other since then.
Amidst the accelerating credit crisis and stock market collapse, Gra-
dient threw in the towel on October 2008, settling with Overstock.com
for undisclosed terms. It issued a statement saying that to the best of its
knowledge, Overstock.com’s stated accounting policies conformed to
GAAP, although it is not clear Gradient ever said otherwise and the com-
pany had, indeed, restated its earnings. Gradient also apologized to the
family of Gordon Macklin, who had died the previous year, for doubting
his suitability or independence.
292 THE MOST DANGEROUS TRADE
Things were far more desperate at Copper River Partners in Lark-
spur. The rm had entered the second week of September up 30 percent.
Yet a disastrous situation was unfolding for the dedicated short fund in
the midst of the calamitous sello.
On the surface, it seemed a combination of poor planning and plain
bad luck: Lehman Brothers Holdings, a custodian of Copper River’s
cash and some collateral, led for bankruptcy on September 15, 2008.
This had eectively frozen Copper River’s cash holdings. Then, on
September 19, Wall Street successfully lobbied the SEC into banning
the short selling of a roster of hundreds of nancial-related stocks.
Washington needed fall guys for the nancial collapse many of the short
sellers had predicted, so they were rst in line.
According to a November 2011 deposition by Cohodes in con-
nection with Overstock.com’s suit against the prime brokerage rms,
Copper River had just a handful of nancial shorts in its portfolio. The
stock market continued to fall in the last week of September, but its big
short positions began to mysteriously jackknife upwards, peaking on
September 22 and 23. Goldman Sachs, Copper River’s prime brokerage,
made house margin calls, more than tripling the haircuts, or margin
requirements, on its positions. Worse, Goldman began demanding that
Cohodes immediately begin liquidating the funds’ short positions.
Prime brokerages are allowed to do so under the contracts they strike
with hedge funds, but there was no obvious reason why Goldman
should do so.
The point man on Goldman Sachs’s side: Ravi Singh, senior vice
president in the prime brokerage division’s New York headquarters.
He declined to take Cohodes’s phone calls that desperate September,
despite Copper River’s 24-year history with Goldman Sachs. While the
rest of the market was plummeting, Cohodes’ big short positions were,
astonishingly, rising, as if someone was trying to squeeze him. One
big holding was American Capital Strategies, a Bethesda, Maryland,
middle market leveraged buyout rm which surged to $21.08 from
$13.96 ve days earlier, a 51 percent gain. By year-end, it had collapsed
to $2.43.
The stakeouts and other hard work by analyst Souza at Joseph A.
Bank Clothiers also came to naught, with its stock surging from $17.32
on August 28 to $26.47, a 53 percent gain.
Cohodes: Force of Nature, Market Casualty 293
In a week’s time, OpenText, a Waterloo, Ontario, enterprise man-
agement software rm, spiked 32 percent from $28.84 to $38.21.
And Tempur-Pedic International of Lexington, Kentucky, another
big Copper River short position, rose to $14.04 on September 22 from
$9.32 on September 17, a gain of 51 percent. The mattress maker n-
ished the year at $7.09.
Cohodes believed that Goldman Sachs or somebody else was
front-running Copper River’s trading, putting in orders ahead of the
fund’s to reap a prot. “Someone was running in front of these trades,
someone was,” Cohodes said.
As his hedge fund was collapsing, Cohodes furiously tried to negoti-
ate a transfer of his positions to another bank, Paris-based BNP Paribas.
Goldman Sachs categorically refused to release them. Cohodes then
started negotiations with Farallon Capital Management, a prominent San
Francisco hedge fund rm. Cohodes talked to Bill Duhamel and Lee
Hicks, who considered the idea of nancing Copper River’s positions
or having them taken over by Farallon itself.
Then the two balked, telling Cohodes, according to his deposition,
that Goldman Sachs’s proprietary trading desk had called to tell them
not to do so: Copper River would be out of business in a few days any-
way. “The fact that the Goldman prop desk knew about this is not a
surprise to me because I think the guys at Goldman are common crim-
inals, just common criminals,” Cohodes said in his 2011 deposition.
Farallon founder Thomas Steyer worked early in his career on Goldman
Sachs’s risk arbitrage desk under xed income chief Robert Rubin, later
Treasury Secretary in the Clinton administration.
Cohodes estimates that Copper River, which had nearly $2 billion
in assets at the time, would have earned $1 billion, or 50 percent, if it
had held on to its positions. Indeed, the fund was up 20.4 percent at the
end of August 2008. Instead, it was eventually shut down and suered a
loss of 53.8 percent for the year. By early 2009, Cohedes was spending
most of his time trying to nd jobs for his Copper River colleagues.
In December 2009, Copper River agreed to pay Overstock.com
$5 million to settle its suit—avoiding a trial which, Cohodes says, would
have involved putting David Rocker on the stand. “We decided that
the litigation costs did not justify passing up a practical way to end four
and a half years of meritless litigation by Overstock,” Cohodes said in a
statement at the time.
294 THE MOST DANGEROUS TRADE
Predictably, Byrne gloated. “The good guys won,” he declared in
a press release and went on to excoriate the SEC, short sellers, and the
nancial journalists who had covered the saga. The SEC investigations
into Overstock.com continued, although following the restatements, no
actions to date were brought.
Overstock.com’s suit against the brokerage rms was eventually nar-
rowed to Goldman Sachs and Merrill Lynch. Though thrown out in
March 2012 on a procedural matter, it had an ironic denouement.
Overstock.com had led a motion in early 2012 to unseal certain
documents that had been entered into evidence. In opposing the move
to unseal the documents, Goldman Sachs’ lawyers mistakenly entered
an unredacted version of Overstock.com’s motion, which—you guessed
it—included the very same material they were trying to keep under seal.
Yes, Patrick Byrne, there is a Santa Claus.
And, yes, the documents indicated that Goldman Sachs and Merrill
Lynch were, as Overstock.com’s suit alleged, engaged in a n---d
short selling scheme—though there is no evidence to suggest it was
ever intended to drive down the share price of any particular public
company. Among the evidence that the investment banks attempted
to have sealed was a series of e-mails, phone transcripts, and memos
that explicitly showed that Goldman Sachs and Merrill Lynch were not
borrowing the shares their clients would need to execute a legitimate
short sale. Sometimes, it seems, this was with customers’ knowledge,
and other times it seems not.
The documents make for interesting reading. One e-mail was to a
large Goldman Sachs client, Wolverine Trading LLC, which was con-
cerned that Goldman Sachs might be making an eort to clear up some
of its FTDs, or Fails, in trading desk argot. That’s when a stock that
is supposed to have been located for borrowing is not delivered to the
appropriate account. “We will let you fail,” a Goldman Sachs assured
Wolverine. In other words, the message suggests that it would con-
tinue to let Wolverine short stocks without locating borrowed shares
for the rm.
Some hedge fund clients were clearly in the dark regarding Goldman
Sachs’s failure to locate stocks. In one e-mail, a Goldman Sachs hedge
fund client whose name is not disclosed remarks on how it would ask
“to short an impossible name and expecting full well not to receive
Cohodes: Force of Nature, Market Casualty 295
it and [be] shocked to learn that [Goldman’s representative] can get
it to us.”
Among other things, the e-mails and phone transcripts show that
Goldman Sachs provided details of its clients’ short positions in heavily
borrowed stocks to preferred customers. It cited John Masterson, a Gold-
man Sachs executive, who “sends nonpublic data concerning customer
short positions in Overstock and four other hard-to-borrow stocks to
Maverick Capital, a large hedge fund.” Maverick is run by Lee Ainslee
III, a protégé of legendary investor Julian Robertson of Tiger Manage-
ment LLC.
Quotes from Merrill executives’ e-mails occasionally show an
attempt to stay on the right side of regulations. “We must be within the
rules and we must pass these negs [the negative rebates or borrowing
costs] on to the clients,” one employee writes. Still, the tenor of both
rms was reected best in the response of Peter Melz, the former
president of Merrill Lynch’s prime brokerage division, in May 2005 to
a colleague worried about the company promoting n---d short-selling
against regulations. “F--k the compliance area,” Peter Meltz writes.
“Procedures schmecedures.”
It’s hardly surprising that Cohodes, in his November 2011 deposi-
tion, said he suspected that Goldman Sachs was shutting down Copper
River because of its own n---d short exposures. “Basically the theory
was by Goldman putting us out of business,” Cohodes explained in his
deposition, “and forcing us to cover would have solved their issue, their
n---d issue because they had no economic reason to do what they did.”
Cohodes said he tried to discuss the matter with his account manager
at Goldman Sachs, Richard Sussman, a Goldman managing director and
risk manager whom he considered a friend. Sussman said his hands were
tied. “Sometimes when there’s a house re, you end up burning down
the whole block,” Sussman told him.
David Rocker is less circumspect. “Could Goldman Sachs have been
caught short without having borrowed stock, legitimate stock?” he asks.
“You bet!”
Cohodes believes that the prime brokerage industry—which under-
pins all short sellers—is corrupted. “I think the securities lending market
is just like the mob,” Cohodes said. “I think it’s completely rigged. It’s
a completely manipulated black-hole, nontransparent market.”
296 THE MOST DANGEROUS TRADE
According to Cohodes, the failure of Copper River is largely to
be laid at the feet of Goldman Sachs. “I think Goldman Sachs is like
the mob,” Cohodes said in his testimony. “I think Goldman Sachs is a
racketeering entity that does whatever they can to make a dime without
conscience, thought, foresight or care about ramications.”
In response, Goldman Sachs states: “Mr. Cohodes stated in his
November 2011 testimony that, prior to the losses his fund experienced
in the fall of 2008, he had been a satised customer who had received
excellent service from Goldman Sachs for over 20 years. His opinion
only changed when market conditions turned against the funds’ short
bias and the funds suered dramatic losses.”
Cohodes stands by his characterization. “I think they are cold-
blooded and could care less about the law,” he testied.
And he is always glad to discuss the matter. “That’s my opinion,” he
says. “I think I can back it up.”
About the Author
R
ichard Teitelbaum is a contributing editor to Institutional Investor
magazine. Among other jobs, he has worked as a senior writer
for Bloomberg News, where he shared an award from the Society
of Professional Journalists for investigative reporting; as investing edi-
tor for The New York Times; as a writer for Fortune magazine; and as a
trac reporter in San Francisco. A graduate of Connecticut College,
he lives in New York City with his wife, Nanette. They have three
children—Nicole, Nina, and Jack.
297
Index
AAIPharma, 274–276, 279
ABACUS, 248–255
Abelson, Alan, 179, 193
ABN AMRO lawsuit, 278–279
ABX Index, 246, 252–254
ACA Financial, 248, 250
Ackman, Bill, 1–3, 6–12, 118, 241
Adam (computer prototype), 59– 61
AI International Corp., 246
Airport Authority, 90, 92
Albright, Madeleine, 4
Alcatel-Lucent, 84
Alfredlittle.com, 128, 131
Allain, Keith, 56
Allen, Frederick Lewis, 167
Allen, Paul, 153
Alliance for Economic Stability, 30
Allianz AG, 234
Allied Capital, 96–97, 111–118, 120 – 122, 287
Allied Capital Corp., 93, 113
Alpert, Bill, 290
Alpert, Mark, 115
Amalgamated Copper, short selling gains, 19
Amazon.com, 153–154, 157, 226
Ambac Financial Group, 225
American Can, 217
American Depositary Receipts (ADRs), 152, 168
American General Life, 77
American Greetings, Seabreeze wager, 182
American International Group (AIG), 13, 77–79,
144, 198, 228, 238
American Stock Exchange (AMEX), 28, 30, 33
America Online (AOL), 71–72, 192–193, 272
Ameriquest Financial, 236
AmerisourceBergen, 274–275
Ampligen, 41, 42
Amsterdam Stock Exchange, closed-end fund
management, 6
Analysts, impact, 68–70
Anchor Gaming, shares purchase, 134
Anderson, Benjamin, 167
Anderson, Lance, 276, 280
Anti-Asensio rule, 33
Anti-short selling rule (1724), 17–18
Apotheker, Leo, 82–84
Appaloosa Management LP, 101
Apple, Inc., 93–94, 99, 157, 200–201
Ares Capital, 118
Argonaut, loss, 189
Arkansas Gas & Electric, 185
Arthur Anderson, 76, 111
Asensio.com, 29, 31
Asensio & Company, Inc., 29, 33, 37, 39–40
Asensio, Manuel, 27–38, 41–43, 47–48, 239
Asset bubble, 206
Asset energy providers, transition, 72–73
Asset prices (increase), Federal Reserve (impact),
232
299
300 INDEX
Atlantic Richeld (ARCO), Tice job, 210
Austerians, criticism, 1096
Authorized Intermediaries (A.I.s), impact, 148
Autonomy Corp., 80–82, 84
Average daily trading volume, examination, 183
B2B Internet HOLDRs Trust, 222
Bache Group, 265 – 266
Baird, Patrick & Co., 38
Baker, Richard, 203 – 204
Baldwin-United (BDW), 57–59, 77
Bally Manufacturing Co., Cohodes short, 267
Bankers Trust Corp, 166
Bank of America Corp., 123, 199, 241
Bank of England, Soros (impact), 21
Bank panic (1866), 17
Bank prots, limits (Pellegrini suggestion),
230–231
Banyan Securities, 23, 156
Barbarians at the Gate (Burroughs), 13
Barclays Corp., 123
Barrick Gold, losses, 221
Bartiromo, Maria, 161
Barton, Tom, 215
Baruch, Bernard, 19
Bass, Kyle, 216
Bastiaens, Gaston, 257, 258, 261
Bayes, Thomas, 81
BDO China Dahua Co., 130
“Bears in Hibernation” (Chanos conference), 75
Bear Stearns, 37, 119, 239, 248, 253–254
collapse, 13, 123, 198
Bear, Stearns & Co., 234
Bear, term, 16
Benjamin Moore paints, 197
Berkowitz, Bruce, 89, 91–92
Berkshire Hathaway, 165, 196 –199, 201–202
General Re subsidiary, risk (sale), 77
stock picking, management, 94
Bernanke, Ben, 104 – 105, 122–123, 230–231
money, ood, 155–156, 199
Bernstein, Sanford C., 189
Best, Alan, 69
Big banks, Geithner perspective, 105
Biovail Corp., SAC Capital Advisors impact, 12
Birnbaum, Josh, 247
Blackstone Group, 6
Blanco Territorial de Duba, stock/bond
certicates, 32
Block, Allan, 32
Block, Carson, 125–133, 137, 149
Block, William, 125–127, 132–140
Blue Ridge Capital, 31
BNP Paribas, 118–119
Boehmer, Ekkehart, 14
Bonaparte, Napoleon, 18
Borrow, impact, 40, 156
Boston Chicken, short positions, 71
Boston Consulting Group, 239
Boyd, Roderick, 290
Braswell, Mark, 118 – 119
Brickman, Jim, 120
Bristol-Myers, 52–53
British pound, shorting, 100
Bronte Capital, 146
Brooklyn Rapid Transit, short selling gains, 19
Brown, Bill, 62
Bruck, Connie, 287
Bubblevision, 157
Buckingham Research Group, 133
Buett, Warren, 5, 94–95, 134, 196–199
Fleckenstein, relationship, 163
Bull market, acceleration (1980s), 167
Burroughs, Bryan, 13, 123
Burton, Katherine, 71
Business development companies (BDCs),
111–113, 116, 117
Business Loan Express (BLX), 113–118, 120, 122
BWS Financial, 284
Byrne, Jack, 289
Byrne, Patrick M., 13, 280–281, 285 –287, 290
California, laws/crisis, 74–75, 288
Callan, Erin, 121 – 123
Call options, usage, 9
Cambridge Neurodynamics, 80
Camelback Research, 284, 287
Capital markets, function, 122 –123
Capital Midwest, 107
Capital structure arbitrage, 15
Capstone Mining Corp., 221
Cardinal Health, 274–275
Cardinal Investments LLC, 215–216
Carnes, Jon, 128
Carruthers, Jim, 114, 119
Carter, William, 41–42
Carve-out, 102
Case-Shiller home price index, 244
Case,Steve,72
Cash squeeze, trigger, 75–76
Cash-synthetic CDOs, 244
Castro, Fidel, 34
Celeghin, Daniel, 34
Center for Community Engaged Learning and
Research, 110
Center for Public Integrity, 118
Central Intelligence Agency (CIA), 109
Century Capital Associates, 267, 269
Index 301
Chan, Allen, 149–150
Channel stung, 218, 275
Chanos, James Steven, 12, 34, 51–68, 205, 273
bets, 71, 79
fraud documentation, 85
portfolio outsourcing, 101
short, initiation, 82
Chicago Board Options Exchange (VIX Index),
199
Child World, Cohodes channel-checking, 270
China Development Bank Corp., 151
China Investment Corp., 94
China, issues, 129–131
China Media Express Holdings, 144–147
China Mobile, 145
China New Borun, 131
China Security and Surveillance Technology, 151
Chipotle Mexican Grill, 93
Chiuchiarelli, Claudio, 23, 156, 163, 174
Christian, Wes, 286
Chrysler, bankruptcy proceedings, 266
Churnham & Burnham (ctional brokerage rm),
132
CIBC World Markets, 137
Ciena Capital, bankruptcy, 118
Circle T Partners LP, 191
Cisco Systems, shares, 174, 182–183
Citigroup, 119, 198
Citron Research LLC, 43, 128, 131
Clayton Homes, 197
Closed-end fund, Pershing Square management, 6
Closed-end mezzanine fund, trading, 113
CNBC, advent (impact), 169
CNBC Institutional Investor Delivering Alpha
Conference, 10
Coalition of Private Investment Companies, 15
Coca-Cola, 38, 100, 145, 196, 226
Cohan, William, 6
Cohen, Steven, 288
Cohodes, Marc, 92, 257–267, 273–274, 295
Colarusso, Dan, 290
Coleco Industries, 59 –62, 270–271
Coleman Co., acquisition, 218
Cole, Robert, 242–244
Collateralized debt obligations (CDOs), 119, 225,
235–245, 250, 276
Collery, Peter, 110
Combs, Todd, 94
Commercial mortgage, Lehman Brothers exposure,
127
Community Reinvestment Act (1977), 208
Compagnie des Indes, 17
Company-specic characteristics, impact, 98
Compaq Computer, 153
Compaq Computer Corp, purchase, 84
Computer Associates (CA), 82
ConAgra Foods, Prudent Bear investigation, 226
Concorde Financial, 210
Concorde Value, 210
Consumer credit, negative view, 241
Convertible arbitrage, 15
Cook,Tim,94
Cooperman, Leon, 31, 100, 180, 191, 211
Copper River Management, 92
Copper River Partners, 262–263, 291–293, 295
CopyTele, 59–60
Corporate insiders, shares (selling), 74
Corporate malfeasance, Cohodes understanding,
274
Corporate prot margins, compression, 156
Corzine, Jon, 132, 135–136
Corzine, Josh, 136
Countrywide Financial Corp., 155, 241
County residential surveys, 92
Cox, Christopher, 14, 122, 288
Cramer, James, 157, 284, 285, 288
C.R. Anthony, 111
Credit basket, 119
Credit bubble, 204, 240 – 241
Credit crisis (2008–2009), 204
Credit default swaps (CDSs), 78, 237, 246, 248
Credit markets, seizure, 206– 207
Credit Opportunities II, 245, 253
Credit-related problems, 120
Credit Suisse, 254
Cross the wall, term (usage), 96–97
Crowl, John, 166–167
Crown Zellerbach, 217
CTR Media Intelligence, data/analysis, 144–145
Cuban Cane Products Co., stock/bond certicates,
32
Cuban, Mark, 94
C.V. Starr & Co., 144
DAK Securities, 190
Danaher Corp., 193–195
Data Access Systems, 266
Davidson, Dave, 23–25
David Tice & Associates, 205
David-Weil, Michel, 234
Davis Accounting Group PC, 129
Davis, Lanny, 12
Days sales outstanding, 156
DealFlow Media LLC, 129
Debt-to-equity conversions, 104
Deep Capture, 289 –290
Deferred revenue growth, Kynikos focus, 82
Deationary cycle, 220
302 INDEX
Deloitte Touche Financial Advisory Services Ltd.,
140
Deloitte Touche LLP, 130, 144, 147
Dennett, Daniel C., 94
Depositary Trust & Clearing Corporation
(DTCC), 285, 287, 290
Deutsche Bank, 60, 62, 115
Devroye, Daniel, 133
DIAMONDS Trust Series I, 222
Diana Corp., 31
Dictaphone, 259, 260
Dillon Read & Co., 110, 234
Dimon, Jamie, 37
Dirks, Ray, 59
Diversication, benets, 99
Diversied Mortgage Investors, 194
Dividends, oering, 113
Dodd, David, 98, 134, 165
Donaldson Lufkin & Jenrette Securities Corp.
(DLJ), 109
Donaldson, William, 109
Dorfman, Dan, 191
Dow Jones & Co., 179
Dow Jones Industrial Average (DJIA), level, 266
Dragon Systems, 259, 260
Dreman, David, 165
Drew, Daniel, 18
Drexel Burnham Lambert, 64, 190, 288
Druckenmiller, Stanley, 103, 211
Due diligence, 81
Duerden, John, 261
Dunlap, Al, 217
Dunlap, Carter, 261–262
Dunlap Equity Partners, 261–262
Dunn, Patricia, 119
Duoyan Global Water, Inc. audit documents
forgery, Muddy Waters accusations, 147
DuPont Pharmaceutical Group, Bristol-Myers
acquisition, 52–53
Duquesne Capital Management, 103
Dutch East India Company, stock price
(rise/decline), 16–17
Dynegy, 72, 76
Earnings before interest, taxes, depreciation, and
amortization (EBITDA), 216
East Asia Minerals Corp., 221
Eastbourne Capital Management, 117
East Shore Partners, 156
eBay, restructuring, 7
Ebbers, Bernie (conviction), 205
e-Discovery, 80, 81
Educational Investment Fund (EIF), 209
Einhorn & Associates, 107
Einhorn, Cheryl Strauss, 95, 108, 110, 118,
286–287
Einhorn, Daniel, 107
Einhorn, David Michael, 34, 89–110, 113–115,
252
Ira Sohn speech, 122
macroeconomic outlooks, incorporation,
128–129
phone records, access, 119
SEC interrogation, 118–119
short candidates, credit basket, 124
speech, 87
Value Investing Congress presentation, 125
Eisinger, Jesse, 115, 259, 286, 290
Electronic Data Systems, purchase, 84
Elkind, Peter, 72
El Paso, gain-on-sale accounting (usage), 72
EMCOR, 111
EMC, Prudent Bear investigation, 226
EMC, shares (trading level), 182–183
Emshwiller, John, 76
Energy markets, deregulation, 73
Enron, 72 –76
ENSERCH Corporation, 210
Equity Funding, scandal, 59
Erie Railroad shares, issuance, 18
Ernst & Young Hua Mong LLP, 130
European Central Bank, 175
European Commission, 175
European Rate Mechanism (ERM), 21
Event arbitrage funds, 254
Everett, Cal, 221
Evergreen Energy, shares (decline), 45
Exchange-traded funds (ETFs), 99–100, 222, 225
Faber, Marc, 173, 204
Faherty, Michael, 259–260
Failed to delivers (FTDs), 290
Fairfax Financial Holdings (Rocker Partners
examination), 289
Fairholme Fund, 89
False Claims Act, 117–118
Farallon Capital Management, 56, 293
Farmhouse Equity Research, 119
Fastow, Andrew, 73–74
Federal Agricultural Mortgage Corp. (Farmer
Mac), Ackman wager, 12
Federal Deposit Insurance Corporation (FDIC),
108
Federal Funds Target Rate, increase, 67–68
Federal Home Loan Mortgage Corporation
(FHLMC), collapse, 13, 220
Federal National Mortgage Association (FNMA),
collapse, 13, 220
Index 303
Federal Open Market Committee (FOMC),
162, 169
Federal Reserve policy, 104, 107, 157–158
Federal Reserve System, 118
Federated Investors, 206
Feshbach brothers, 215
Fidelity Investments, 148
Financial Accounting Standard (FAS) 159, 120
Financial Accounting Standard Board (FASB)
regulation, impact, 161
Financial Bear, 215
Financial crisis (2008–2009), 105, 118
Financial Crisis Inquiry Commission (FCIC), 240,
250, 252, 254
Financial Crisis Inquiry Report, 23
Financial rms, asset energy provider transition,
72–73
Financial Industry Regulatory Authority (FINRA),
29, 33, 48
Financial repression, 104
Financial Select Sector SPDR Fund, 222
Financial stocks, shorting (temporary ban), 22
Finite earnings reinsurance, Chanos attention, 78
Finite reinsurance, 77
Finova Group, 112
Fiorina, Carly, 84
Fireman’s Fund Insurance Co., acquisition, 234
First Albany Companies Inc., 190
First Albany Corp., 180
First Alert, acquisition, 218
First American Corp., 244
First Energy Corp., 44
First Executive Corp., 62, 190
Fish, Jill, 34
Fisk, Jim, 18
Fixed income pensioners, Bernanke
(impact), 104
Fleckenstein Capital, 166, 168
Fleckenstein Partners LP, 157, 164
Fleckenstein, William Alan, 24, 153–167,
170–173, 219
Flextronics, 31
FLV Fund, 260–261
Focus Media Holdings, 151
Foundation for New Era Philanthropy, 222
France, national debt, 85
Fraud School, 130
Frazer Frost LLP, 129
Fremont General, 251
Froley, George, 165
Frost, Peter, 42
Fudgement Day, 159
Fuld, Richard, 121–122
Furman, Brad, 48
Fushi Copperweld, 151
Futures, usage, 225
Gain-on-sale accounting, 72–73, 115, 277
Gain on Sale Room, 95
Galbraith, John Kenneth, 85
Garner, Will, 212
Garrecht, Harold “Fritz”, 156
Gates, John, 18–19
Gateway, Fleckenstein shorting, 159
GE Capital, 213–214, 276
Geithner, Timothy, 104
General Electric (GE), 194, 198, 213
Generally accepted accounting principles (GAAP),
57, 281–283
General Nutrition Companies, 39–41
General Re, 77
GeoInvesting LLC, 131
Getty, Richard, 30
Gilford Securities, 57, 59 –60
Gillette K-Fuel, plant, start-up, 44
Glass-Steagall Act, 60, 158
Glaymon, David, 69, 80
Glickenhaus & Co., 189–190
Glickenhaus, Seth, 190, 194
Global Hunter Capital Markets, 129
Global Hunter Securities, report, 146–147
Global Risk Advisors LLC, 235
Go2Net Inc., 171
Goldberg, Allen, 190
Goldman Sachs, 188, 247–249, 291, 294–296
CDP trading desk, subprime mortgage market
short, 253
Corzine, involvement, 135–136
description, 13
fraud, accusation, 228
impact, 128
preferred stock, 198
Gold mining stocks, investments (advocacy), 106
Goodyear Tire & Rubber Co., 101 – 102
Gorman, Keith, 251– 252
Gotham Partners, 3, 7, 115
Gould, Jay, 18
Gouws, Johann, 188, 192
Gradient Analytics, 12, 283, 286
Graham, Benjamin, 98, 134, 165
Grant, James, 64, 158, 160, 171, 173
Great Depression, 90, 208
Great Recession, aftermath, 79–80
Great South Sea Bubble, Chanos description, 86
Greenberg, Allan Ace, 239
Greenberg, Herbert, 116, 193, 259, 285–286, 288
Greenberg, Maurice “Hank”, 77–79, 144
Greenbrier Partners, 215
304 INDEX
Greenlight Capital, 34, 87–102, 118, 120
gain (1996), 112
macro bets, 105–106
Spitzer subpoena, 115
Greenlight Opportunistic Use of Preferreds
(Go-Ups), 94, 95
Green, Mark, 187
Green Mountain Coee Roasters, 93, 95
Greenspan, Alan, 22, 157–158, 169–170,
220
Gregory, Joe, 121, 123
Griey, Jr., Ken, 94
Gross domestic product (GDP), 103, 232
Groupon, 182
Growth stocks, focus, 108
Gruss, Joseph (Gruss Partners), 239
GSAMP, 251
GSC Partners LLC, 248
Haidt, Jonathan, 32
Hall, Ross, 63, 66
Hallwood Realty Partners, Icahn stake, 7
Harbin Electric, 151
Harrington, Patrick, 114, 117
Hartman, Scott, 276, 278
Harvey Hubble, 185
Hasbro Inc., 270, 271
Hauspie, Pol, 260–261
Hayek, Friedrich, 219
Hayman Capital, 216
H.C. Wainwright & Co., 188
HEB Research, 42
Hedge funds, 20–21, 69, 99–100, 110–111
deep dive research, 92
lock-up periods, 214
short-selling hedge funds, problems,
156
Heimbold, Jr., Charles (indictment), 53
Hemispherx Biopharma, 41–43
Hempton, John, 146
Henry, John, 94
Henry Paulson, 127, 199
Herbalife, 1 – 5, 9–12, 93
Hewlett-Packard, 82 – 85, 99
HFRI index, 24
Hickey, Fred, 155, 171, 173
Hobbs, Charles, 69
Holmes, Bob, 56 –57, 60
Home prices, 246, 250, 251
Hoover, Herbert, 20
House Subcommittee on Capital Markets, Wall
Street investigation, 203
Housing, issues, 225, 228, 242–244
H&R Block, 132
HRPT Properties Trust, 7
HSBC Holdings, 149
Hungton Post, 105
Human motivational behavior, 68–69
Hunt Brothers, 265 –266
Hurd, Mark (resignation), 84
Hurwitz, Charles, 38
IBM, growth stock (focus), 107
Icahn, Carl, 6–10, 111, 211
IDOL search engine, 80
Ignarro, Lou, 4
IKB Deutsche Industriebank, 251
Index futures, shorting, 99–100
Industrial Select Sector SPDR Fund, 222, 225
Industries, problems, 63–64
Industry-specic exchange traded funds, shorting,
99–100
IndyMac, 155
Ination, 103, 106
Integrated Resources, 62, 64
Integrity Research Associates, 43
Intel, 153–154, 171, 174
International Business Machines Corp, 74, 155,
185, 200
International Lease Finance, 77
International Monetary Fund (IMF), 175
Internet Architect HOLDRs Trust, 222
Internet bubble, 74, 155, 160
Internet HOLDRs Trust, 222
Intra-company interest payments, elimination, 113
Inverse 10-bagger, miss, 77
Investment banking, Einhorn perspective, 110
Investment Company Act (1940), 20
Investment ideas, analyst generation, 68 – 69
Investor redemptions, BNP Paribas suspensions,
118
iPrefs (Einhorn campaign), 95
Iraqi Gulf War (1990–1991), 66
Ira Sohn Investment Research Conference (2005),
103, 113, 122, 127
Iron Mountain, 82
iShares Russell 2000 Growth Index Fund, 225– 226
Jahnke, Gregg, 210, 212, 214
Jiwei, Lou, 94
Jakobson, John, 190
Japan Air Lines, 168
Japan, interest rates (long-dated call options), 105
Jenrette, Richard, 109
Jiminez, Marcos Daniel, 47
JKE Research, 210–211
Job growth, 232
Johnson, Hugh, 190
Index 305
Johnson & Johnson, 196
Johnson, Melody Miller, 165– 166
Johnson, Paul, 167
Jones, Alfred Winslow, 20, 100
Jones, Charles M., 14
Jones, Jim, 160
Jong, Lily, 70–71
Jordan, Jerry, 184, 201–202
Jordan Management Company, Inc., 184
Joseph A. Bank Clothiers, 273–274, 292
J.P. Morgan Cazenove, 81
JPMorgan Chase, 198, 237, 241, 254
J.S. Charles Securities (Kass research), 180–181
Ju, Carol, 269
Junior miners, 221
Juniper Networks, Prudent Bear investigation,
226
Junk bonds, investments, 65
J.W. Charles Securities, 190–191
J.W. Seligman & Co., 132
Kass, Doug, 177–191, 196–198
Kass Partners, 191
Kaufman, Henry, 204
KB Home, 225
Kennedy, John F., 20
Kerr-McGee, restructuring, 7
Keswin, Je, 110
Keynes, John Maynard, 17, 219
KFx Inc., 43–45
Khan, Daud, 81
Kickers, impact, 112
Kidder Peabody, 165–166, 192
Kimberly-Clark Corp., 217
Kingdon Capital Management, LLC, 43
Kingsford Capital Management, 43
Kinsley, Michael, 187
KLA-Tencor Corp., Prudent Bear investigation,
226
Korea Development Bank, 123
Koresh, David, 160
Kozlowski, Dennis, 196, 222–224
KPMG Huazhen, 130
KPMG Peat Marwick, 261
Krensavage, Michael, 275
Krispy Kreme Doughnuts, product trend, 63
Kroll Associates, 114, 287
Krueger, Ivar, 86
Krugman, Paul, 106
Kuhn, Thomas, 187
Kunda, Ziva, 32
Kun, Huang (prison time), 131
Kynikos Associates, 34, 52, 65–68, 71 – 79, 82–84
hedge fund managers, portfolio outsourcing, 101
name, origin, 63
short sales, 12, 128–129
Kynikos Opportunity, 54, 79
La Compagnie des Indes, 85
Lam Research, Prudent Bear investigation, 226
Landini, Paul, 262, 266, 274
Lassergrams, 189
Lasser, Lawrence, 189
Law, John, 85– 86
Lay, Ken, 75– 76
Lazard Frères & Co., 234
Leeds, Marshall, 190
Lee, Kai-Fu, 131
Lefevre, Edwin, 19
Left, Andrew, 128, 131
Lehman Brothers, 120 –123, 127–128, 155, 254
accounting problems, 225
bankruptcy, 198
short-selling eort, 118
Lehman Brothers Holdings, 93, 292
Leland O’Brien Rubenstein Associates, 167
LeMaire, Isaac, 16
Lennar, 225
Lernout & Hauspie Speech Products (L&H),
257–259, 260–261, 272
Lernout, Jo, 260–261
Leucadia National, 89
Level 3 assets, 122
Levin, Richard, 56, 75
Levitas, Jim, 60, 62, 64
Levy, Leon, 239
Lexington Insurance, 77
Lexmark, Kynikos short, 83
Lindsey, Lawrence, 204 – 205
Lin, James (database tracking), 112
Lipton, Marty, 12
Liquidity, 119, 232
Liu, Zhenyong, 126–127
Livermore, Jesse Lauriston, 19–20
LoanPerformance, 244
Loeb, Daniel, 9, 116–117
Loeb & Loeb, 129
Loeb & Loeb LLP, 139
Long-dated call option, Einhorn purchases, 105
Long investments, screening (usage), 98
Long investors, stock holdings, 173–174
Long-only managers, presence, 99–100
Long-short investing, mastery, 100
Long-Term Capital Management LP (LTCM), 172
Love Box Self Storage, 139–140
Lowi, Theodore, 108
Lucas critique, 232
Lufkin, Dan, 109
306 INDEX
Luo, Ping, 146–147
Lycoming County Fair, 177
Lynch, Michael, 80, 83
Lynde, Russell, 271, 273
MacAndrews & Forbes, 178
MacDonald, Liz, 285
Mack, John, 13
Macklin, Gordon, 285, 291
Macro bets, series, 104–105
Macroeconomic factors, bets, 103
Macro investors, 103
Mado, Bernard, 2, 85
Maintenance depreciation, 216
Malaysia, currency collapse (1997), 21
MaloneBailey LLP, 129
Management fee, charge, 100
Maremont, Mark, 259
Mariner Investment Group, 229, 235
Market downdrafts, mitigation (avoidance), 100
Market dynamics, problems, 174
Market neutral investing, 15
Market risk, 111
Market volatility, short selling (impact), 21
Marketwatch, 116
Markit Group Ltd, 246
Mark-to-market losses, risk mitigation, 10
Marvel Entertainment, 178–179
Mass psychology, avoidance, 184
Master Kong, 145
Masters, Blythe, 237
Maverick Capital, 295
Maxxam, Inc., 38
McDonald’s, growth stock (focus), 107
McDonnell-Douglas, loss, 67
McGraw-Hill, short candidate, 120
MCI Communications, 205
McKesson, 274 –275
McLean, Bethany, 72, 73, 75, 284
MDC Holdings, 102–104, 111
MdDonald’s Corp., bond oering (pitch book
creation), 67
Medco Health Solutions, 30, 48
Medway, Robert, 109
Melz, Peter, 295
Merchant Equity Partners, 81
Merger arbitrage spreads, compression, 240
Mergers and acquisition (M&A), 107, 109
Meridio, acquisition, 82
Meriwether, John, 172
Merrill Lynch, 123, 136, 206, 215, 294
Metal prices, prots, 170
Meyer, Albert, 212, 222 – 223
Mezzanine loans, usage, 112– 113
MGIC, 57 – 59, 155
M.H. Meyerson & Co., 133
Michaelcheck, William, 229, 235
Micron Technology, 153, 170
Microsoft Corp., 93, 259
Middleswart, Je, 218, 220, 225
Milken, Michael, 190, 288
Miller + Ta b ak + Hirsch Inc., 189
Millett, Doug, 54, 70 –71, 73
Milliman Inc., 163
Miscreant’s Ball, 287
Mishra, Arvind, 135–136
Mispricing, dynamics (impact), 98
Mississippi Company, 17
Mitchell, Hutchins & Co., 267, 268
Mitsubishi UFJ Financial Corp., 240
Mizel, Larry, 103
Momentum, impact, 24
Money, borrowing (Ponzi nance), 65
Monster Beverage, shares (Cohodes bet), 262
Montgomery, Mark, 273
Moody’s Investor Services, short candidate, 120
Moore, Michael, 187
Morgan, John Pierpont, 19
Morgan Stanley, 91, 119
Morgenthau, Robert, 224
Morland, Paul, 81
Mortgage markets, worsening, 253
Mortgage-related structured debt, exposure, 121
Mozilo, Angelo, 241
Mr. Coee, acquisition, 218
Muddy Waters LLC, 43, 140 –143, 151–152
Muddy Waters Research LLC, 127–128, 131–132
Munger, Charles, 200
Municipal bond oering prospectuses, 92– 93
Mutual funds, 100, 214
Mutual Series Funds, 217
Myers-Briggs Type Indicator, 121
N---d shorting, usage, 13
N---d short selling, 294
NASDAQ-100 Shares, 222
NASDAQ Composite, 67, 154, 158 –159, 162, 172
Nash, Jack, 239
National Association of Securities Dealers (NASD),
27–28
National Fire Insurance Company, 77
Nebraska Furniture Mart, 197
Netix, 156
New Century Financial, 93 – 94, 119, 243,
251–252
New economy, 154, 160
Newmont Mining, losses, 221
New World Entertainment, 178
New York Stock Exchange (NYSE), 115, 168
Nike, growth stock (focus), 107
Index 307
Nikkei Stock Index, 168
Nocera, Joe, 290
Nokia, shares (book value), 99
Noland, Doug, 219–222
Nonrecurring charges, 223
Non-Recurring Room, 95
Northern Trust Company, 262, 266 – 267
Northwest Florida Beaches International, 89
NovaStar Financial, 262, 276–280
Novation Companies, 280
Noxell Corp., Tice stock warning, 211–212
NQ Mobile Inc., Muddy Waters research report
(2013), 151–152
Nutrition clubs, 2, 11
Nyrstar NV, Greenlight long approach, 102
O’Brien, Bob (Easter Bunny), 277, 279, 285
O’Connor, Jack, 246
Odyssey Partners, 239
Olympic Capital Management, 166
O’Meara, Chris, 124
Omega Advisors, Inc., 100, 180, 191
One Dundee Capital Markets, 150
Ontario Securities Commission (OSC)
investigation, 150
OpenText, 293
Oppenheimer & Co., 189
Optionality, 101
Options, 175, 223
O’Quinn, John, 286
Oracle, 81 – 82, 182–183
Orient Paper, 125–128, 140
Overstock.com, 280, 282–284, 289 –293
Gradient Analytics research reports, 286
short seller target, 13
Ownit Mortgage Solutions, 236
Oxford Health, short positions, 71
Pacic Growth Equities, cofounding, 23
Pacic International Securities, 221
Pacic investment Advisors, 165
Paging Network, 216–217
PaineWebber, 56, 57
Pairs traders, actions, 100
Pairs trading, 15
Pairs trading, Einhorn (perspective), 112
Palm Inc., purchase, 84
Pan American Silver Corp., 170
Paradigm shift, 187
Parvest Dynamic ABS, 118–119
Paull, Matthew, 6
Paulson Advantage, 240, 245
Paulson & Co., 148, 227, 238–242, 252, 254
Goldman Sachs protection, 247
Paulson Credit Opportunities I, 235, 244
Paulson, Henry, 122, 199
Paulson, John, 30, 34, 37–38, 148, 238–241
Pecora, Ferdinand, 20
Pellegrini, Paolo, 227–235, 237–238, 242
Penny Room, 95
Pentagon, terror attacks, 22
People’s Choice, 236
Pepsico, stock purchases, 100
Perella, Joseph, 36
Perelman, Ronald, 178, 179
Peretz, Martin, 6
Perry Corp., 43
Pershing Square Capital Management, 1, 4, 6, 9,
241
Phantom company, 146
Philadelphia Stock Exchange Gold & Silver Index,
value (loss), 221
Phillips, Roger, 81
Pillsbury Winthrop, 129
PolyMedica Corp., 28, 30, 45–48
Ponzi nance, 65
Ponzi scheme, 85, 222
Porter, Michael, 6
Portfolio insurance, investments, 167
Portfolio selection agent, Goldman Sachs hiring
suggestion, 248
Port St. Joe, 88
Pre-announce, strategy (usage), 171
Precious metals, investment (advocacy), 106
Pretexting, 116–117, 145
Price, Michael, 217
PricewaterhouseCoopers Zhong Tian CPAs Ltd,
130
Prime brokerage, actions, 291
Procter & Gamble, 196, 205, 212
Project on Government Oversight, 118
Property deeds, 92
ProPublica, 115
Prudent Bear, 204 –206, 219–222
asset level, 225–226
net short exposure, increase, 214
Prudent Bear Fund, Paging Network short, 217
Prudent Bear Safe Harbor fund, 206
PSQR LLC, 228, 229
PSQR Management LLC, 229
Punch Taverns PLC, 96–97
Putnam Investments, 184
Putnam Management Company, 189
Pyramid Scheme, denition, 3–4
Qatar Holdings LLC, 6
Qihoo 360 Technology Company, 131
Qiu, Jianping, 142
Quantitative easing (QE), 79–80, 105, 123, 230
Quarterdeck Oce Systems, 258
308 INDEX
Racketeer Inuenced and Corrupt Organizations
Act (RICO), 43
Radio Corporation of America (RCA), short
selling gains (absence), 19
Rajaratnam, Raj, 264
Rales, Steve/Mitchell, 194
Rate reset rates, impact, 242–243
Raymond James Financial, 275–276
Real estate investment trust (REIT), 194, 276–277
Realty Income, Ackman wager, 12
Recession, Gulf War (impact), 109
Redmond, Carol, 286
Redneck Riviera, 88
Reex rallies, impact, 174
Regal Cinema, Seabreeze wager, 182
Regan, Sean, 125–127
Regression line, usage, 243
Regulation SHO (SEC), 22
Regulatory arbitrage, 77
Regulatory changes, impact, 98
Rei, Dan, 187
Reminiscences of a Stock Operator (Lefevre), 19
Remond, Carol (subpoenas), 288
Renna, Phil, 269
Rent-Way Inc., impact, 137
Research in Motion, 155, 157
Residential Mortgage-Backed Securitizations
(RMBSs), 242, 245
Resource Mortgage Capital, 276
Reverse takeover companies (RTOs), 129, 130,
142, 147
Reversion to the Mean (RTM), 154 – 156, 170
Reversion to the Mean 2.0 (RTM 2.0), launch,
158–159
Richards, Christine, 11
Richebacher, Kurt, 219
RINO International Corp., 141–144
Ritchie Capital Management, LLC, 43
RiverTown (St. Joe Project), 90–91
Robertson, Julian, 22, 61, 66, 295
Rocker, David A., 13, 71, 267–269, 272, 291
Rocker Partners, 43, 269–270, 286
Rodman & Renshaw Capital Group, 129
Roger & Me (Moore), 187
Rogo, Kenneth, 231
Roll, Penni, 114
Roll-ups, 80, 264
Roosevelt, Franklin D., 19, 20
Roseman, Alan, 252
Rosenkrantz Lyon & Ross, 133
Rose, Rusty, 215–216
Rosner, Joshua, 276
Ross Hall, 62
Rothbart, Dean, 12, 61
Roth Capital, 129, 151
Rothschild Bank AG, 6
Rowe, Frederick, 64, 215
Rukeyser, Louis, 107
Rummell, Peter, 88
Russo, Patricia, 84
SAC Capital, 12, 96, 288, 289
Sadomonetarists, 106
Salomon Brothers, 136, 168
SanityCheck.com, 277
Sara Lee, Prudent Bear investigation, 226
Sauer, Richard, 273, 281
Saving and loans (S&Ls), deregulation, 65
Savoy, Bill, 153 – 154
SC Capital Management, 23
Schapiro, Mary, 30, 33
Schmuck insurance, collection, 7
Schneider, Michael, 13
Schurr, Steve, 70–71
Schwartz, Laura, 248 – 249, 252
Schwartz, Mark (charges), 224
Scion Capital LLC, 285
Scott Paper, 217
Screening, usage, 98
Seabreeze Long-Short Fund LP, 180, 191 –192
Seabreeze Partners Short LP, 180, 191–192
Seagate Technology, 93
Seagram, share oer, 36
Sears Holdings, 156
Securities and Exchange Act (1932), 210
Securities and Exchange Commission (SEC), 18,
20, 110, 115–116
Bristol-Myers settlement, 53
Regulation SHO, 22
See-throughs, construction, 64
Select Reinsurance Ltd, 235
Selz, Furman, 173
Seo, Joo Chul, 261
Serial acquirers, Cohodes search, 264
Serial restructurer, impact, 53
Sexton, Mark, 45
SG Cowen & Co., 261
SGS North America, 44–45
Shanaman, Samuel, 47
Shanghai Ba-Shi (Group) Industrial Co. Ltd, 145
Shoreline Fund I, 24, 25
Short-biased hedge funds, HFRI index, 24
Short candidates, credit basket, 119–120
Short generation, Fleckenstein technique, 175
Shorting, temporary bans, 22
Short positions, Kass control, 191
Short sale, 15, 16, 63–64
Short sellers, 13–15, 19 –24, 61–62
Index 309
problems, 156
tips, 69–70
Short selling, 15 – 19, 21, 54 –55, 98
business, dynamics, 259
short-selling hedge funds, problems, 156
Short squeeze strategy, 9
Siegler, Collery & Company, 110
Siegler, Gary, 110
Silvercorp Metals, 131
Simpson, Mary Fleckenstein, 160
Singh, Dinakar, 56
Singh, Ravi, 292
Single premium deferred annuities (SPDAs), 57–59
Singleton, Henry (stock buybacks), 56
Sino-Forest Corp., 147–150
Sirach Capital Management, 166
Sirrom Capital, 111 – 112
Sitrick, Michael, 12
Skilling, Jerey, 74–76
Small Business Administration (SBA), 111,
114–115, 117
Smartest Guys in the Room, The (McLean/Elkind),
72
Smith, Ben, 20
Smith, Jim, 54–55, 66
Smith, Rebecca, 76
Société Financière Union, 36
Sohn Conference Foundation, 3, 151
Sony Corp., 168
Soros Fund Management, 21, 96, 100, 103
Soros, George, 21, 61, 66, 100, 205, 211
Southland Corp., 65
SouthMark Corp., 65
South Sea Bubble (1734), 17
South Seas Company, bubble, 17
Southwest Airlines, 112
Souza, Jerome, 273–274, 292
Sovereign wealth funds, 121
Sparrow, Suzanne, 112
SPDR Gold Trust, Greenlight holdings, 105
Spears Leeds and Kellogg, 111
Special purpose entities, setup, 260–261
Special reserves (setup time), acquisitions (impact),
52–53
Spitzer, Eliot, 11, 54, 77–79, 115
Spooren, Ellen, 258
Spring Investment Conference, Einhorn
announcement, 121
Stahl, Lesley, 12
Staley, Kathryn, 17
Standard & Poor’s 500 (S&P500), 22, 103 – 104,
119, 222
gain, 68
Greenlight, comparison, 92–93
Standard & Poor’s (S&P), S&P/Case-Shiller
20-City Home Price Index, 240
Starr, Cornelius Vander, 77
Startec Global Communications, 113
State Administration for Industry and Commerce
(SAIC), 127, 151
Static Residential Trust (START), 244, 247
Steinhardt, Fine, Berkowitz & Co, 267, 268
Steinhardt, Michael, 61, 66, 205, 212
Steyer, Thomas, 56, 293
St. Joe Company, 88–92
Stock analysts, corruption, 204
Stock Bar, The, 136
Stocks, 12–13, 65, 99
Strat-O-Matic, 208
Stratton Oakmont, 41
Structured nance market, exposure, 119
Structured Product Correlation and
Trading, 247
Structured products, securitization, 119
Structures of Scientic Revolutions, The (Kuhn),
187
Subprime mortgages, 246, 253
Sullivan, Martin, 79
SummerCamp Beach (development), Einhorn
valuation, 91
SunAmerica, 77
Sunbeam Corp., 71, 217 –219
Swaps, purchase, 237
Sweeney, Joan, 114
Synthetic CDOs, 246–248
Synthetic puts, 183–184
Tabbiner, Philip, 274
Taibbi, Matt, 13, 123
Target Corp. investment, call options
(usage), 9
Taulli, Tom, 18
Tax Reform Act (1986), 64
Technology bubble (1990s), 22, 78
Technology companies, roll-up, 80
Teledyne Inc., 189
Teledyne, stock buybacks, 56
Temasek Holdings, 148, 151
Tempur-Pedic International, 293
Tenenbaum, L.J., 188
Tenet Healthcare, 132
Tepper, David, 94, 101–102
Term Asset-Backed Securities Loan Facility (TALF)
program, usage, 231
Texas Commerce Bankshares, 65
Thatcher, Margaret, 21
Third Avenue Value, 89
Thompson, Ken, 84
310 INDEX
Tice, David, 203–215
defense, 225
Noland interactions, 220–222
shorted nancials, exit, 226
10-day rule, 222
Tiger Management LLC, 295
Tiger Management LP, 22, 61
Time Warner, 7, 72, 75, 192
Tiscali, 192
Tisch, Larry, 22
Tobias, Seth, 191
Toll Brothers, 225
Tonka acquisition, 271
T-OnLine, 192
Toshiba Corp., 168
Tourre, Fabrice, 247 –249, 251, 255
Toys Plus, Cohodes channel-checking, 270
Toys ’R’ Us, Cohodes channel-checking, 270
TPG-Axon Capital Management, 56
Trade balances, impact, 103
Train, John, 165
TransAsia Lawyers, 140
Travelers Corp., 234
Triad Securities, 133
Troubled Asset Relief Program (TARP), 199, 280
Trust Company of the West (TCW), portfolio
selection agent, 247
Tsai, Jason, 135
Tufte, Edward, 56
Tyco International, 71, 194, 196, 222–224
U4ians, 157
UBS, 254
Umicore, 102
Union Pacic Corp., shorting, 19
United Kingdom, 79, 83, 97
United States dollar, risk, 104 –105
Uptick rule, 20
Ursus (Chanos fund), 65–68, 79
Vallassis Communications, 182
Value Added Tax (VAT), 143, 149
Value Investing Congress, 87, 120
Vanguard, expense charges, 100
Variable interest entity (VIE), 142
Varney, Stuart, 160
Velocita, 113, 114
Veninata, Bob, 69
Vinson, Glen, 62
VIX index, change, 199
Volatility, impact, 272
von Mises, Ludwig, 219
Voyles, Adam, 286
Vulcan Capital, 153, 154
WAB Capital, 125–126, 137
Wachovia, 84
Walgreens, growth stock (focus), 107
Wall Street, independence (absence), 204
Walton, Bill, 114
Wapner, Scott, 7
War of 1812, 18
War of the Spanish Succession, 85
Warzecha, Terry, 269
Washington Mutual, Inc., 155, 198, 241
Wasserstein, Bruce, 36
Waste Management, 59
Watsa, Prem, 289
Wattley, Glenn, 37
Weil, Jonathan, 72– 73, 279
Weiss, Gary, 290
Welch, Jack, 213, 214
Wells Fargo & Co., 215, 252
Weschler, Ted, 94
Westerich, Lucas, 251–252
Western Silver Corp., 221
White Mountains Insurance Group, 281, 285,
289
Whitman, Meg, 83, 84
Wiggen, Albert, 20
Wigmore, Barry, 167
Wilson, Kendrick, 235
Wilson, Woodrow, 19
WindMark, 88, 91
Winnebago Industries, 155
Winslow, Alfred, 100
Wolverine Trading LLC, 294
Woods, Jr., Thomas F., 208
WorldCom, fraud, 205
World Trade Center, terror attacks, 22, 46
Worthington, Ralph, 57
Wriston, Walter, 188
Xera, U.S. dollar renaming, 157
Xugong Group Construction Machinery,
138
Yahoo! Returns, restructuring, 7
Yellen, Janet, 230
Yi Bao Sheng Ptl Ltd (YBS), 138, 139
Zantaz, acquisition, 82
Zhang, Xiaoyan, 14
Zi Brothers Investments, 71
Zi brothers, wealth, 66
Zimmerman, Jorg, 251
Zinifex, 102
Zou, Dejun, 142
Zuckerman, Gregory, 238
