A few weeks ago, we interviewed famed hedge funder Jim Chanos at his office in Midtown Manhattan.
We spoke for around an hour, touching on topics that ranged from his time shorting companies like Tyco and Enron to what kind of girl scout cookies he likes. Chanos spoke at length on more modern topics as well, such as Greece and how he’s shorting China.
The whole conversation was education, but we thought we’d boil down….
10 particularly interesting things we learned >
Be sure to check out our interview with Jim Chanos:
Part I: Greece Is A Prelude
Part III: Inside The Fall Of Enron
But what people forget is that the CDS market was created exactly for that. Because if you are a creditor of that government with a non-marketable instrument, say Greece owes you money, say Greece has promised to fund your projects. You don't own a Greek bond. You can't market that IOU, but you have economic risk. Your project may be imperiled if Greece cannot fund it as promised. The only way you can hedge that off is through the CDS market.
So that's exactly why the CDS market was invented. Not just to hedge sovereign debt instruments, because you can simply sell those instruments if you're bearish! It's actually to hedge off non-marketable instrument risk. We saw the same thing during the banking crisis when people started saying 'Oh there's been an explosion of buying CDSes on banks, and short-selling the shares of banks in the Spring and Fall of '08.
A catalyst for our involvement was simply a phone call I got from a friend in Dallas who ran a hedge fund who asked if I had seen Jonathan Weil of the Texas Wall Street Journal's Heard On The Street column if I had heard the accounting of the energy merchant banks. And I had not seen it.
So he faxed it to me - email was still not ubiquitous at that point - and it was a really interesting column about how the energy merchant banks had lobbied the SEC successfully for getting mark-to-model and mark-to-market accounting for their long term investing in energy derivatives. To take the present value of all the future profits that were written into the derivatives were sold as opposed to adjusting it pro-rata over the life of the contract. And they were celebrating.
The article if I can recall went on to say that there were a number of academics and accountants who were worried about this practice. That anytime you could front-load profits you'd really suspect that company of corporate abuse. We had experience with this in a number of areas in the first subprime fiasco in the mid-90s and then way way back going back to the annuity issuers - Baldwin United and others - back in the early-80s. They were selling insurance policies and cooking up all their future assumed income up front.
The next thing that caught our eye was even with what looked to be some pretty aggressive accounting, we calculated the company's pre-tax return on capital including their derivatives book to be somewhere a little north of 6% but below 7%. And based on what Enron bonds were trading at and the equity risk premium, we realise this company wasn't earning its cost of capital.
So it was a giant leveraged hedge fund as my partner Doug Mellon said at the time that was earning 6% a year if you would, on a leveraged balance sheet and you were gonna pay six to 10 times book for it. It made no sense.
Then finally, there were the more interesting secondary issues like the insider selling through 2000. A lot of executive departures in 2000. So all these things for us were enough for us to start initiating a position in November of 2000.
The 'A-Ha!' moment for me that I suddenly knew that something was not in the grey area but the black area was when Skilling resigned. That's when I knew.
When Skilling resigned abruptly at that point I knew that something was very very wrong that we couldn't see. And what we couldn't see of course was the gua ranted payments that they had made to the offshore entities should they sell them assets were suddenly loss-making. So in order to get these toxic assets off their books, they agreed to issue Enron shares as a 'make-good' to the offshore entities. And they didn't disclose that.
That was the hidden troll, in terms of an equity analyst.
Keep in mind that the average median income in China, and it's only slightly higher in the cities, is something like $3500 per person. Typical second-tier city real-estate prices have now gone above $100 a square foot. So a typical 100 square meter condo is probably going to cost you after all your expenses (if you build it out to live) $120,000 to $140,000 US. Well say you're a dual income couple and you make $7000 to $10,000 a year total. OK? Even if you put down the 20% down that everyone's pointing to, that's 20% on your purchase price. You're still paying mortgage interest of probably ... 60 to 100% of your income, pretax.
The other interesting thing about the boom here is that it is completely high end. When people talk to me about China's 'migration of people' into the cities and the population and blah blah blah, and the growth of the economy, I said 'That's all and good but they're putting up the equivalent of New York City highrises at almost New York City prices for a populous that is 1/10th of that per-capita income.' So this building boom is aimed at: A) the corporate market, corporate highrises and office buildings or B) very high end of the residential market. It's not the masses - it's for people speculating.
Yes, there's nothing wrong with mark-to-market accounting if there's a liquid market in instruments. The problem really for Enron, and then as we found out later for the banking industry in the latest financial crisis, was really mark-to-model accounting. Mark-to-market for lots of derivatives is really, for the vast majority of them, looks towards something that's liquidly traded, say something like a Treasury bond or IBM stock. And if it's an option on IBM stock, or say it;s a simple mortgage-backed bond that trades off of Treasuries, it's fairly easy to get a reasonable set of assumptions as to what your derivative might be worth by looking at the price of the 'underlying' as they say.
When Chanos walked into the conference room, he brought with him a fresh box of Girl Scout Cookies. Thin Mints, to be precise. The man has good taste!
Dubai was a property bubble. Plain and simple. Go to Dubai and see what happened. It was…what I call it the 'Edifice complex' - it's just, we can grow by putting up lots and lots of buildings and trying to attract people to come here, stay here, and put up offices here and sooner or later, you put up too many. And whether it's the Palm Island project or the indoor ski resort or, you know, take your pick because everyone has lots of Dubai stories. At first it seemed plausible and economic and by the end of the boom, they were putting on drawing boards all kinds of crazy projects. So it didn't take a rocket scientist to see the excesses. They were pretty visible to the naked eye.
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