In his 1991 novel Time’s Arrow, Martin Amis tells the story of a Nazi war criminal as if lived backwards in time. The time reversal shockingly inverts the morality of the protagonist’s actions—as an old man he snatches toys from children and sells them for money, while in Auschwitz he gives life to thousands of Jews and rehabilitates them into society, even providing them with free gold teeth from the Reichsbank.
I was reminded of this novel in David Einhorn’s book, where he gives a boilerplate description of short-selling. “When you are long”, Einhorn writes, “the idea is to buy low and sell high. In a short sale, you still want to buy low and sell high but in this case the sale comes before the purchase”.
Einhorn, whose fund Greenlight Capital manages $6 billion, is a rare example of a hedge fund manager who has written an autobiographical account. He probably wouldn’t have done that were it not for his epic battle with Allied Capital, a now-defunct US small-business lender. To understand the bitterness of that battle—and a similar one he had with Lehman before its bankruptcy—you have to appreciate the psychology of short-selling.
To many people, borrowing and selling a stock in order to buy it cheaply in the future appears to go against the natural order. After all, the stock market is supposed to give people a chance to participate in economic growth by providing capital to companies that drive that growth and benefit from it—such as Apple. Over the long term, the stock market provides a return above inflation precisely for this reason.
Wanting to reverse this seems almost diabolical. As Amis might put it, in September 2008, Einhorn bought Lehman shares for almost nothing. From then to late 2007, as the US economy grew and house prices increased, Lehman stock surged until Einhorn sold the shares for a handsome profit in September 2007.
That whiff of brimstone provides some explanation of why Einhorn encountered such difficulties in his Allied short, where company PRs found it easy to brief journalists against him, and rather than regulators listening to his allegations of irregularities at the company, they investigated him instead.
Einhorn is not oblivious to this psychological context. By his own account, he is careful to have keep Greenlight’s short positions as a smaller percentage of its overall portfolio than long ones (for example, Greenlight is currently a significant shareholder in Apple Inc). This is not just because short-selling is riskier—he recounts instances during the dotcom bubble where he was forced to exit shorts that went sky-high—but also for psychological reasons. “I have no desire to spend my life hoping for a market crash”, he writes.
Rather than bet against the rising tide that lifts all boats, Einhorn looks for individual boats that are holed below the waterline—in other words, companies whose financials don’t add up, suggesting hidden problems or fraud. That separates him from the ‘big shorts’ such as John Paulson or Steve Eisman who forecast the subprime meltdown and profited from it with credit default swaps. By contrast, Greenlight entered the crisis in early 2007 with a large stake in subprime lender New Century Financial, a bet that cost Einhorn heavily.
Einhorn evolves his short positions with a forensic approach that pits him directly against his target companies and their (usually bullish) analysts. Unlike many hedge fund managers he is relatively transparent about what he does and sticks to his guns, often for years at a time. Once he has identified a target and shorted it, he often shares his analysis with other investors at industry conferences.
That makes Einhorn resemble an investigative journalist whose job is to sniff out corporate scandal and put it in the public domain. The key difference, and one that allowed PRs to undermine him in some journalists’ eyes, is the fact that he has a bet against the companies he talks negatively about.
Einhorn rebuts the charge that he publicises his shorts in order to drive their stock prices down. The way Einhorn sees it, having a strong opinion about a company isn’t meaningful without a bet that makes the opinion credible. Talking about the opinion is then just a matter of revealing the truth. And he complains that long investors don’t get similarly accused of trying to drive up the prices of holdings they talk about publicly.
Einhorn’s best defence against the dirt that gets thrown at him is to argue that his shorting helps keep capitalism honest. The Allied story highlights the difficulty that investigative financial journalists have in tackling stories based on the subtleties of accounting and valuation. Why begrudge the likes of Einhorn the reward of a (risky) short sale in return for helping to expose fraud at a company like Allied that the press failed to uncover?
While Allied never was a particularly important company in its own right (knowing this makes it hard to keep following the minutiae of Einhorn’s book at times), it was a shadow bank dependent on government tax breaks and loan guarantees, and exploited the politics of small-business lending to the hilt. Einhorn shows how toxic this environment can be for regulators—something worth remembering today when shadow banking, government loan guarantees and support for small-business lending are still hot issues.
Lehman was on a different scale. Einhorn’s bet against Lehman focused on the investment bank’s $2.3 billion equity position in Archstone Real Estate Investment Trust. In an April 2008 speech, Einhorn pointed out that Lehman’s valuation of Archstone was about 20-30 percent too high, and was promptly attacked by Lehman and its supporters in the press as a rabble-rouser. In only a matter of months, Einhorn was vindicated.
Yet Lehman was the exception of 2008. Its investment in Archstone was relatively simple to analyse, compared with bailed-out institutions such as AIG, Royal Bank of Scotland or Citigroup whose balance sheets were riddled with far more complex holdings. Only investors like Paulson, who actively worked in secret with Goldman Sachs on designed-to-fail bets that were sold to RBS and others, had enough insight to take short positions against these banks as well.
If you are going to make Einhorn’s keep-capitalism-honest-with-short-selling argument apply to large banks, then you have to deleverage them and simplify them first. In other words, make the likes of JPMorgan and Barclays small and transparent enough so that if they misbehave, someone like Einhorn can come along and drown them in the bathtub without damaging society at large.
